From most value investing metrics, the stock of Gamco Investors (NYSE:GBL) looks dirt cheap. Based on the trailing twelve-month earnings per share, GBL trades at a Price-to-Earnings ratio of about 5.3:
If we use the 2019 Earnings per Share, the trailing P/E is about 4:
The operative word here is trailing, of course. By definition, Value Traps look cheap.
The Flight from Active Investment Strategies
Stock prices are not a reflection of the past but rather the market expectation of the future. As such, the stock price is reflective of the market perception of Gamco Investors as someone who has an open wound and with uncertain prospects of reaching the hospital in time.
That Gamco is bleeding out is hard to refute. Gamco is in the Asset Management Business and as such, the management fee that they generate will be a function of the volume of assets that they have under management. Since 2017, Gamco has been bleeding assets.
There are two main ways that assets under management shrink. Either the net returns (after taxes and fees) of the investments are negative between periods or by returning funds to investors either through dividends or redemption. Gamco, like other managers of active mutual funds, is bleeding assets as assets move from active strategies to passive.
The COVID Effect
At the end of the First Quarter of 2020, Gamco’s total AUM had fallen from $36.5 billion to $27.5 billion. As markets were at their lowest at the end of March, due to the Coronavirus Disease, $7.9 billion of the decrease was due to market depreciation. Net outflows were $953 million and distribution were $142 million.
In a press release on the 4th of August, Gamco Investors published the results for the Second Quarter of 2020. According to the release, Assets under Management at Gamco were $29 billion at the end of the first half of 2020. An expected reversion, but still far away from the $36.5 billion at the end of 2019.
Appreciation of investments accounted for $3.7 billion. This was offset by net redemption of $1.7 billion, mostly from institutional and private wealth accounts.
Taking Gamco Behind the Barn
Since the bleeding of Gamco is beyond debate, a more important question is if Gamco will reach treatment in time. As a thought exercise, we can try to take Gamco behind the barn and shoot it.
Imagine if all of Gamco’s investors would call in tomorrow and cease their relationship with the company. The open-ended mutual funds and initial and private wealth management accounts are liquid and easily redeemable for investors.
This leaves $6.8 billion of Closed-End Funds under management of Gamco Investors. Although it is certainly possible for unit-holders of Closed-End Funds to ratify the relationship with a fund’s investment manager, this capital is relatively captive. Gamco generated $67 million and $65 million in revenues from Closed-End Funds in 2018 and 2019 respectively.
Scalable Business Models
Most of the time, when people talk about scalable business models, it is in reference to how easily those companies can grow. In the context of Gamco Investors, the beauty lies in how the business scales down.
Even though Assets under Management have dropped by 1/3 since the end of 2017, costs have scaled-down along with it. As a result, Gamco has remained profitable even though revenues have shrunk dramatically. In 2017, Gamco’s operating income margin was around 40% and it remains around 37% for the trailing twelve months.
In a highly pessimistic scenario, where Assets under Management were to contract to $7 billion and revenues to $70 million, it is plausible that the company would still be able to generate an operating income of $20 million (~30% OI-margin).
Gamco Investors’ current market capitalization is around $330 million but the company has around $100 million in excess cash. As a result, in this extremely pessimistic scenario, GBL’s current stock price represents an EV/EBIT ratio of 11. On a trailing basis, the EV/EBIT ratio of Gamco is less than 3.
Getting Back to Growth
Most businesses consume cash to generate earnings, hence they need capital expenditures to grow. Fund management business models are at the other end of this spectrum. They are highly cash flow generative and there is a limit to what capital can do for growth.
This is a blessing and a curse for active asset managers, such as Gamco. Their mutual fund products have a structural disadvantage to passively managed index mutual funds and exchange-traded funds (ETFs). Passively managed funds charge lower fees and ETFs have a more tax-friendly structure for investors.
As a result, Gamco’s ability to grow its earnings is not a direct function of capital expenditures. Rather, Gamco will grow revenues and earnings only if its investment products are competitive in Marioterms of investment performance and product structure.
In the press release for the 2nd Quarter Results, Gamco highlighted specific business activities during the quarter, one of them being the following: “Gabelli Funds filed the registration statement for the Gabelli ActiveShares ETFs in May. These actively managed ETFs will have the same tax and operating cost advantages of mindless ETFs and will be priced intraday.”
ActiveShare ETF Products
There is a possibility that the development of ETF products around active strategies will allow Gamco to offer their investment strategies in new and improved packaging. This is currently not being done. Today all ETFs are either passive strategies or some form of Smart Beta (they are passively managed but the strategies are designed to beat a specific benchmark).
In the 2019 Annual Report, Dennis J. DeCore, who is leading the Active ETF initiatives at Gamco, says:
“[I]n 2020, Gabelli Funds LLC expects for the first time to enter the Exchange Traded Fund (ETF) business and bring to market several actively managed ETF products, using the first Non-Transparent ETF structure ever approved by the SEC, called ActiveShares.
ETFs have become a very important part of the financial landscape because they possess product attributes that a significant portion of the investing public desires, including better cost and tax efficiency and intra-day liquidity.
Since the first ETF, the S&P 500 Depository Receipt, was launched in 1993, the ETF business has grown by year end 2019 to $6.3 trillion in AUM worldwide, with the U.S. representing $4.4 trillion of that total. Prior to the approval of ActiveShares, all ETFs were transparent in nature, which means that positions are disclosed daily. In addition, the overwhelming majority of equity ETFs have been either “passive” in nature, or some form of “smart beta”. Very few were truly “active” in the traditional sense. What makes ActiveShares ETFs unique is their on-transparency.
As with our mutual funds, positions will be disclosed quarterly on a sixty-day lag (sooner if we so choose). This means that for the first time we can offer our clients access to our strategies in an ETF “wrapper” designed to both protect our intellectual property/proprietary strategies and our clients’ capital. This last point is extremely important. ActiveShares are designed to minimize or eliminate the possibility of “front running” and “free-riding”, which could be detrimental to investor returns. Importantly, from the investor’s point of view, ActiveShares will look and trade like any other ETF, ex the transparency. This will allow us to compete ETF to ETF with passive and other strategies, in addition to through our mutual funds.”
The Tender Offer
Gamco has over $100 million of cash and short term investments on its balance sheet. If the company is not able to reinvest this capital into the business at a productive rate of return, how should the company allocate it?
I think that we have a pretty strong hint in terms of what Gamco intents to do. In March 2020, Gamco announced a tender offer to repurchase shares for $30 million. The tender offer was structured as a Dutch Auction, whereby Gamco Investors would repurchase share in a range between $15-$17 per share.
Only 9 days later, Gamco announced the termination of the tender offer, as the offer was subject to certain triggering events: “On March 12, 2020, and March 16, 2020, the New York Stock Exchange (“NYSE”) suspended trading for fifteen minutes following a material decline in the S&P 500 Index. In addition, on March 16, 2020, each of the New York Stock Exchange Index, the Dow Jones Industrial Average, the NASDAQ Global Market Composite Index, and the S&P 500 Index experienced a decrease of more than 10% in the general level of market prices for equity securities in the United States.”
The filing also said that Gamco had increased the authorization for its repurchase program to $30 million. According to the Second Quarter 2020 press release, the shares outstanding are currently are roughly 27.6 million, decreasing by less than 30 thousand shares in the quarter.
Gamco currently trades at about $12 per share, 20% under the lower bound set in the Dutch Auction from 5 months ago. In fact, the last time Gamco traded around $12 was more than 20 years ago. My guess is that soon enough, Gamco will either aggressively buy shares in the open market or announce a tender offer for a significant amount of their shares.
There is a floor to how much AUM they are at risk of losing and a smaller version of Gamco is likely to remain profitable and free cash flow generative. If any of the ActiveShares ETF products become successful, they can scale up their AUM fast. For investors in Gamco, this offers optionality that currently not reflected in the stock price of Gamco.
Time will tell if Gamco Investors’ stock is a Value Trap or not. I, for one, don’t think it is.
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