October 2020: Mutual funds sahi hai

In this newsletter, we would like to discuss asset management companies (AMCs). Asset management is a business we have some understanding of, since we are ourselves engaged in the same business. It is a tough business when you are small in terms of asset under management (AUM) because fixed costs are high and the base on which you are earning is small. However, as you attain scale, the business economics improve considerably – the fixed costs can be expensed over a larger and growing revenue base and the operating margin for an Indian AMC that has achieved scale, can be as high as 75%. Moreover, the business requires very little in capital and therefore the business offers huge free cash flow potential – free cash flow is as high as 100% of the net profit over the last 5 years.

What is furthermore attractive about this business is that it has a very long runway of growth. The Indian financial sector is underpenetrated and the financialization of savings in India is a long-term growth story. Out of India’s population of 1.3 bn people, only about 59m file tax returns, roughly 40m have depository accounts and only 21m have folios with mutual funds. The total AUM in the mutual fund industry is just 12% of GDP as compared to 120% in the US and 63% for the global average. One can thus visualize a very long-term growth story for AMCs in India as Indians move away from physical savings to financial savings.

To set up a mutual fund in India requires a license from SEBI, the regulator. The success of a mutual fund depends on 4 pillars – brand, distribution, risk management and performance. Over the years, only a few players have managed to get these 4 pillars right and have managed to achieve scale. The industry is reasonably consolidated with the top 10 players controlling about 84% of the market (up from 79% in FY2015) and continuing to gain share. Given the scale economics, it becomes tough for a new entrant in this space.

An asset management company has 3 levers of growth, particularly for companies who can hold on to their existing investors – first is that the underlying asset is expected to experience some growth, in line with the returns generated; second is that existing investors are expected to add more money over the years as they channel their savings into investments and the third is acquisition of new customers. As such, because of these 3 levers of growth, we expect asset management companies to show robust long-term growth in assets, well ahead of nominal GDP growth. Over the last 10 years, the total assets of all Indian AMCs put together, have grown at 15.1% p.a. while the 20 year growth number is 17.7% p.a.

We have invested in 2 AMCs – HDFC AMC and Nippon India AMC. HDFC AMC is the market leader in the industry with 14-15% market share while Nippon India is the fifth largest with 7-8% market share. Both have achieved scale and are immensely profitable. HDFC AMC is one of the most profitable asset management companies in the world. In 2019 Nippon Life bought a controlling stake from Reliance Capital and became the sole promoter of Nippon India AMC. Since then, the company has been trying to gain back its lost market share and is also working on improving its cost structure to improve profitability. As such both companies present a great opportunity to harvest the long runway of growth available to asset management companies in India – moreover this growth is likely to be accompanied by improving profitability as the companies scale up.