October 2022: AMCs – Growth at a reasonable price

In this newsletter we would like to review asset management companies (AMCs) which are part of our portfolio. The reason we like AMCs are manifold – 1) Strong financials – AMCs which have achieved scale have very high return on equity (ROE) – in fact in many cases, the core ROE is infinite because the cash on the balance sheet exceeds the net worth of the company. Moreover, this is a business which has zero inventory, very low receivables and requires very little by way of fixed assets either. 2) Long runway of growth – The Indian financial sector is underpenetrated and investment into mutual funds is low compared to developed markets. The total Assets Under Management (AUM) of the Indian mutual fund industry as a proportion of GDP is 16% against 120% in US and 74% for the global average, as on 31-Mar-22. 3) With scale, operating profits are expected to grow at a faster pace than AUM.

There are however some question marks around the third point in recent years. In 2018, SEBI made some changes to the mutual fund regulations. One change was that SEBI determined that as a mutual fund scheme grew in size, it must reduce the Total Expense Ratio (TER) that it can charge to the mutual fund scheme. The fee of the AMC and the distribution expenses are both part of the TER. SEBI also divided the various schemes of the mutual funds into different categories and mandated that an AMC can have only 1 scheme in each category. As AMCs consolidated their schemes in the same category into 1 scheme, these schemes became larger in size and thus the TER on these mutual fund schemes reduced, thus affecting the revenue yield for AMCs. Also, with increasing competition, AMCs were forced to pass on a higher share of the TER to distributors.

What has further depressed AUMs in the current year is that debt mutual funds saw a lot of outflows because returns for longer term debt mutual funds were muted because of the rise in interest rates (Rising interest rates cause bond values to fall). There is also significant growth in passive products like Exchange Traded Funds (ETFs) and index funds which typically are low cost products, and thus the yield that an AMC makes on a passive product is significantly lower than active mutual funds. As a result of all these factors, the profit growth for the industry from FY2018 to FY2022 has been slower than the growth in the AUM.

What must be noted here is that the reduction in TER has benefited mutual fund investors through lower pricing. This has made investing through mutual funds a very attractive option for investors and this should spur long term growth in the industry. A sizable Systematic Investment Plan (SIP) book, at Rs 156,000 crore (annual) which is also steadily growing every month further adds to the growth trajectory. While there is a compression in yields for AMCs over the last few years, over the long term, the lower TER should be set off by scale and operating leverage. This is a business where growth in AUM happens just by the growth in the underlying investment over the long term – other levers add to this growth.

Asset Management is a business which generates healthy cashflows and the listed AMCs have also been distributing a significant part of their profits via dividends. As such most of the listed AMCs are trading at attractive dividend yields as also a reasonable Price to Earnings ratios. This is in particular contrast with the high valuation of other high-quality companies with good growth prospects. A great company at a reasonable price is just what we think the doctor ordered.