Play the Rebound With Asset-Manager Stocks

Whether your mutual fund soars in value or drops like a stone, you still must pay fees to the manager of the portfolio, quarter after quarter, year after year. That's one of the reasons why the business of managing other people's investments is such a good one.

Asset-management firms are often found among the stock market's top performers. Boston-based Eaton Vance, for example, was the top-performing U.S. stock during the 18-year period stretching from April 1979 to October 2007, producing an annualized 32% return, according to merchant bank Grail Partners.

The business is not labor-intensive and requires relatively little capital investment. As a result, it is highly profitable. Operating profit margins of 25% or better are not unusual. Those profit margins tend to stay high because customers -- for better or for worse -- aren't terribly price sensitive. Investors pay far more attention to a fund's one-year or three-year returns than they do to its expense ratio. In addition, barriers to entry are fairly high. It takes skill and a track record to attract investors' money.

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But despite asset managers' eye-popping numbers, it can be easy to forget during a bear market just how successful they usually are. Their fees are usually based on a percentage of the assets they manage. And when the market goes south (Standard & Poor's 500-stock index fell 39.9% over the past year through April 8), asset managers lose two ways: The value of the assets they manage falls, and customers compound the damage by pulling their money out of the market. Last year, investors pulled more than $256 billion out of stock funds and hybrid funds (those that own a mix of stocks and bonds), although the loss was somewhat offset by money moving into bond and money-market funds, according to the Investment Company Institute, the mutual fund industry trade group. Unfortunately for money managers, bond and money funds usually command lower fees than stock funds do.

As a result of all this bad news, once-lofty share prices of asset managers have fallen back to earth. Those that are part of the S&P 500 fell an average of 49% in 2008 (the index lost 37% that year), although they have held steady so far this year. (Eaton Vance, by the way, is down 49.5% from its high point last summer.)

Investors looking for a way to play a market rebound couldn't do much better than asset managers. Since it doesn't cost much more to manage $100 billion than it does to manage $50 billion, the profits from any new dollars that come through the door go directly to the bottom line. So when the market rises, shares of asset managers -- at least those that manage mostly stock funds -- should rise faster. Of course, the same principle works in reverse, which is why these stocks fell further than the market on the way down. Asset managers were unable to cut their costs quickly enough as their assets under management evaporated.

Although stock-heavy asset managers should get a bigger pop from a rising market, we prefer more-diversified, all-weather firms. Even though management fees for bond and money funds are generally lower than for stock funds, companies that play in each of these markets should produce smoother earnings results, overall. They also will provide more protection for your portfolio should the recent stock rally, which boosted the S&P 500 by 20% from March 9 through April 8, prove to be a head fake.

We also prefer firms that cater primarily to institutional investors -- pension funds, insurance companies and the like -- rather than individual investors. Institutional money is cheaper to manage (which is reflected in lower fees for institutional investors) and tends to stay put longer. In addition, size matters in this business, and so does international reach. In coming years, sovereign-wealth funds and the rise of middle-class investors in emerging markets will be important sources of growth in the asset-management business. Among the companies that should benefit from some or all of these factors:

AllianceBernstein (symbol AB) manages $462 billion (down from $800 billion a year ago), primarily for institutional investors, which account for 63% of its assets under management. Individual investors provide for just 22% of assets. During good times AllianceBernstein boasted an operating profit margin of better than 30%. But the margin was just 16% in the fourth quarter of 2008, a period in which management fees fell 43%. Still, when the market rebounds, so will New York City-based AllianceBernstein. It is among the most international of U.S.-based asset managers. About 40% of its assets come from non-U.S.-based investors, so its health is not entirely dependent on U.S. markets.

The firm is organized as a master limited partnership, so it must pay out most of its profits to shareholders. At the stock's April 8 close of $16.57 it is 75% below its 52-week high and yields a robust 6.2%. The payout -- $2.68 over the past 12 months -- will rise and fall along with the firm's profitability. Investors will also face more paperwork at tax time because of the partnership structure.

Although about two-thirds of assets managed by Franklin Resources (BEN) come from individual investors, we like the nice mix of stock funds (44%) and bond funds (35%). We also like Franklin's size -- $378 billion in assets under management (down from $647 billion at the end of 2007)-and its strong balance sheet. The San Mateo, Cal., firm has minimal debt and about $14 a share in cash and investments, which can be used to buy weakened rivals. Franklin pays an 84-cent annual dividend (resulting in a 1.4% yield at the stock's April 8 close of $57.00) and is one of the few asset managers that is currently buying back its shares.

Investors with a taste for risk might want to look at Legg Mason (LM), one of the hardest- hit asset managers. The Baltimore-based firm has suffered not only from poor performance - super-high-profile manager Bill Miller's Legg Mason Value fund ranks among the bottom 1% in its category - but also from exposure to sub-prime mortgages in its money-market funds. At $17.25 the shares are off 70% from a year ago and trade for about half their book value (assets minus liabilities).

Legg Mason recently unloaded the last of its sub-prime-related assets, and has about $1.5 billion in cash (more than $10 a share), counting a tax-loss benefit due in June. The company, which has grown by acquisition over the past decade, has about $3.5 billion in debt. But it appears able to meet its debt covenants, freeing managers (and investors) to focus on its strengths: $700 billion in assets under management (down from $999 billion at the end of 2007) and a well-diversified portfolio of management firms, including Western Asset Management, a bond investing firm catering to institutional investors, and the Permal Group, which manages funds of hedge funds. The 96-cent annual dividend provides a 5.5% yield.