Brookfield Asset Management: Strong Value Creation In The Long Term
Brookfield Asset Management (BAM) has created a massive amount of value for shareholders over the long term. The asset management company has more than tripled the S&P 500 over the years on the back of consistent cash flow growth and sustained profitability.
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Data by YCharts
Past performance does not guarantee future returns, and the stock is trading at all-time highs, so a pullback in the short term is to be expected.
However, in terms of both fundamental quality and valuation, Brookfield Asset Management still offers abundant upside potential for investors in the years ahead.
A High-Quality Business
With the acquisition of a 61.2% interest in Oaktree Capital Management, Brookfield has cemented its position as a leading player in the industry. Considering Oaktree and Brookfield together, assets under management stand at $500 billion for the new company and fee bearing capital is $270 billion. The combined company has 1,800 institutional investors globally.
Size and diversification are key sources of competitive strength for the business. According to a recent survey, nearly 25% of new capital raised is going to the top 10 players in the sector, so a successful market leader such as Brookfield Asset Management tends to get stronger over time.
In essence, Brookfield is the business of investment management and capital allocation, and management quality is crucially important in these areas. When you buy a share in the stock, you are basically investing in CEO Bruce Flatt and the rest of his management team since capital allocation decisions make all the difference in the world.
Flatt joined Brookfield in 1990 and became CEO in 2002. Different media outlets have referred to Mr. Flatt as "Canada's Warren Buffett" because of his value approach to investing, his focus on the long term, and his impressive track record over the years.
In a talk at Google in 2018, Flatt explained his approach to risk management:
We make lots of mistakes. It's not possible in investing not to make mistakes, so everyone should remember that you just have to keep making them. We don't try to limit the amount of mistakes, we try to limit what the effects of those mistakes are.
This is a crucial consideration for investors in Brookfield Asset Management. You want to invest alongside a CEO who takes calculated risks and who understands that risk needs to be managed because mistakes are going to happen sooner or later. Importantly, management owns 20% of the company, so their incentives are well aligned with those of shareholders.
In times of historically low-interest rates all over the world, with real rates in negative territory across Europe and Japan, institutional investors are increasingly allocating larger shares of capital to real assets in order to achieve their returns targets. This puts Brookfield in a position of strength over the long term.
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Source: Brookfield Asset Management
Management calculates that target allocations in real assets will increase towards 40% in 2030 versus nearly 25% now, and the potential capture in size is worth around $25 trillion. As long as the company continues to play its cards well, Brookfield should benefit from outstanding growth opportunities in the years ahead.
Reasonable Valuation
A company such as Brookfield Asset Management can be complex and hard to value, and the traditional valuation metrics don't always tell the whole story for such a unique business. However, when approaching valuation from multiple perspectives, the stock looks reasonably valued, especially for such a high-quality business.
Management publishes an estimated plan value, which is basically calculated by applying valuation multiples to fee-related earnings and carried interest in order to provide a value estimate for the business. As of September of 2019, this value stands at $80.14, which implies that the current market price of around $57.42 represents a discount of almost 40%.
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Source: Brookfield Asset Management
Management estimates of value should always be taken with a grain of salt, and we obviously need to consider the fact that value changes over time. If the economy enters a recession, for example, these kinds of valuation metrics would be affected to a considerable degree. That said, Brookfield Asset Management has a solid track record in terms of value generation over the long term.
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Source: Brookfield Asset Management
Looking at a more simplistic valuation metric, Brookfield Asset Management is generating nearly $2.5 billion in annualized free cash flow and $4.3 billion in funds from operations (FFO). This means that the stock is trading at a multiple of nearly 13.4 times FFO. This back of the envelope valuation is not unreasonable at all, especially if cash flows continue moving in the right direction over the long term.
If we take a look at the evolution of the price to sales ratio, which admittedly has many shortcomings as a valuation metric, in this case, shares of Brookfield Asset Management are trading near the low end of the valuation range in the past decade.
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Data by YCharts
Valuation is not just about looking at the company's ratios in isolation. Price is what you pay and value is what you get, so the price tag needs to be evaluated in the context of other quantitative return drivers such as financial performance and momentum.
The PowerFactors system is a quantitative algorithm that ranks companies in the market according to a combination of quantitative factors that includes: financial quality, valuation, fundamental momentum, and relative strength.
In simple terms, the PowerFactors system is looking to buy good businesses (quality) for a reasonable price (valuation) when the company is doing well (fundamental momentum) and the stock is outperforming (relative strength).
The algorithm has delivered market-beating performance over the long term. The chart below shows backtested performance numbers for companies in five different PowerFactors buckets over the years.
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Data from S&P Global via Portfolio123
This has bullish implications for Brookfield since the stock has a PowerFactors ranking of 83 as of the time of this writing. This means that the stock is firmly in the top quintile of companies based on a combination of quantitative return drivers as measured by the PowerFactors system.
The quantitative algorithm does not guarantee future returns. The backtested data shows that, in aggregate, companies with strong rankings tend to deliver higher returns than those with low rankings over the long term. However, this does not tell us much about how a specific company such as Brookfield Asset Management is going to outperform in a particular period.
Also, stocks with high PowerFactors rankings generally carry strong price performance, and this can be a double-edged sword. Winning stocks tend to keep on winning more often than not, but they also tend to produce bigger losses when the trend changes its direction.
Brookfield Asset Management is a very particular business, and valuation is difficult to assess in these cases. However, it is not about reaching a precise fair value estimate for the company.
At the end of the day, the true value of the business will depend on the cash flows that such a business will produce in the future, and the future is always a matter of probabilities as opposed to certainties. For this reason, we need to be humble and avoid false precisions when analyzing valuations.
The main point is assessing if Brookfield Asset Management is offering a reasonable valuation for investors at current prices. Considering management estimates of value, traditional valuation ratios, and multi-factor analysis, I see no reason to consider that Brookfield is unreasonably priced by the market right now.
Risk And Reward Going Forward
The asset management business can be particularly cyclical. During a recession, companies in the industry tend to not only deliver lower earnings, but they can also lose some of their investors in a full-blown financial crisis.
The company has lots of exposure to areas such as renewable energy, infrastructure, and real estate. These sectors are highly cyclical, and the impact of a recession could be considerable.
The chart below shows the evolution of the stock price and the maximum drawdown - meaning maximum decline from the peak - for Brookfield Asset Management over the long term. The 2008 recession was a major blow for the stock price.
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Data by YCharts
Granted, the 2008 recession was one of the toughest ones in history, and Brookfield Asset Management is now larger, stronger, and more diversified. Nevertheless, the stock price would probably be vulnerable to deteriorating economic conditions in the future.
With the company having such a diverse range of operations all over the world, it can be difficult for investors to evaluate the true quality and strength of its different investments and business. Management is doing a good job at providing clear metrics to increase visibility, but this is still a risk factor to keep in mind, and it can provide a reason why the stock could trade at discount to intrinsic value.
In spite of these risk factors, Brookfield Asset Management is a high-quality company with a smart business model and a management team with a proven track record of success over the long term. Valuation is more than reasonable for such a strong business.
The stock price is in a vigorous uptrend, and it looks overbought in the short term. In this context, it makes sense to be patient when building a position in Brookfield Asset Management since a pullback could be a distinct possibility in the short term.
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Source: TOS
However, as long as the fundamentals remain strong and management keeps leading the company in the right direction, any pullback down the road should be considered a buying opportunity to acquire a world-class business for an attractive valuation.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in BAM over the next 72 hours.
Disclaimer: I wrote this article myself, and it expresses my own ...
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