Eco Investor December 2015

Core Securities

Is Australian Ethical Investment Ltd a Value Investment?

Damien Lynch
Managing Director
August Investments Pty Ltd

A general principle in value investment circles is that the higher the rise in a company's share price, the lower the value of those shares. But is this necessarily so?

We will use the ASX listed shares of Australian Ethical Investments Ltd (Australian Ethical) as an example.

Australian Ethical is a funds management company with $1.2 billion under management. The organization is considered by many to be the premier ethical investment group in Australia, with high returns to fund investors and a strong green and social focus for its investments.

The company's share price on the ASX is currently $61, a rise of 300 per cent over the last three years. A basic tenant of value investing is that once a company's share price has risen significantly, the value of that company's shares falls significantly. So, do Australian Ethical's shares represent good value at the current price?

We will examine three aspects of the company's accounts to attempt an answer to this question. These areas are earnings, balance sheet strength, and growth in financial ratios.

Earnings

At first sight the earnings profile of the company is poor. Based on the 2014/15 accounts, at $61.00 the PE of 33.8 is very high and not considered to be good value. The dividend of $2.00 per share is actually greater than profit of $1.80 per share for the same period, i.e. the retention rate for the period was negative. This is usually seen as a negative and unsustainable in the long term. However, cashflow is a massive $5.92 per share, or 9.7 per cent per annum. This moderates somewhat the assessment of the negative retention rate. Such yields are a function of the share price and management may not have much control over this.

Return on equity (ROE), which is unrelated to the share price, is a healthy 17.7 per cent. This could also indicate that the share price has gone too high too quickly.

For an investor purchasing shares at $60, the earnings profile could be considered to be, at best, below average.

Balance Sheet

When we turn to the balance sheet, a totally different proposition emerges. Basic balance sheet ratios relating short term assets to long term assets and other such ratios are very strong. (For example, the current ratio - current assets divided by current liabilities - is a very healthy 2.5 times.) The picture gets even better when we look at the cash of the company. Cash in the bank is twice the amount of total liabilities (total debt and provisions), or $12.23 million cash compared with $6.08 million liabilities. The company is wallowing in cash. The balance sheet is so strong it could be considered 'lazy'. Management needs either to spend some money on future development or return some capital to shareholders.

So the balance sheet can be assessed as very strong.

Growth

In the last financial year Australian Ethical's profit growth per share actually fell by 22 per cent. However, this was mainly due to a cut in fees charged to superannuation accounts managed by the company, as well as increases in general expenses. Further fee cuts are expected in future years, with further possible declines in profit. We see this as short term pain for long term gain, as a cut in fees will influence some superannuation investors to take up the company's products and existing investors to stay with the company. It is yet to be seen to what extent that management follow this path, and if it will take some time for the short term profit declines to reverse.

That is the short term experience. When medium term historical growth rates (weighted average over five years) are considered over a number of areas, Australian Ethical comes in positive for all of them. This applies even to the growth in profit per share, which is 8.7 per cent per annum. Operating cashflow has grown at 45 per cent per annum and the value of the assets held by the company as measured by net tangible assets has grown at 12 per cent per annum per share. These growth rates explain how a company share can increase in value, yet can still continue to be considered to be a value investment.

Our assessment is that such growth rates will continue, with the exception of growth in profit per share, as discussed earlier. We based this expectation on ongoing growth of funds under management. Funds under management grew by 32 per cent over 2014/15. We expect future growth, even at a lower rate, to offset the reduction in fees and any growing level of expenses.

The overall growth assessment could be considered as strong.

Other considerations

Earnings, and hence dividends, have been significantly impacted by the issue of options, performance rights etc to staff, and senior management in particular. AEF has a high ratio of board/senior staff remuneration as a proportion of earnings. It would seem that a significant benefit would flow to shareholders if existing senior staff remuneration is moderated to a small extent. However, even after that, an investment in Australian Ethical could be considered as a high value investment.

Competition in the area of ethical investment funds management is increasing. While Australian Ethical has been considered to be the premier such organization, there are new entrants to the market as ethical investment becomes more mainstream. One such is Future Super. While a recent entrant just this year, Future Super is actively targeting investors in Australian Ethical superannuation to change over to Future Super, claiming to be the greener of the two. Whether this strategy makes a significant impact on Australian Ethical's funds under management (or even if such a strategy may backfire), is yet to be seen.

This assessment of Australian Ethical is made purely on the published accounts of the company and the comparison of its staff remuneration ratio to that of similar companies.

Overall, despite the meteoric rise in the company's share price over the last three years, shares at the current price of $61.00 could still be considered to represent good value for a cautious investor.

Note: This assessment is not intended as investment advice. Investors should seek professional advice which relates to their personal circumstances. The author is a former Managing Director of Australian Ethical and he and August Investments hold shares in Australian Ethical Investments Ltd.

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