Fears over the health of the financial system intensified last week on the back of a deteriorating US employment picture. These worries once again pushed up inter-bank lending rates (ie, Libor), which in turn upped the pressure on the hedge-fund industry. When credit was booming and the cost of borrowing was cheap, many hedge funds loaded up on debt, using it to ratchet up their returns. Now banks are demanding loans be repaid when investments turn sour and funds are being forced to off-load assets at rock-bottom prices to raise cash. Clearly, this is good news for stock-pickers like myself, since it generates excellent buying opportunities. For the hedge industry, however, it is excruciating: many funds are going bust and the reputation of the remainder is hardly being enhanced.
Man Group (EMG), tipped as a BUY by Evolution Securities
The big benefit of hedge funds is supposed to be that they can generate positive returns in any weather. But after recent events it is clear that the reality is somewhat different: some managers are more well-healed gamblers than generators of absolute returns.
I suspect that all this will lead not only to substantial cash outflows over the next few years, but will also put pressure on management fees – which historically have been a whopping 2% a year and 20% of profits.
With this backdrop, I’m surprised that shares in Man Group – the world’s largest hedge-fund provider and grand-daddy of the sector – haven’t yet been affected by the turmoil. This may partly be due to the board’s upbeat trading statement in January, which said that funds under management grew by 4.5% to $71.7bn in the last quarter of 2007 and that its flagship AHL fund was up 5.1%. This sounds good, but the figures exclude the storms so far in 2008.
Furthermore, the valuation looks stretched, even for a well-run business such as this. The City is forecasting underlying earnings per share of 34p for the year ending March 2008, putting the stock on an expensive multiple of around 16 times earnings. Indeed, in light of the likelihood of choppier waters ahead, I just cannot see this premium justified when compared with the rest of the sector.
For instance, rival RAB Capital, who themselves have been felled by gambling on the wrong side of the Northern Rock fiasco, are presently trading on a lowly nine times p/e. I would rate Man Group, assuming it doesn’t slip up on any giant banana-skins, on a 12 times p/e ratio, putting the shares at 410p or 25% lower than today. But if they were to suffer a major loss, then I could see the shares going into freefall, driven down by a tsumani of fund withdrawals.
Overall, with the industry under the kosh and the stock looking vulnerable, I would advise investors to lighten up their positions and recycle gains elsewhere.
Recommendation: TAKE PROFITS at 548p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments