Record — Update 30 November 2015

Record successfully expanded its passive hedging strategy mandates in H116 and these now account for 79% of its AUME and produce 41% of its management fees. This represents steady progress from the 61% of AUME and 15% of fees in 2012, as we show in the following exhibits. Passive mandates are considered to be a stable revenue stream, less sensitive to investor sentiment than other strategies and therefore useful in ensuring that Record continues to earn profits in a variety of economic environments and reduces profit volatility. Passive fees covered 22% of administrative expenses in 2012, but 64% in H116, showing the improvement in Record’s quality of earnings in that period. As a currency manager, Record manages the impact of foreign exchange fluctuations and not the underlying assets, so its assets under management are notional rather than tangible. To distinguish them from the AUM of conventional asset managers, Record uses the concept of AUME.

Record offers clients two main types of hedging strategies: passive hedging and dynamic hedging. The former seeks to reduce the client’s exposure to currency risk as its sole objective, while dynamic hedging mandates have this reduction as their principal objective, as well as a secondary one of generating value. Dynamic hedging seeks to allow clients to benefit from foreign currency strength while protecting them from weakness. Passive hedging is particularly popular in Continental Europe (especially Switzerland), Record’s largest market by AUME with 68% of the total at 30 September 2015. Regulations require Swiss pension funds to hedge the currency exposure of their non-Swiss franc assets and Record has successfully won some of this business away from the local Swiss banks. Record’s passive hedging mandates performed in line with client expectations in H116.

Dynamic hedging tends to be more popular with Record’s US clients. In H116 the US dollar generally weakened against developed market currencies, reflecting concerns about a delay to US interest rate increases, and Record’s dynamic hedging strategies allowed its clients to benefit from the foreign currency strength.

In addition to offering clients hedging services, Record offers currency for return products. It does not attempt to predict currencies, but seeks to exploit systematic features of currency markets to produce consistent returns for its clients. The strategies are:

In H116 the momentum and value strategies performed positively over the period, but the FRB and emerging markets strategies underperformed, as shown in Exhibit 3 below.

The underperformance of the FRB strategy was attributable to long positions in New Zealand and Australian dollars, high-yielding currencies, which depreciated in the period as a result of concerns over falling commodity prices. The emerging markets strategy underperformed as a result of the decline in emerging market asset prices due to fears surrounding a rapid deceleration of Chinese growth. As a consequence of the underperformance of these two strategies, there was a slight dip in Record’s multi-strategy performance in H116, although it has remained positive since inception. In H116 the multi-strategy product obtained the three-year track record that many consultants require before they recommend the product to their clients, so the slight downturn in performance is unfortunate, but Record does not believe it is serious enough to permanently affect the attractiveness of the product to clients.

NNM (net new money) was -$0.6bn in H116 largely as a result of the reduction in the size of currency for return strategies, which fell by $2.4bn; there were net inflows into passive hedging strategies of $1.8bn. The fall in the currency for return strategies was largely the result of the decline in a bespoke mandate to manage a client’s currency position. When the mandate increased in March 2015 Record warned that its size could be volatile, and this proved to the case. In August 2015 Record informed the market that the client had withdrawn $2.8bn from the mandate, so there was $0.4bn net of other inflows into the currency for return strategies. As a consequence of the net outflows and the performance of the assets, average AUME in dollar terms in H116 was 4% higher than in H215 and H115. Fee rates by strategy in H116 were unchanged for the hedging strategies, but fell by 1bp for the currency for return strategy, reflecting a slightly lower fee level for the bespoke mandate. The increasing importance of passive hedging in the mix resulted in a decline in the total management fee rates of 4% compared with H215 and a 2% fall compared with H115. The rise in average AUME in dollar terms, together with favourable currency movements, offset the slight reduction in average fee rates and led to H116 management fees rising 13% y-o-y and 4% h-o-h. Record did not earn performance fees in H116, unlike H215 when it earned performance fees in its dynamic hedging mandates, and there were £0.2m of losses recorded in other income from Record’s investment in its seed funds, which declined in value during the period. The outturn was a 9% rise in underlying revenues y-o-y and 2% fall h-o-h. In addition, Record consolidates the results of seed funds in which, along with those connected to it, it has a controlling interest according to accounting rules. The non-controlling element of these seed funds incurred a loss of £0.4m in the period, resulting in reported revenue of £10.4m in H116, a rise of 3% on H115 but a 6% fall on H215.

Expenses in H116 increased 9% y-o-y, and 3% h-o-h, mainly driven by a previously announced 10% salary increase across the board from May 2015 to attract and retain top-quality staff. The underlying operating margin in H116 was 33.4%, in line with H115. After deducting profits from non-controlling seed funds, attributable profits increased 10% y-o-y in H116, but fell 4% h-o-h.

The interim dividend was increased to 0.825p from 0.75p last year, and Record has indicated that it will also pay a final dividend of 0.825p, making 1.65p for the full year, the same as the previous year.

Record had cash and marketable securities of £33.4m at 30 September 2015, up from £30.1m at end March 2015 and we estimate its Tier 1 capital is around £33m. This compared to a published Pillar 1 capital requirement of £2.6m and a Pillar 2 capital requirement of £8.5m, so the company remains well capitalised.

We have made minor changes to our revenue and profits forecasts and summarise these in Exhibit 5 below. Record has said that since end September 2015 it has started a new dynamic hedging mandate of around $600m and converted a £900m dynamic hedging mandate to a passive one of reduced size. We have incorporated these announcements into our forecasts for H216 and 2016 but, as usual, have not included any NNM inflow for Record’s considerable efforts to win additional mandates.

We maintain our dividend forecasts at 1.65p for 2016 and 2017. Management has said that it wishes dividends to be at least covered by earnings, which will be the case in FY16 and FY17 if our forecasts are realised.

The near-term outlook for Record’s business depends on two market developments:

Record believes that these two factors could increase the demand for its hedging services and increase the opportunities for its currency for return strategies to produce positive returns and be attractive to clients who award Record increased currency for return mandates. The increase in currency volatility over the last year can be seen in the large currency moves in the Swiss franc when the SNB ceased to cap its value to the euro in January 2015; other examples include the moves in many emerging markets currencies as a result of the slowdown in the Chinese economy and the collapse in commodity prices.

The likely rise in US interest rates has been a long time coming, but expectations that it will happen soon are high, with a Bloomberg survey reporting a 74% probability for a December 2015 hike, 77% for one in January 2016 and 88% for March 2016. The US dollar has been strong for some time, which suggests that the currency may already have discounted some of the increase in US rates, but may still continue to strengthen after the rate rise has occurred. In the past the US currency has exhibited long cycles of performance and underperformance against other currencies, as shown in Exhibit 6 below, and if these are repeated the recent strength of the US$ could be just the start of a long period of outperformance. Record believes that US interest rate rises, together with a strengthening currency, could be the tipping point for many of its prospective US clients to engage its services. It continues to see a high level of currency engagement, for both its hedging and currency for return strategies.

Record’s P/E ratio for FY16e is 12x, 18% lower than the average multiple for US and UK asset managers, according to Bloomberg data, although the range is wide – from 7.4x to18.5x – indicating that P/E ratios are only a rough guide to valuations of asset managers. Record has a large amount of cash and cash-equivalent resources in its balance sheet, equivalent to 52% of its current market capitalisation. On an EV/EBITDA basis, it is trading at around a 50% discount to other asset managers for FY15 and its multiples do not appear challenging. Record has a prospective dividend yield of almost 6%, a strong balance sheet and, unlike traditional asset managers, should benefit from currency volatility.