All the Right Moves

W.P. Stewart is an asset-management company with a 28-year record of beating the S&P500. It is also a publicly traded stock with a dividend yield of 6% and a management team making all the right moves when it comes to returning cash to shareholders.

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By Zeke Ashton
August 28, 2002

I first discovered W.P. Stewart (NYSE: WPL) a year ago while researching high-dividend-paying stocks for The Motley Fool Select. The investment-management company based in Hamilton, Bermuda, certainly qualifies as a high-dividend payer, routinely paying out 60% to 80% of its reported earnings in dividends every year. But that's just one reason why I now own the stock in every portfolio I manage.

W.P. Stewart shares have only been listed on a U.S. exchange since December of 2000, when the company completed a public offering of about 25% of its common shares then outstanding. But the company has a 28-year history as a provider of investment-management services, primarily to high net worth individuals. The founder and CEO of the company, William Stewart, espouses an investment philosophy that sounds like a hybrid of Warren Buffett and Janus. Here's a sample quote from the 2001 annual report:

Our experience has taught us that by identifying and focusing on leading companies in great businesses that are likely to increase profits every year, in good times and bad, we can optimize the return and minimize the risk associated with any investment portfolio.

The W.P. Stewart investing approach borrows from Warren Buffett in its emphasis on the "look-through" earnings power of the companies within its investment portfolio, and also in its willingness to run concentrated positions. This approach essentially means that W.P. Stewart runs extremely concentrated portfolios of large-cap growth stocks.

According to the 2001 annual report, the total number of publicly traded companies in the world that meet its investing criteria is in the range of 30 to 40, and the company typically invests its managed portfolios in only the 15 to 20 of these that offer the most attractive current valuations. The company relies on extensive research to identify any business risk associated with its portfolio companies.

This unique approach has worked well, judging by the company's historical returns. From inception in 1974 through the end of 2001, W.P. Stewart's portfolios have compounded at 20.7% post-fee versus the S&P500, which has averaged 14.8% annually.

Even more impressively, in each of the 10 annualized periods from July 1, 1992 through June 30, 2002, the company's investment performance has outperformed the S&P500 on both a pre- and post-fee basis.

Even in the great bull market of the last 25 years, 20% annual growth is getting close to Buffett territory -- and we all know what a great investment his company has been. I'm not saying that W.P. Stewart is Warren Buffett; don't misunderstand. I am saying that good investors are, by definition, good capital allocators, and therefore companies run by good investors tend to make for good investments.

Good investors make for good investments
Now let's look at the stock. W.P. Stewart intrigues me as a long-term investment for several reasons. The first is that the company is engaged in a business where exceptionally high profit margins are possible, a quality to which the company's historic pre-tax operating margins of over 50% would attest.

This high profitability holds true even in the worst of times -- now, for example. Since asset-management companies get paid on a percentage of assets annually, a massive bear market is the worst thing that can happen to them. With the S&P down a third, and the Nasdaq having lost two-thirds of its value in the past three years, this is a painful time for asset managers. Not only are the assets under management (or AUM) melting away, but many skittish investors are yanking what's left of their money out of the stock market, reducing managed assets further.

In the brutal second quarter, when the S&P500 dropped by 13.4%, W.P. Stewart's AUM declined by 12.6% from $9.5 billion to $8.3 billion. Net income dropped slightly more than AUM, dropping 14.5% to $14.8 million in the second quarter from $17.3 million in the first quarter.

The AUM decline was entirely attributable to capital depreciation, as total net asset flow was slightly positive for the quarter. The company's equity performance was also slightly better than the benchmark indexes in the quarter. Post-fee, the company's investment portfolios were down 12.1% for the quarter on a composite basis, versus the 13.4% loss for the S&P 500.

Even in the face of a horrible market downturn making for the worst industry environment in 30 years, the company's pretax profit margin in the second quarter was over 45%. That's amazing. There isn't a scenario short of nuclear war or alien invasion that would cause a company like W.P. Stewart to lose money.

The offshore advantage
Now let's look at the tax advantage of the company's Bermuda domicile, where corporate profit taxes are 10%. This gives W.P. Stewart a huge advantage over its U.S. counterparts, which generally pay 30% to 40% effective tax rates. As an example, Baltimore-based T. Rowe Price (Nasdaq: TROW) paid out 36% of its operating profits to Uncle Sam, based on its income statement for the first quarter of 2002.

This tax savings obviously gives W.P. Stewart a tremendous competitive advantage over its domestic competitors, which are paying much higher taxes, and it appears to be a more or less permanent competitive advantage. (There have been some rumblings about IRS crackdowns on companies that have token offices in tax havens such as Bermuda in order to circumvent the U.S. tax rate. Since W.P. Stewart is headquartered and employs a large staff in Hamilton, the company appears to be safe.)

The company returns a large portion of this tax savings to shareholders in the form of dividends. The company currently pays out $0.30 per share in quarterly dividends, for an annual indicated yield of about 5.4% at the current stock price of about $22. Altogether, the company had paid out a total of $28 million in the first half of 2002, or about 75% of available free cash flow generated by the business during this period of depressed earnings.

Shareholder-oriented management
There's another reason that I like this company. You may remember my last article about the four ways management can allocate capital to either increase per-share intrinsic value or return cash to shareholders. Well, since the asset-management business doesn't require a lot of capital, W.P. Stewart's management returns virtually all the cash produced by the business back to its shareholders, and not just via dividend payments. W.P. Stewart has been actively repurchasing shares of the company stock during this downturn, and the recent spending on share buybacks and dividends is actually outpacing cash flow.

In the second quarter, the company spent $26.7 million to buy back about 1.1 million shares at an average price of just above $24 per share. On July 30, the company's board of directors authorized another $30 million share buyback. The company was still buying back shares in early August, when the price had fallen well below $20 per share. (By the way, these share buybacks aren't a new thing; W.P. Stewart repurchased $26 million worth of shares in 2001.) While the company obviously can't continue to return more cash to shareholders than the business produces, the management obviously feels its own shares represent a decent investment at recent prices.

On July 31, the company announced weak second-quarter results. To me, the earnings press release was a thing of beauty, though the most appealing information was included under the heading "Other Events," which the company threw in almost as an afterthought on page 3 of its release. There were three "other events" noted:

  • W.P. Stewart spent over $26 million repurchasing shares in the second quarter.

  • The company announced it will begin expensing stock options in 2003.

  • The company paid out a quarterly dividend of $0.30 per share.

Folks, you can't expect every business to produce earnings growth every year. The investment-management business almost guarantees occasional down cycles, though it had been so long since we'd experienced one that many people probably forgot.

But you also can't expect much more from a management team -- W.P. Stewart produces good returns for its clients, returns excess cash to shareholders, and has made the right decision when it comes to accounting for options.

While I'm not necessarily recommending the shares at the current price (15 times trailing earnings), I don't think it's unreasonably priced. I will consider adding to my position when the price drops to the point where the stock yields above 6%.

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Guest columnist Zeke Ashton has been a long-time contributor to The Motley Fool and was a full-time analyst and writer at TMF for several years. Zeke is also the managing partner of Centaur Capital Partners LP, a money-management firm based in Dallas, Texas. Please send your feedback to The Motley Fool has a disclosure policy.