As a Foolish investor, you probably recognize the wisdom of making your decisions by analyzing a stock's fundamentals and ignoring the noise that determines the market's short-term movements. But what if you're looking at the stock of an asset manager? Can you evaluate a firm's prospects without trying to make some forecasts about the unpredictable movements of the broader market? It would seem that maintaining a view on the short-term direction of the securities markets would be a critically important factor in evaluating the earnings potential of most asset managers, because they generally derive their fee income from the value of the assets they manage.
But Federated Investors (NYSE:FII) is not like most asset managers, and there are a couple of reasons why this adviser's outlook is largely positive, regardless of how the market might behave. First, Federated -- an Inside Value recommendation -- is predominantly a manager of money market funds. As such, its performance has less to do with stock prices and more to do with the shape of the yield curve. With short-term rates now higher than long-term rates, money market funds offer better liquidity and a better yield than fixed-income securities with longer maturities. That unusual situation makes money market funds very attractive. With fears about inflation now subsiding, many market observers believe that the yield curve will steepen only after the federal funds rate is lowered. In that event, managers of money market funds could still experience strong net inflows -- at least temporarily -- as investors seek outstanding short-term instruments before new issues come to market at the prevailing lower rates.
Second, Federated is unlikely to undertake a radical acquisition that might destroy shareholder value. A larger scale can give asset managers better operating efficiency and improved distribution, and that dynamic inspired a number of recent combinations of large fund groups. Among the most prominent deals have been BlackRock's (NYSE:BLK) merger with Merrill Lynch's (NYSE:MER) asset management unit and Legg Mason's (NYSE:LM) acquisition of Citigroup's (NYSE:C) investment adviser.
With a market capitalization of $3.5 billion and a price-earnings multiple of just 18, Federated lacks the currency of a rich stock to initiate a similar transaction. More likely, the firm will continue to nibble at more modest deals, such as recent acquisitions of small, privately owned equity managers that have helped increase assets under management and incrementally diversified Federated's product offerings. This strategy of selectively adding small equity managers, which tend to earn higher fees than managers of fixed-income products, has helped Federated steadily improve its profit margins without altering its basic character as a manager of money market funds. Of the $222 billion of assets under management at Federated, more than 70% is invested in money market products.
Federated shares have declined by about 10% year to date, and the stock has underperformed its peer group over the past several years. While that history may position the company to deliver better returns in 2007, investors should consider recent news that might cast a shadow on Federated's prospects. The SEC announced an expanding investigation into whether firms that perform administration services for certain mutual funds have been paying undisclosed kickbacks to the funds' investment advisers. The investigation follows a settlement that the SEC reached with fund administrator BISYS (NYSE:BSG), and it focuses on the activities of bank-sponsored mutual funds, a corner of the business where Federated is especially active. Federated's name has not come up in connection with the SEC's inquiry, but getting caught in a new scandal would be damaging to a firm that has had more than its share of regulatory issues.
Many analysts place Federated's name on the list of promising candidates for a management-led buyout. While it's impossible to predict such an event, the possibility would help support a largely positive outlook for Federated shares in the year ahead.
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Federated and Legg Mason are both Inside Value recommendations. Learn more about finding undervalued stocks from analyst Philip Durell.
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Fool contributor Michael Leibert welcomes your feedback. He does not own any of the stocks of the companies mentioned. The Fool has a disclosure policy.
