Global asset management firm, Victory Capital Holdings, Inc. (NASDAQ:VCTR) has outperformed the market over the last five years. it has been able to do so thanks to its ability to grow profitably. The fate of the company depends upon its ability to grow assets under management (AUM). It has so far been able to do that thanks to rising markets, and its ability to earn suitable returns for investors to prevent a mass exodus. That understates the success of its strategies in beating their benchmarks. Those conditions are, in the long term, likely to remain. That makes the current undervaluation, which is largely a product of poor market conditions in 2022, an opportunity for investors to invest in a high-quality business.
In the last five years, Victory Capital’s share price has risen by over 135%, compared to nearly 40% for the S&P 500.
The company’s strength on the markets reflects the outstanding financial performance it has enjoyed over that period.
Exceptional Financial Performance
Revenue has grown from $409.63 million in 2017 to $890.27 million in 2021, for a 5-year revenue compound annual growth rate (CAGR) of 16.8%. According to Credit Suisse’s “The Base Rate Book“, just 6% of firms achieved a similar rate of growth between 1950 and 2015. That rarity explains why Victory Capital was once again named on Fortune magazine’s 1000 Fastest Growing Companies 2022 list. In the TTM period, revenue was $882.41 million.
Gross profitability rose from 0.4 in 2017 to 0.53 in 2021, reflecting the growing attractiveness of the company. Robert Novy-Marx’s research in “The Other Side of Value“, showed that gross profitability in excess of 0.33 is attractive. In the TTM period, gross profitability declined somewhat, to 0.53.
The operating margin rose from 22.01% in 2017, to 41.99% in 2021. This places Victory Capital’s operating margin among the top 20% from a historical perspective. In the TTM period, operating margin rose to 46.39%.
Net income rose from $25.83 million in 2017, to $278.39 million in 2021, for a 5-year earnings CAGR of 60.88%. Only 0.5% of firms achieved a similar rate of earnings growth in the 1950-2015 period. In the TTM period, net earnings rose to $292.98 million.
The company’s sustained profitability is all the more remarkable when you consider that Victory Capital grew its asset base from $792.62 million in 2017, to nearly $2.6 billion in 2021, for a 5-year asset growth CAGR of 26.62%. Typically, managers overestimate their growth prospects, raise capital and deploy it aggressively in capex, committing allocation errors in the process. When it turns out that the growth prospects are not as electrifying as management believed, the firm is left with disappointed shareholders, debts that now appear too expensively priced, and assets that it needs to get rid off to sanitize their balance sheets. This leads to an inverse relationship between asset growth and future returns. So, the company’s ability to grow profitability is highly important and suggests that the business has some competitive advantages.
In the last five years, free cash flow (FCF) has grown from $94.07 million in 2017 to $363.52 million in 2021, at a 5-year FCF CAGR of 31.04%. In the TTM period, FCF further grew to $371.59 million.
Finally, Victory Capital’s return on invested capital (ROIC) more than doubled between 2017 and 2021, from 15.7% to 39.3%. In the TTM period, ROIC declined somewhat to 32.1%.
Victory Capital is a global, diversified asset management firm with $147.3 billion in AUM as of the end of September 30, 2022. The firm serves a broad base of retail, institutional and direct investors.
According to the 2021 Annual Report, through its 12 autonomous Investment Franchises and Solutions Platform, it provides a range of investment products, such as “actively and passively managed mutual funds, rules- based and active exchange traded funds (ETFs), institutional separate accounts, variable insurance products (VIPs), Environmental, Social, and Governance (ESG) and impact investment strategies, alternative investments, private closed end funds, and a 529 Education Savings Plan”. These offerings are similar to Berkshire Hathaway’s biBerk small business insurer. The asset manager’s strategies can also be accessed through third-party investment products, “such as mutual funds, third-party ETF model strategies, retail separately managed accounts (SMAS) and unified managed accounts (UMAs) through wrap account programs, Collective Investment Trusts (CITs), and undertakings for the collective investment in transferable securities (UCITs)”. Since the end of 2021, the firm’s Franchises and its Solutions Platform have managed a diversified set of 130 investment strategies for their clients.
The company has a very explicit capital allocation framework and strategy. While this should not be anything to write home about, the reality is that most firms do not even mention “capital allocation” in their communications with the public, do not have teams or committees focused on capital allocation, and do not seem to have a defined way to think about capital allocation. Yet, getting capital allocation right is crucial for delivering sustained economic value to investors.
Victory Capital’s long-term growth and capital allocation strategy are designed to achieve profitable growth. growth is to be achieved through a combination of organic and inorganic growth. Organic growth obviously stems from the value their existing strategies and solutions provide. Inorganic growth comes from strategic acquisitions, mostly of investment management firms that Victory Capital feels have high-quality investment teams and can improve the growth and financial profile of the company, improve its diversification, help it with its integration targets, expand its distribution capabilities, optimize its deployment of technology, and improve its operating platform. Management believes that its ability to give targets access to its multiple distribution channels is a competitive advantage in battling for mergers and acquisitions targets.
The 2021 Annual Report also indicates that Victory Capital offers “equity, fixed income, investment models, alternative investments, closed end private funds, and solutions strategies” across a range of market capitalization segments, industry sectors, investment styles and approaches. Diversification is multi-layered, existing in terms of asset class mix, vehicle mix, and Franchise/Solutions Platform mix.
Victory Capital owns 12 Investment Franchises, none of which account for more than 18% of total AUM. Within each franchise, there is a different investment approach. This reduces the correlation between return streams from franchises investing the same way.
The company’s strategies have been very successful in beating their benchmarks. As of November 4, 2022, over a 5-year window, 79% of AUM had outperformed its benchmark, and 65% of the strategies had outperformed their benchmarks, with 68% of total mutual funds and ETFs having a 4- or 5-star overall Morningstar rating.
Profitability depends upon the level and composition of its AUM. In turn, the level and composition of AUM are determined by the investment performance of the strategies, net client flows, industry trends, the firm’s ability to retain talent, decisions around closing or restricting strategies, and market sentiment.
The firm earns revenue from fees, with around 75% being investment management fees, and the balance being fund administration and distribution fees. Investment management fees accrue as a percentage of daily average AUM, monthly average AUM or point in time AUM. Fund administration fees are largely asset-based and are earned from open-end funds. They fluctuate according to the level of average open-end fund AUM and the rates levied for services. Fund distribution fees are also asset-based and derived from open-end funds. They too fluctuate according to the level of average open-end fund AUM, with the distinction that asset composition and the corresponding fees determine the overall level.
As of November 4, 2022, the average fee rate (bps) was 51.8. Over time, fee compression has taken hold as a result of enormous competition in the industry, and the success of passive investment vehicles.
Built to Last
Despite the secular shift in fees, Victory Capital’s growth in AUM has offset declining fee rates. This is likely to continue for two reasons: firstly, over time, the market tends to go up (see the chart below of the S&P 500’s historical prices), a trend that has accelerated over the last forty years, which means that AUM is likely to continue to rise, so long as there is no major exodus of capital; secondly, the firm has so far maintained a prudent capital allocation strategy that is designed to prevent the kind of major outflows that could break the company.
The company can sustain its growth in AUM because that growth does not depend on any significant incremental capital. Incremental expenses are largely driven by personnel compensation and benefits. Personnel compensation and benefits contribute around 45% of total operating expenses.
High Switching Costs
Despite pressure from low-cost passive investment vehicles, asset managers such as Victory Capital enjoy a robust business model. This is because investors tend to dislike switching from asset manager to asset manager. The costs, not just in terms of money, but in terms of time, and the hassle of finding a reliable alternative, are too high for clients to switch accounts except in the most extreme circumstances. The switching costs increase when it comes to retirement products with defined target dates. Thus, there is room for the business to sustain market losses and still maintain the bulk of their revenue base. A firm has to be really reckless to lead to enough disaffection to kill the business.
Furthermore, the market will always have a place for active managers because of their role in price discovery. Given the firm’s success, investors will naturally be attracted to the firm to help them earn returns in excess of the market. The past does not predict the future, but it is a great ad for an asset manager. The firm is highly regarded, highly rated, and in 2021, it was recognized by Barron’s in the Best Funds Families of 2021 ranking.
A Scalable Business
The company enjoys a capital-light business model, with incremental capital deployed, as we have seen, mostly toward compensation. With little in the way of capex demands, the firm is able to scale very aggressively. It is not surprising then that the firm has been able to more than double ROIC over the last five years.
Victory Capital’s valuation relative to the S&P 500 is very attractive, with the company having a price-earnings (PE) ratio of 7.36, compared to a PE multiple of 20.84 for the S&P 500. With $371.59 million in FCF in the TTM period, and an enterprise value of $2.92 billion, Victory Capital has an FCF yield of 12.73%. The company’s FCF yield is six times greater than the market average. The FCF yield tells us that the company is generating 12.73% of its enterprise value in FCF in the TTM period. Compare that FCF yield with the 2.1% FCF yield enjoyed by the 2,000 largest firms in the United States, as calculated by New Constructs. Victory Capital’s underlying FCF performance is superior to the average of the 2,000 largest firms in the country, and the market is likely to reward it in future with superior stock market returns.
The immediate risks are tied to market sentiment. The company struggled last year as global markets stumbled. That is to be expected. If 2023 proves to be similarly problematic, shareholders will have a tough ride.
In the long term, risks emanate from the company’s ability to grow AUM. That success is reliant on a continuation of long-term market trends toward asset appreciation, and on the company continuing to achieve sufficient returns to keep investors. Could that long-term trend be broken? That is hard to imagine. What is not hard to imagine is a sustained period of underperformance on the part of the market. Could the company’s diversified strategies collectively fail? That is highly unlikely, but a possibility.
Over the last five years, shareholders in Victory Capital have beaten the market. The asset manager’s success is a result of the excellent underlying economics, which have allowed it to grow profitably over that period. At the heart of the company’s success has been its ability to grow AUM, and to earn sufficient returns for its investors to prevent any meaningful exodus of investors. Given the switching costs involved in leaving an asset manager, and the success of the firm’s strategies, and the overall trend toward stock market appreciation, Victory Capital is likely to continue to grow AUM within the foreseeable future. With an attractive valuation, the firm could be a big performer for the long-term investor.