Westwood Holdings A Financial Small Cap Gem

Westwood Holdings (NYSE:WHG) has launched several global and emerging market funds over the past couple of years to expand its assets under management and add more revenue stream with a higher profit margin (especially for non-US clients). The company has shifted its priority to focus more on institutional and private wealth management after the 2008-2009 downturn to meet the fast-growing market demands. WHG achieved double-digit revenue growth and free cash flow the past five years with a minimum debt. It is an attractive small-cap with a steady growth potential.

Westwood Holdings is a Dallas, Texas-based financial services and asset management firm with a market cap of $489 million and assets under management (AUM) of around $20 billion.  Westwood has successfully managed its performance with steady growth over the past 30 years. Its revenue grew at 15-25% YOY over the past five years with operating margin at 32%. It has managed to increase both book value and free cash flow per share at 15% YOY with a minimum debt ratio. WHG is a steadily growing small-cap gem.

WHG Chart

WHG data by YCharts

After 2009, the company expanded its business rapidly. According to its 10-K for FY2015, institutional and private wealth services increased significantly, standing at 55% and 26% of its AUM, respectively. Mutual funds accounted for 18% of AUM. Based on the revenue analysis, assets-based fees and trust fees accounted for 76% and 22% of the company’s total revenue, an increase of 12% and 40% since 2014. However, performance-based fees and other fees have decreased 29% and 62%.

Expanding Private Wealth Management Globally

Since more individual investors have switched to low-fee automated index funds and ETFs, the mutual fund industry faces intense competition with a shrinking profit margin. Because of this threat to the mutual fund industry, Westwood adapted well and shifted its focus towards fast-growing institutional and private wealth management clients, especially for non-US investors. By the end of 2015, non-US clients represented 18% of AUM. Since 2012, it has launched a global advisor business with the headquarters in Toronto to invest in global and emerging market securities and convertible bonds. The company also acquired Houston-based Woodway Financial Advisor firm in 2015 to add $1.6 billion in AUM to expand its trust and private wealth management team.

Now, the question is if the company’s expansion, especially the global and emerging market securities business, will bring sustainable revenue growth in the next three to five years. Westwood has managed 15 funds by the end of 2015, and only a couple of US funds outperformed the benchmarks net of a fee – Concentrated Large Cap Value and Small Cap Value. For US equities, WHG adopted a bottom-up approach to concentrate on individual company analysis rather than macro economy trend analysis. The firm has applied this strategy for a long time, and it has proven to be a winning strategy.

On the global side, most global and emerging funds started around 2012 to 2015 to take advantage of distressed and extreme undervalued investment opportunities in the European and Asian markets. Global funds also adopted this bottom-up approach with the assistance of quantitative tools. The global and emerging market funds are relatively new compared to their core US securities model. While these funds offer the company with diversified revenue stream with higher service fees and management fees, they also have more complex regulation risk exposure. Two teams are involved in the global and emerging market funds. One team is in charge of the global and emerging market securities while the other exclusively focuses on convertible bonds to provide investors superior risk-adjusted return over medium- to long-term horizons. So far neither of these global funds has outperformed benchmark indexes, net of the fees they charge. Investors need to be cautious to monitor these funds’ performance in order to gauge the sustainable growth of their diversified revenue stream.

In the recent annual report, CEO Brian Casey emphasized his top priority is to focus on protecting capital from downside risk. In 2015, Westwood acquired Woodway to add $1.6 billion in assets under management while the market capital depreciated with a loss of 1.1 billion. It is reasonable to assume the firm may increase the cash reserves or hedge to protect the drawdown risk. The strategy may impact the funds’ performance in the short term, but should preserve capital for the long-term future growth.

Conclusion

Westwood is a steady growth small-cap with a minimum debt ratio of 26% in a profitable industry. During 2008, its revenue and net income suffered an 8% and 24% temporary draw-down. We might see similar temporary setback risks ahead during the next downturn. So far, only a couple of funds outperformed the benchmark indexes. Since five out of 15 funds launched in the last two years, these funds may experience a tough test during the next downturn to tell if they can survive well and keep growing at a sustainable speed. For valuation consideration, its P/B 3.7, P/E 17 and P/Cash Flow 8.4 are close to 2008 levels. Despite these risk factors, Westwood’s impressive growth track record, consistent management, and a diversified revenue stream make it a small-cap financial with lots of potential.

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