Disclosure: No HCP fund or account has a long or short position in AGF, and none is contemplated in the short to medium term.

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One key theme we discussed is the near complete consolidation of the domestic financial services market. The result was the creation of a sector utterly dominated by nine giant financial intermediaries[1] that are able to lever their outstanding brands, massive/multi-pronged distribution platforms, and sheer financial power/capital scale to the detriment of their smaller, independent competitors.

To highlight the implications of the market structure changes, we have frequently cited AGF Investment Management (AGF) as one of the victims of these structural shifts[2], and predicted that – in absence of a sale – AGF’s share price was headed to $5.00 (compared to ~$13.00 at the end of 2013). With the stock below $6.00 since September (and currently at ~$4.20), we thought it worth revisiting.

Why did we make this prediction?

We believe the Canadian mutual fund sector has evolved to a point where significant captive distribution – something that AGF does not possess[3] – is a critical key success factor. As a result, over time, the cumulative impact of its scale disadvantages has become so great that the firm cannot really grow (and indeed, continues to shrink).

This is not a new issue. For the independent investment banks, the Big-6 banks’ combination of corporate and investment banking was extremely harmful to their competitive positioning. Recognizing that access to a bank balance sheet had become a critical success factor, virtually all of the independent investment banks sold to the Big-6 banks rather than suffer the inevitable degradation of their businesses[4].

With respect to the independent mutual fund managers, they adapted to the creation of these giant financial intermediaries in primarily three ways: (i) selling to larger/global platforms (Trimark, Bissett), (ii) selling to larger Canadian platforms with captive distribution (Mackenzie[5], Dynamic, Clarington, TAL) and/or (iii) consolidating amongst themselves to gain scale (too numerous to mention)[6].

The result?

The remaining independent mid-cap Canadian financials either operate in markets not dominated by the banks/lifecos (FFH, MIC, IFC), are highly specialized (GS, HCG), and/or have regional character (IAG, CWB, LB). Those mid-cap competitors still competing directly with the banks/lifecos, including GMP and CF, have been experiencing significant competitive pressure.

Which brings us back to AGF.

It is our view that the challenges facing AGF are structural – i.e., the firm is simply too small to offset its scale disadvantages, including a lack of significant proprietary/captive distribution. At the same time, the firm is too large to generate fund outperformance sufficiently robust to offset these competitive disadvantages. These pressures are not new and have contributed to the firm’s material decline in AUM over the past many years.

Unfortunately, it would appear that the competitive pressures facing the Canadian independent asset managers are actually intensifying. The two most important emerging pressures – (i) regulatory changes (CRM2) on fee disclosure, and (ii) competition from ETFs (including eventually within the MFDA channel) – have the potential to exert material downward pressures on margins. Larger competitors with huge scale and captive distribution are in a much better position than the independents to absorb these structural changes.

What does this mean?

AGF has lots of great portfolio managers/products. However, the firm’s competitive position and its lack of distribution power/scale make it extraordinarily difficult for the firm to create shareholder value. With competitive forces set to intensify, it is our opinion that management should take a realistic view of the firm’s future prospects and sell it to maximize the remaining shareholder value. Moreover, AGF should make that decision in 2016. To do otherwise is to expose its shareholders to the risk of ongoing franchise erosion.

Notes

[1] Big-6 banks (BMO, BNS, CM, NA, RY, TD) and Big-3 lifecos/Power Financial (SLF, MFC, GWO/PWF).
[2] It also helps the banks that their retail branch networks are not required to offer open architecture. We addressed this topic in an essay published in The Globe and Mail; see “Are the Canadian Banks Becoming Too Powerful?” in which we called for regulators to require Canadian banks to offer open architecture.
[3] This is why during our presentations we took great pains to emphasize this prediction was not based on a conclusion that the firm had poor portfolio managers or fund products.
[4] Since 1990, the most notable independent investment banks to sell include: Burns Fry, Richardson Greenshields, First Marathon, Newcrest (founded and sold), Midland-Walwyn (sold to Merrill Lynch a few years post-merger) and the once powerful Gordon Capital (damaged by regulatory issues, sold to HSBC).
[5] In 2001, Mackenzie was acquired by Investors Group (one of Canada’s largest non-bank mutual fund and financial advisory firms). Investors Group had previously been acquired by Power Financial in 1986.
[6] It is also worth noting that two of the largest fund assets managers in the U.S. – Capital Guardian and Fidelity – entered into the Canadian market, further adding to competitive pressures.