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Can the Australian Ethical Investments Limited (ASX:AEF) share price double again?

One small-cap fund manager I’ve regularly recommended readers consider investing in since 2014 is Australian Ethical Investments Limited (ASX: AEF).

Today the fund manager updated the market to expect net profit of between $4.7 million and $5 million in financial year 2018, which compares to an “underlying” profit of $4.235 million in financial year 2017.

Notably, last year’s underlying profit backs out the disastrous financial impact of a unit pricing error, which in total cost the business around $2.8 million in unitholder remediation and project costs.

Investors shrugged off this news as a one-off blunder and since 2014 the stock has more than quadrupled to $136 as AEF delivers solid investment performance and operating metric improvements in particular in growing its funds under management (FUM).

Fund managers earn revenues as a fixed percentage of funds under management and as at the end of 2017 the group had $2.6 billion in FUM, which represents growth of 41% over the prior year.

Importantly, AEF is still growing off a small base which explains the rocketing stock price tracking the profit growth.

For example it is far easier to double FUM from $2 billion to $4 billion than from $40 billion to $80 billion, although you have the same potential to double revenues and given the scalability of fund managers you can grow profits even faster.

This is because fund managers have operating leverage in that they can add FUM to any investment fund without having to hire additional staff to manage it or take on many other costs. Relatively fixed costs and rising revenues are a powerful profit growth combination and AEF remains reasonably well positioned on this front for a couple of reasons.

First, is the tailwind of Australia’s ever-growing superannuation pool that is finding its way into AEF’s funds, while the ethical or green investment space is also growing in popularity.

AEF may have a slight competitive advantage in being an independent “ethical” manager, while other firms like Perpetual Limited (ASX: PPT) or AMP Limited (ASX: AMP) offer “ethical” funds, but only in the context of offering wider funds with no particular ethical or environmental commitments.

AEF earned $1.98 in earnings per share on a net profit of $2.31 million for the six-month period ending December 31 2017, which places it on around 34x annualised earnings per share. However, given the group expects to post a stronger net profit in the second half this earnings multiple is likely to come down a little.

Either way it’s clearly priced at a premium, although that may be justified given it’s still a small fund manager operating in a giant sector. As such if it’s able to win institutional business at the same time as growing retail inflows it could grow far larger. For example at the big end of town a single institutional mandate managing money for a charity or government pension fund could be as large as a $1 billion, or more than a third of AEF’s total FUM at the moment.

The group would need to increase costs in scaling up to compete for these kind of mandates over the long tern, while its short-term future will depend on investment performance and the unknown of markets.

As such I’d rate the stock a hold for now.

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Motley Fool contributor Tom Richardson owns shares of Macquarie Group Limited.

You can find Tom on Twitter @tommyr345

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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