We recently compiled a list of the 10 Best Asset Management Stocks to Buy According to Short Sellers. In this article, we are going to take a look at where Bain Capital Specialty Finance, Inc. (NYSE:BCSF) stands against the other asset management stocks.
On a market level, investing can be described into two categories, active investing and passive investing. Active investing, as the name suggests, is a hands on approach which involves the investment manager or the regular investor regularly evaluating their portfolio to trim holdings or add to them depending on individual equity and broader market performance. On the other hand, passive investment is when the retail investor or a fund manager buys stocks and then holds on to them for dear life for a long timer period to mirror the performance of a broader stock index instead of focusing on the merits of individual stocks.
Comparing the two, passive investing requires less focus. Naturally, it’s unsurprising that this approach has dominated the market over the past couple of years. Data from Morningstar Financial shows that the 2023 end was historic for the stock market as the amount of assets held by all passive funds crossed those held by active funds for the first time. The year’s close saw passive mutual funds hold $13.29 trillion in assets, which was $60 billion higher than the $13.26 trillion in assets of the active funds. This shift appears to be driven by the tendency of passive funds to outperform active funds over the long term. As per the S&P, over the past two decades, 90%+ of active equity funds underperformed their underlying benchmark.
This shift, however, doesn’t appear to affect all categories of active funds. Morningstar’s data adds that there is a stark contrast between active exchange traded funds (ETFs) and active mutual funds. Analyzing the net inflow into these two categories between 2008 and 2023, while the inflows in the mutual funds significantly led up until 2014, the trend somewhat reversed after that. For the years between 2015 and 2023, only 2021 was the year for positive inflows into active mutual funds as approximately $150 million of funds went into them. For all the other years, all the inflows were negative, with 2022 being the worst year which saw roughly $1 billion of outflows. On the other hand, inflows for the actively managed ETFs were positive for all these years and marked a 37% average growth in the decade ending in 2023.
However, while passive funds have beaten active funds in terms of total assets, there are nevertheless a variety of active funds that have performed well during this turbulent period. The three active fund categories that have generated robust returns recently are fixed income, real estate, and small cap funds. Active fixed income funds had a 53% success rate in 2023, and it’s real estate where the active funds truly shine. For the decade ending in 2023, 51% of active real estate funds outpaced their passive counterparts making them the only funds to have done so over this time period. Finally, the fund managers benefited from their expertise and resources, as 41% of small cap active funds beat the passive funds and saw their excess returns cross 16%.
While the growth in passive funds hints towards a democratization of the stock market since these funds are preferred by retail investors, it also leads to some untoward consequences. For instance, a 2019 study from the Federal Reserve shows that in December 2019, passive ETFs and mutual funds held by the top five asset managers had $7.7 trillion in assets under management. This accounted for 47% of all these funds, with Vanguard in particular accounting for 25% of the pie.
Research from Harvard and Columbia adds further color particularly when it comes to the control that the biggest asset managers might be able to exercise on the stock market. Harvard estimates that as of 2021, the three biggest index funds managers namely BlackRock, Vanguard, and State Street held a median stake of 22% in the benchmark S&P index’s companies which translated into 25% of the votes cast at these firms. Columbia adds that for 90% of these 500 companies, one of the Big Three is not only a shareholder but the largest shareholder.
Another consequence of the shift towards passive investment is the impact on large cap stock valuations. According to the Man Group, $2 out of every $3 in US large cap equities comes through passive investments. As we’ve witnessed in the artificial intelligence boom, big tech stocks have driven stock market valuations, and research from the London School of Economics and the University of Michigan provides more details about the growth of passive investment and its impact on large cap valuation. It shows “that flows into passive funds raise disproportionately the stock prices of the economy’s largest firms, and especially those large firms that the market overvalues” and adds that these flows can “cause the aggregate market to rise even when flows are entirely due to investors switching from active to passive.”
These recent trends have also hit small cap stocks quite hard. According to Morningstar’s Dave Sekera, small caps “are actually trading at about a 20% discount, you know, to our fair values, so there’s a lot of value there. So I think once we get past, you know, a lot of the thematic trading that’s really driven the market for the past year and a half, get much back more to more of a stock picker’s market which I think we’re gonna need to see for the market to continue its gains. But I think stock pickers, especially in that small cap space, have a lot of runway ahead of themselves.”
Our Methodology
To make our list of the best asset management stocks to buy according to short sellers, we ranked these stocks by their short interest as a percentage of outstanding shares and picked the stocks with the lowest percentage and a market capitalization greater than $600 million to remove the effects of low liquidity.
For these stocks, we also mentioned the number of hedge fund investors. Why are we interested in the stocks that hedge funds pile into? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points (see more details here).
A banker in front of an open vault, symbolizing the company’s vast investments.
Bain Capital Specialty Finance, Inc. (NYSE:BCSF)
Number of Hedge Fund Investors in Q2 2024: 9
Short Interest % of Shares Outstanding: 0.39
Bain Capital Specialty Finance, Inc. (NYSE:BCSF) is another middle market loan provider. Its business model is primarily built on loan originations and merger and acquisition activities – two markets that do well in a low interest rate environment. As a result, Bain Capital Specialty Finance, Inc. (NYSE:BCSF)’s stock is exposed to market perceptions of the Fed’s interest rate cuts, and the shares can see tailwinds if rate cut expectations are brought forward. The firm’s business model, which sees Bain Capital Specialty Finance, Inc. (NYSE:BCSF) invest in firms with operating incomes ranging between $10 million to $150 million means that it can charge higher fees and rates due to the riskier business nature of these firms. It also means that the asset management company has to carefully select its targets, especially due to its exposure to high interest rates. This business model allows Bain Capital Specialty Finance, Inc. (NYSE:BCSF) to benefit from high growth businesses too in case its targets end up successfully scaling operations.
Bain Capital Specialty Finance, Inc. (NYSE:BCSF)’s management shared details for its portfolio companies during the Q2 2024 earnings call:
“We also remain focused on investing in debt structures that provide us with strong lender controls. 95% of our Q2 originations to new companies were structured with documentation containing financial covenants tied to management’s forecasts, and we have majority control in nearly 80% of these debt tranches, allowing us to drive eventual outcomes at our discretion. These statistics are consistent with our broader portfolio, showing our continued focus on these core tenets.
Moving on to credit quality, our portfolio companies continue to perform well in the current market environment. Investments on nonaccrual status declined quarter-over-quarter and are below industry averages. Our non-accruals represented 1.2% and 1.0% at amortized cost and fair value, respectively, as of June 30. Credit risk rating trends were also stable during the quarter, with only a small percentage of our portfolio underperforming and on our watch list. We’ve been very pleased with the performance of our borrowers operating in a higher interest rate environment in recent years, and we believe this is a testament to Bain Capital’s disciplined and highly selective underwriting process. Lastly, we also enhanced our capital position during the quarter by attracting new lenders to our platform.”
Overall BCSF ranks 7th on our list of the best asset management stocks to buy according to short sellers. While we acknowledge the potential of BCSF as an investment, our conviction lies in the belief that AI stocks hold greater promise for delivering higher returns, and doing so within a shorter timeframe. If you are looking for an AI stock that is more promising than BCSF but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.
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Disclosure: None. This article is originally published at Insider Monkey.