These 2 ASX shares from a beaten-up sector look like buys to me

I sense an opportunity in these two stocks that investors are being negative about.

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Key points

  • The funds management industry has suffered amid difficulties in asset markets
  • Australian Ethical can benefit from superannuation inflows and operating leverage
  • Pinnacle is seeing inflows again and is also expanding its growth potential with investments

Some industries such as the technology sector have rebounded strongly from the lows experienced in 2022. But, I believe some ASX shares can deliver a market-beating performance over the next 12 months from a particular sector: funds management.

It's understandable why some areas of the market have suffered amid the higher interest rate environment, such as (office) real estate investment trusts (REITs) because of the impact it has on their interest costs and the underlying valuation of the assets.

But, after everything that has happened, the fund manager sector seems like a place to find opportunities.

Australian Ethical Investment Ltd (ASX: AEF)

Australian Ethical describes its activities as providing "investors with investment management products that align with their values and provide competitive returns. Investments are guided by the Australian Ethical Charter which shapes its ethical approach and underpins both its culture and its vision."

Since August 2022, the Australian Ethical share price is down over 50%, despite the company's funds under management (FUM) increasing significantly since then after taking on Christian Super members.

In its FY23 update to 31 May 2023, the company said that in the two months from March 2023 to May 2023, it experienced net inflows of $90 million and positive investment performance of $170 million. This took the funds under management to $9.02 billion.

As a result of the higher FUM, the ASX share's revenue is expected to be 21% higher than the first half and underlying profit after tax (UPAT) is expected to be approximately 30% higher than the first half.

I think it's a very good sign that the business is expecting and demonstrating operating leverage. Fund management businesses are typically capital-light, enabling them to become very profitable as they get bigger.

With Australian Ethical set to benefit from the regular contributions of superannuation by members, I believe the stronger FUM will drive revenue, and increasing operating leverage should help profit growth even faster.

Pinnacle Investment Management Group Ltd (ASX: PNI)

Pinnacle is also involved in funds management, though it doesn't invest in shares itself. Instead, it invests in compelling fund managers that are starting their own funds management businesses.

The ASX share can then help those fund managers grow with seed FUM and working capital, distribution and client services, middle office and fund administration, compliance, finance and legal, technology and other infrastructure.

It had been growing strongly for a number of years prior to the interest rate hiking cycle which has paused that progress. Even so, the first three months to 31 March 2023 saw net inflows of $1.9 billion, with $1.7 billion of that money coming from institutional sources.

The company noted that investors are remaining cautious and defensively positioned, but I don't think that's always going to be the case. While performance fees have currently slowed, a return to improving share market returns could mean the resumption of strong performance fees.

The ASX share and its affiliates have been investing in other areas of growth that could help drive earnings in the future, which could help boost the business. It's around 50% lower than it was at its peak in November 2021.

Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Australian Ethical Investment and Pinnacle Investment Management Group. The Motley Fool Australia has positions in and has recommended Pinnacle Investment Management Group. The Motley Fool Australia has recommended Australian Ethical Investment. 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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