Is the pessimism engulfing Magellan overdone?

Over the last two years Magellan Financial (ASX:MFG) has shifted from market darling to market disaster. The share price hit an all time high above $72 in February 2020. Today it trades below $9, a fall of 88%. Anyone who purchased their shares after May 2013, nearly ten years ago, will be sitting on unrealised losses.

But the past is the past and cannot be undone. The question is, where to from here? If you hold it, should you continue to, or if you don’t hold it should you consider a purchase?

The troubles for Magellan Financial (ASX:MFG)  began with some large portfolio positions in Chinese big tech companies. These investments, along with some others, dragged down the performance of the flagship global equities fund. The fund has now underperformed its benchmark over every period up to 10 years.

And then there were the personnel travails. We won’t dwell on it here as it has been well documented, but within a month they lost their CEO and then founder and star fund manager Hamish Douglass.

Magellan was a classic case of a business with very high key person risk. However, when that risk materialised, many shareholders (including myself) were surprised at the severity of the reaction.

Financial services businesses are built on trust. Investors trusted that Douglass was going to deliver the high returns that they had come to expect and when he exited suddenly, their trust was undermined. Funds under management (FUM) declined from $116.4 billion in November 2021 to $50.2 billion a year later, with institutional investors dominating the withdrawals.

They are now in a build back phase. They have a new CEO, David George who has good pedigree, but is unproven in a CEO role. He is focused on the obvious first priority, restoring good performance. All of Magellan’s major strategies have underperformed their benchmarks when measured over the last 12 months, and only the Airlie Australian Shares portfolio has outperformed over a three year period.

Source: magellan.com.au as at 23/12/22

Whilst they have generally been known as a manager of global equities, this part of their operations has been hardest hit by outflows as well as underperformance. It now only accounts for 49% of FUM, with infrastructure accounting for 33% and Australian equities 18%. The source of funds is split approximately 60:40 between institutional and retail.

Active funds management is a difficult business. Almost all active fund managers will experience periods where they are underperforming. Bill Miller holds the record for the longest consecutive period of outperformance, beating the index for 15 years in a row. That came to an end in 2005. As institutional investors dominate the modern sharemarket, they effectively are the market. Therefore on aggregate they would be expected to deliver the market performance, less their fees. For every manager that beats the market, someone else doesn’t.

Active managers have been under pressure world wide as passive funds management products, like index funds and Exchange Traded Funds (ETFs), experience very strong growth. This reflects the fact that not only are the fees they charge far lower, but also the growing realisation that picking an active fund manager who will deliver consistent outperformance is really difficult. This has in turn put pressure on the fees that active managers can charge as they try to retain investors.

Australia resisted this trend for longer than other markets in part due to the wall of money flowing into investments from compulsory superannuation. But as the big super funds have become really big, they have started to use their weight to put a lot of pressure on fees and in some cases to bring funds management in-house.

These trends all came to a head in 2021 and 2022. At the start of 2021, ASX listed fund managers were trading on an average forward PE ratio of 16 to 17. 18 months later that had collapsed to eight, before rebounding to ten in the second half of this year. The industry had risen on the back of strong fund inflows, but that shifted to outflows over the last two years.

Magellan did not struggle alone in FY22 but they were by far the worst affected. All the ASX listed fund managers experienced strong outflows except for newly listed GQG Partners (ASX:GQG). Magellan had the dubious distinction of having the highest outflows of fund managers globally.

The stock is rated as Contrarian in Stockopedia. This is due to the fact that the quality score is high, the value score has increased as the share price has decreased, while the momentum score has been smashed by both the falling share price and plunging earnings expectations.

If it can maintain its quality performance indicators, it represents a solid value proposition.

However, that is a big IF.

Barring a miracle, revenue, profits and dividends are going to fall this year, as they are all a function of average funds under management. Average fund under management was $94 billion in FY22. It is unlikely to be much above $50 billion in FY23. This means the Health Trend (F-score) will fall along with ROCE and ROE.

Contrarian plays are by their nature high risk and only for the adventurous. There is a very real risk that as the FY23 interim and full year results are released Magellan may begin to shift from a contrarian style to a value trap. There is also the distinct possibility that the share price has already factored in all of the negative scenarios and begins a strong rebound delivering outsized returns to those adventurous enough to hop on board.

It largely hinges on the ability of the new CEO David George to stabilise and then turn around the performance and consequently investment flows. This will not be easy, but with a good team and robust processes there is a fairly good likelihood that it can be achieved.

The X-factor with Magellan is Barrenjoey. Barrenjoey is a start-up investment bank with a cadre of big name hires and they have already started making some serious waves in the Australian investment banking scene. Magellan was one of the initial financial backers of Barrenjoey with a 40% economic stake. This was diluted to 37% when Barclays contributed more capital, however at a significantly higher valuation. Barrenjoey has already generated a small profit. It is tricky to make predictions, but it is possible that in the long-term Barrenjoey could make a substantial contribution to the overall value of Magellan.

Investors need to shift their mindset. Magellan is no longer the growth stock that was built on the back of a star fund manager with exceptional marketing and relationship building skills who rode the ever growing wave of money flowing into compulsory superannuation. Those days are over.

It is now an active fund manager competing with all other active fund managers and having to prove its value proposition to a skeptical investing community. There are a lot of risks to consider. But if trust can be re-established, there is a solid platform for new management to build on.

---

Important Information: Stockopedia Ltd ABN 39 757 874 670 UK business registration number 0637267 (“Stockopedia”) is an Authorised Representative of Daylight Financial Group Pty Ltd ABN 77 633 984 773 (“DFGPL”) which is the holder of an Australian Financial Services Licence (AFS Licence No. 521404).

Information in this commentary is current as at date prepared unless otherwise stated. However, please bear in mind that investments can go up or down in value, and that past performance is not a reliable indicator of future performance. For more Important Information please refer to the Disclaimer section of this website.

This communication may contain general financial product advice. It has been prepared without taking into account your personal circumstances, and you should therefore consider its appropriateness in light of your objectives, financial circumstances and needs before acting on it.

If our advice relates to the acquisition or possible acquisition of a particular financial product, you should obtain a copy of and consider the Product Disclosure Statement (PDS) before making any decision.

The author holds interests in the following stocks mentioned in this article: MFG. This position can and will change at any time without notice.