Treasure Chest: Magellan Sailing Into Rough Waters?

This story features MAGELLAN FINANCIAL GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: MFG

FNArena's Treasure Chest reports on money making ideas from stockbrokers and other experts. Magellan Financial Group has been a runaway winner amongst funds management peers in recent times but has it been caught out by the sudden rotation back into value from growth?

-Long-time outperformer of peers
-Substantial valuation premium to peers
-November returns turn negative

By Greg Peel

Long before covid hit, Magellan Financial Group ((MFG)) was the standout performer among fund managers listed on the ASX. While all about Australian fund managers were consistently bleeding funds flows, Magellan continued to attract investors.

This led the listed stock to trade at what analysts considered a justifiable premium to peers.

A listed fund manager has to manage a balancing act between satisfying both fund investors and shareholders. Value for shareholders is typically derived from charging fund investors management and performance fees. Performance fees are collected when the fund in question exceeds a targeted return over a specific benchmark.

That benchmark could be the ASX200 for example, or some international benchmark, which is Magellan's forte.

A fund manager's value is measured by its funds under management (FUM), which is a combination of investment funds coming in and the return on those funds. 2020 has clearly been a difficult year for fund managers, due to unprecedented volatility; unprecedented in the sense no one alive had ever had to deal with the impact of a pandemic before.

When Magellan reported its September quarter FUM earlier this month, analysts were once again impressed. Ord Minnett noted the fund manager generated its strongest institutional net inflows for a half-year since 2015. Magellan offers funds management at both the retail and institutional (other fund managers, insurers etc) level. Ord Minnett upgraded the stock to Buy.

While performance was below benchmark in retail funds over the period, it was still a better performance than analysts expected and retail funds flows remained positive.

With momentum in net flows and product initiatives in the pipeline, UBS (Neutral) suggested Magellan's FUM growth prospects for the near-term remained robust. Credit Suisse acknowledged the stock's price/earnings multiple appeared stretched, but the broker retained Outperform on optimism over the outlook for flows and fund performance.

Yesterday Morgan Stanley published a report noting Magellan is trading at a forecast FY21 PE of 25x compared to the Australian peer average of 16.5x.

Morgan Stanley also noted the relative return on Magellan's key global fund in November to date was -9.5%. Platinum Asset Management ((PTM)) is among those fund managers that have struggled in recent times as Magellan has surged ahead. Its flagship Global Equity Fund has returned 3.5% over the period.

It appears Magellan has fallen victim to the rotation-into-value.

For years before covid, older world "value" stocks had been consistently left behind by new world "growth" stocks, most evidenced in the rise and rise of US Big Tech.

When covid hit, this imbalance was amplified, sending stay-at-home winners such as social media, video streaming, video conferencing, online retail, and pretty much anything internet based and thus stay-at-home beneficiaries, soaring. Meanwhile, traditional industrial stocks, including manufacturers, oil companies, bricks & mortar retail and banks, wallowed.

Wall Street, and thus other stock markets across the globe, did experience some stuttering attempts at rotation back into value and out of seemingly overvalued growth stocks throughout the post-March recovery, but none of them stuck. That was until Biden appeared to have won the presidency and immediately after, Pfizer was the first to announce it had a vaccine.

This month rotation has been on in earnest as investors look to the clouds clearing in 2021. Magellan's investment strategies, Morgan Stanley notes, have resulted in negative returns on the value rotation.

To that end Morgan Stanley believes Magellan's funds flows are at risk, and institutional flows are more vulnerable than retail flows. The volatile Year of Covid has led to a lot of institutional mandate rebalancing, the broker notes (shifting investment funds from one manager to another), pointing out that most of Magellan's institutional mandates are from the US, UK and EU.

"We acknowledge that relatively better returns and more capacity in the global infrastructure strategies should, in part, protect insto flows. But overall, we think MFG is at risk of seeing insto redemptions [withdrawn mandates] and subsequently de-rating".

Morgan Stanley recalls that in November 2015, Magellan reported surprise institutional outflows and the stock dropped -9% in one day.

Downside catalysts could be the fund manager's monthly flow updates in early December and January, the broker warns.

To justify its premium valuation to peers, suggests Morgan Stanley, Magellan needs to grow its core product with sufficient flows to offset margin fee compression and switching from full-price strategies, launch its delayed retirement product, and deliver suitable return on equity in new "adjacencies", such as its strategic investment in Barrenjoey Capital.

Morgan Stanley retains an Underweight rating on the stock.

That strategic investment prompted Morgans (not Morgan Stanley) to upgrade to Add back in September.

Macquarie retained an Underperform rating on Magellan after its August earnings result release, citing over-valuation, but has not since updated.

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