Weighing up Magellan Financial Group after Douglass surprise exit

-- | 13/02/2022 Text size Decrease

Read the analyst note: <a href="https://premium.morningstar.com.au/investments/security/ST/0P0000A0Z2">Capable Hands Remain at the Helm of Magellan; Valuation Upside High as Shares Lose Steam</a> Emma Rapaport: Hello, and welcome to Morningstar. I'm Emma Rapaport. Magellan is back in the news. After two years of underperformance its Global Equity Funds have recorded further losses this year with major investments in Netflix and Meta in steep decline. Then, on Monday, news broke that its Chairman and CIO, Hamish Douglass, is taking an indefinite leave of absence after a period of intense pressure on his personal and professional life. Joining me today to discuss the fallout is Morningstar equity analyst, Shaun Ler. Shaun, thanks for joining us. Shaun Ler: My pleasure, Emma. Rapaport: Shaun, I'd really like to get to your long-term thesis for Magellan, which I understand is still strong, but I do want to get your reaction upfront to Hamish Douglass stepping back from the firm. Ler: Well, Emma, we're of the view that the vast majority of the share price weakness that was beside Magellan is purely due to sentiment which overshot way beyond the actual weakening in Magellan's fundamentals, and that noise also includes Hamish pulling back. I mean, all of these factors are a combination of factors that are immaterial in isolation. But when you combine everything, that will be enough to make someone nervous. So, if we just put aside Hamish stepping back for a bit, there are many factors that have led to today's event. Firstly, you get the underperformance of Global Equity strategies. Next, you get news of Brett Cairn's sudden departure. And then, you get news of Hamish's family issues. And then, you get the recent (turmoil) which has caused things like – stocks like Facebook and Netflix to derail. Now, all of these are actually factors which are immaterial in isolation. And then, when you combine all of them together, it would be enough to make investors nervous. So, if I were to just look at Hamish's leave of absence in isolation, in my opinion – in our opinion anyway, it's not enough to detract from the fundamental performance of the Magellan Global Fund because the Magellan Global Fund in essence is a buy and hold (indiscernible) long-term strategy. I could be cheeky and say that Hamish can afford to take leave and come back and the portfolio itself could look the same. So, this in itself does not really affect Magellan's outlook. But I guess, when we combine multiple factors and (indiscernible) what has happened in the past, some investors could see this as a sign of instability, some of them could start to panic and start to pull the plug. Rapaport: He is what you would consider a star fund manager. When you think of Magellan, you think about Hamish Douglass. I'm just curious to get your sense of why you don't think this will have – or you do think this will have an impact on client confidence and outflows going forward? Ler: Well, I think, clients and investors deserve to know – in the minds of clients and investors, they want to know a few things. Number one, what does this mean for the management of Magellan Global; number two, whether or not the portfolio can outperform; number three, what would happen to fund ratings and net outflows; and number four, what happens to the health of the other part of the business. So, if we just look at the first point, what does this mean for management of Magellan Global, in our opinion, the Magellan Global Equity strategies remain in very good hands. And we've always stressed that the talent pool runs way beyond Hamish and includes a 45-men strong team, which includes Arvid. Now, Chris Mackay and Nikki Thomas will work together to manage those strategies, and we are talking about excellent investors that are comparable with Hamish. I mean, Chris Mackay was previously Magellan's Chairman and CIO, currently at MFF Capital, which adopts a similar investing strategy as Magellan Global without the devastating China exposure. Nikki Thomas similarly a Magellan alumni who has worked with Magellan before leaving to Alphinity where she managed global equities over there, which by the way, delivered consistent top quartile performance. If you look at their other strategies, Infrastructure, (early), ESG and Core series, they are similarly undamaged and are separately run by other heads. And I think the blessing in disguise over here is that it sets the foundation for Magellan to reduce key person risk. I mean, even some of the portfolio management responsibilities, it clears off the image that Magellan is a one man show. Now, I'll just quickly touch on other aspects of the firm. I think that Magellan's fortunes right now is really tied to whether or not the portfolio can outperform, and I think this is the primary earnings catalyst. And the good news is that we think that the Magellan Global portfolio has greater odds to outperform. I mean, firstly, we estimate that those holdings are on aggregate more undervalued than the global equities asset class. Secondly, our global analysts covering Magellan's holdings collectively estimate the Magellan Global, the top 10 holdings to deliver EPS growth of about 17% per year on average over the next three years and over the next five years; seven are expected to deliver double-digit earnings growth and the remaining three mid to high single digits. Now, all of this is way superior to the mid-cycle equity market return of 9% per year. We have no visibility into what the research houses, the asset consultants will do. But seeing how previous ratings of Magellan Global were based off Hamish, I believe that the consultants may want some time to get comfortable with Chris and Nikki's track record. Now, I also stress that with or without ratings downgrades net outflows will happen and some investors would see this as a sign of instability and try to pull the plug. Rapaport: Yeah, I did read in your report that you expect 40% of funds to come out of the fund over the next five years, which seems like an enormous amount of money to lose. Ler: Well, the thing is that we believe that the net outflows will stabilize when the relative performance improves with higher consistency unlike the market, which is currently pricing Magellan to lose more, close to 60% of fund. Now, if Magellan were holding a portfolio of, I would say, stocks that can't compile earnings that are expensive, then that would signal to us that the chances for it to outperform to deliver excess returns is low and therefore we will change our view. But that's not our base case. Rapaport: Yeah. Just one thing to close out. In your report that you put out yesterday you did say that one of the things you expect Magellan to do to stop the outflows and to encourage investors to stay in is that they might reduce the price on their funds. Can you explain why you think they might do that and whether or not you think that will lead to some margin pressure for the company? Ler: Well, if you look at the retail side of the equation, Magellan has historically been a really strong brand with retail investors, with the financial advisor community. So, as the Magellan Global Fund starts underperforming, naturally we get some sort of inertia to leaving some sort of switching costs due to its intangible brand. Now, we are seeing investors telling Magellan, now we want to stick with you, but we want you to cut fees. Now, that in isolation might not be material. But if we consider the combination of factors that have happened to Magellan in the past, that is enough to make many investors nervous. Now, in this situation, I think that the bargaining power has switched from Magellan to the clients. Clients today have greater bargaining power, they have greater choices, they need to meet BID requirements, they need to justify recommending an underperforming fund to their clients. So, in this situation, I think that the client, the retail investors and the financial advisors really hold a stronger bargaining power over here, and I believe that Magellan, given its high fees, which are above average, there's really little leverage that they have to justify those fees. Now, on the institutional side, the story is a little bit different. Magellan's institutional fees are actually pretty attractive at about 0.3%, which is one of the lowest, which is comparable to a multi-manager fee in fact. And as a result, we're expecting slightly slower margin compression on the institutional side bearing in mind that they are institutional investors who buy Magellan to deliver those, sort of, lower-quality absolute return benchmark as compared to purely beating the benchmark like what many retail investors are seeking. Rapaport: Right. Thank you. I'm sure this is a stock that we'll continue to follow over next few months. So, thank you very much for joining us. Ler: Thanks, Emma.