"A bump in the road" as Magellan loses major client

-- | 21/12/2021

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Lewis Jackson: Shares of Magellan fell more than 30% on Monday as news broke that a major institutional investor had left the fund manager. I'm joined today by Morningstar's Shaun Ler to talk through what the latest blow to the troubled fund manager means.

Shaun, thanks for being here.

Shaun Ler: My pleasure, Lewis.

Jackson: So, talk us through what happened on Monday and why markets reacted so sharply.

Ler: Well, what happened on Monday essentially was Magellan announcing the loss of a mandate, and this mandate is substantial, it's from their biggest client St James's Place, which is a large wealth manager in the UK Obviously, the market has viewed this as a sign of instability, as a sign of diminishing investment powers within Magellan. However, we believe that the Magellan shares have been oversold even before the announcement of the mandate loss. If one were to look at our notes before this, we have long said that at the previous closing price of $28 per share or $29 per share, the market was already foreshadowing the doomsday scenario that assumes Magellan loses $20 billion to $25 billion worth of funds and (indiscernible). So, that is our view that shares have been oversold.

Jackson: So, in saying that you also cut the fair value for Magellan by 25% following the news. Talk us through the logic there and why investors should still have confidence in the company.

Ler: Well, Lewis, if I were to just take a step back to explain the whole issue, the news was certainly disappointing. Now, our understanding was that Magellan's clients (indiscernible) to beat an absolute return, the downside protection, right? And this is something that Magellan has always communicated. It is something that it has always delivered. And these are clients that stood with it for many years, even through its underperformance in 2016.

The reason why we are still positive on Magellan is that Magellan is like Macquarie in the making. It's not a mere fund manager. Now, there are no near-term share price catalysts, and its positive traits will take time to occur. But we believe that Magellan's current share price incorporates just a whole lot of pessimism. Now, we believe that this is a bump in the road. We will see more redemptions and fee compression in the near term. Magellan's bargaining power is now weaker, and it would need to cut fees. But I think investors should know that there are still many people many people who held back from investing with Magellan because of their premium pricing.

And another important thing to note Lewis is that the loss of the St James's Place mandate removes concentration risk and frees up capacity for Magellan to invest. I mean SJP or St James's Place is the only elephant in the room. The next four clients, the next four largest institutional clients each make up about 2% of revenue, or about $4 billion in the firm. Now, Magellan will have more capacity to sell more to other clients, it can invest into more stocks, and we have long said that Magellan's holdings have strong economic moats and are undervalued. Now, all of this would help Magellan outperform in the future.

And the third point is that Magellan's compounding power and its investing caliber is strong, right? If you look at Magellan's funds, it has got $90 billion in funds. So, if you think about that, the mere compounding of a 9% to 10% market return is more than enough to offset, say, four to five years of outflows from (platinum) 3:49 or outflows from Magellan's next two largest in institutional clients.

And I guess, lastly, Magellan has a stable product suite and investments that are not pricey, fairly strong, it's getting good money flows into MFG Core series and FuturePay will be stronger after they build up a stronger track record. Now, Magellan is not going bankrupt as well. I mean, its balance sheet is strong; its cash flows are strong. It has stakes in some of the best investment banks – one of the best investment banks and fast-food restaurant chains in Australia, all of which with a strong growth potential. So, we think that because of that shares are massively oversold and there are still many positive traits of Magellan that admittedly will take time to manifest itself.

Jackson: Now, Shaun, Monday's events took place just days after Magellan's chief executive, Dr. Brett Cairns, resigned. Should investors watching on be concerned that there's more and more pressure piling up on portfolio manager Hamish Douglass?

Ler: Well, Lewis, the thing about these events is that in our opinion they do not detract from Magellan's investing caliber. As we've mentioned before, Brett Cairns is not the investment guy. Brett Cairns has done a lot of good work in implementing new products, introducing new products (indiscernible) investors to invest in. But the portfolio management team, the analyst team, the investing team, they are 50-men strong, and they are still there within the firm. And Dr. Brett Cairns is not part of it. And if we look at issues around Hamish's family issues – now we don't want to speculate it. We do not want to speculate around what Hamish should do with his life. But if we just take a step back and look at what is the Magellan global strategy, it is a patient buy and hold shop that has less than 20% annual turnover per year. Time does much of the work for the portfolio manager, which is Hamish. Now, this is with 1,000% to 10,000% in annual turnover per year in hundreds of stocks which can be very distracting. So, we think that comparing Hamish, comparing Magellan to somewhat of a hedge fund, it's completely unreasonable, it's a completely irrational comparison because they are two very different businesses.

Jackson: So, Shaun, you've talked a lot about Magellan's long-term aspirations, its future as sort of the next Macquarie. But what about the next 12 to 18 to 24 months? And how is the fund manager going to turn around the outflows on the retail side and now on the institutional side?

Ler: Well, Lewis, yeah, there are few things that Magellan can do. I mean, if we first focus on Magellan's products, so importantly, if we look at Magellan's products, they are intelligently designed products to help it capitalize on emerging investor preferences. It has got the low-cost ETFs, it's got retirement income products, and it's got an ESG strategy. Obviously, flows into these new products are not comprising the market, but we believe that the latent growth potential in these products is strong.

As of now, Magellan is starting to market its products. What it will need to do next is to get these funds – get its products rated by research houses, include them into model portfolios, and then we can see new streams of funds coming in. Obviously, this will take time to occur, anytime between one to three years, and hence why this is something that the market has chosen to forget. That is one thing.

Another would be not something that Magellan would want to do, but fee cuts, and this is something that it can do because as of current Magellan's fees are still at a little bit of a premium side. What it can do is to lower its fee margins close to the peer average, close to the peer median. And lastly, Lewis, I would just say is the normalization of its investment performance. Magellan's portfolios are currently more undervalued than the overall equity markets and its portfolios consist of strong developed market stocks that have wide economic moats and are undervalued. As the investment performance normalizes, the collective impact of this will help underpin stronger investor confidence and support further fund flows moving forward.

This report appeared on www.morningstar.com.au 2022 Morningstar Australasia Pty Limited

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