The following is an extract from a report sent to clients on 14/1/14:
Magellan Financial Group Limited (Magellan) is an Australia-based fund management company. The primary business activity of the Company is funds management with the objective to offer international investment funds to high net worth and retail investors in Australia and New Zealand, and institutional investors. It operates in three segments: Funds Management, Principal Investments and Unallocated-Corporate. Funds management activities are undertaken by the controlled entity, Magellan Asset Management Limited (MAM). The principal investment portfolio consists of investments in the Unlisted funds, the Frontegra MFG Funds and in a select portfolio of Australian and international listed companies, cash and fixed interest securities, other investments. Unallocated-Corporate includes interest income on Non-executive Directors' Share Purchase Plan (SPP) loans, costs associated with the Board, ASX listing, audit and regulatory compliance activities of the Group.
ALL STARS ARE ALIGNED
A funds management business typically carries a higher proportion of fixed costs within its business model. Most of the fixed costs include items such as technology infrastructure, employee wages and rental costs. Because fixed costs are stubborn and not related to the level of sales they tend to be a source of headaches for companies in an environment of falling revenues. Unlike variable costs fixed costs are hard to remove because they are required for the ongoing operation of the business.
For a funds management firm a falling market environment usually creates a double whammy of client fund outflows and fund underperformance, since costs are sticky profit margins get crunched during these bear markets. Equally in a rising market funds management firms can take advantage of higher market returns, and if it also outperforms its market benchmark it can attract substantial growth in the form of fund inflows.
Although known for the superior stock picking ability of its investment staff Magellan was not immune to fund outflows and margin decline during and immediately after the global financial crisis of 2008. The investment benchmark used by Magellan's flagship fund the MSCI World index returned 32.8% in FY13. The MSCI World index mainly consists of the US market (54% of the index), and the remainder is made up of the markets of the UK, Japan, France and Canada. Therefore it’s no coincidence that a stellar performance by the US and Japanese markets (making up 63% of the MSCI world index) in 2013 has stimulated fund inflows and translated to a tripling of Magellan's funds under management for its flagship fund. The combination of substantial fund inflow, a rising share market, along with impressive stock picking (> 7% outperformance of the MSCI world index both in the 3 year and 5 year periods by its flagship fund) have meant that the stars are finally aligned for Magellan. The presence of higher fixed costs has meant that profit margins are also up (up 16.5% in FY13), translating to an exceptionally profitable year. Although the US and Japanese market is not expected to generate the same returns in FY14 as it did in the prior year the performance record of Magellan should help it continue to attract sizeable fund inflows.
VALUATION SUPPORT DESPITE STRONG PRICE PERFORMANCE
Despite the strong performance of the Magellan share price over the 2012 and 2013 calendar years we think it is still good value at current price levels. The FUM (funds under management) of a listed funds management firm has historically been a good predictor of its share price. Looking at the Magellan share price against its market cap over the last 4 years, based on current FUM of Magellan, we believe that the company is undervalued by the market. Using the regression equation, a fair value share price for Magellan’s current FUM of A$21.37Billion would be around $13.18, giving the investor approximately 17.6% return upside should the share price trade up to a level to enforce this relationship.
On a comparable company basis the only other listed fund manager in Australia with an international product offering is Platinum Investment Management (PTM). As mentioned earlier fixed costs are an important part of a funds management business and for that reason it is important that a fund manager is able to manage its cost base and keep it to a minimum. Although Platinum has a lower cost to income ratio (total operating cost divided by total revenue), compared to Magellan (21% vs 29%) it trades on a higher P/E ratio (30.3X vs 27.9X), so is more expensive. Although they are both quality funds management businesses our preferred pick is Magellan.
WHAT ARE THE CHARTS TELLING US?
MFG has been trending well for a couple of years now. The moves up are much more impulsive than the moves back down – which indicates that the bulls are still in control of its upwards trajectory. Even though there has been a decrease in the share price since July, the fact that it is very corrective means that we have nothing to worry about at this stage. You can see on the chart how fairly flat this pullback is in comparison to the recent run up at the beginning of 2013. So where is the entry point? Although the recent down trend line has now been broken (the solid blue line), conservative investors may prefer to see the stock make a “higher high”. That is, once it clears $11.63 on an intraday basis, we can enter the stock and expect a quick $1 upside for the short term. Beyond that, as long as it takes out the July high fairly quickly, we should expect a decent uptrend to resume in MFG.
Based on all of the above, MFG has been added to the Fairmont Equities model portfolio. Contact us for a free trial to our client research.