Magellan: Flavour of the month, but will it last?

Magellan Financial Group has certainly been “flavour of the month” in recent times. The company’s shares trade on a high price-earnings ratio of around 26 and they have attracted plenty of media attention. They certainly have achieved good results, but as is so often the case, these results are over relatively short periods of time, and I would argue, due to a unique set of circumstances.
 

A look at the listed Magellan Flagship Fund or the unlisted Magellan Global Fund will immediately reveal the modus operandi of the company – buying large good quality (mostly American) companies at what they deem to be attractive prices (e.g. Google, Microsoft, Apple, Wells Fargo, Visa, McDonalds, Yum Brands and so on). Sound familiar?

Hamish Douglass and Chris Mackay, (the founders of Magellan), like so many Australian fund managers these days, are die hard Buffett acolytes. Buffett of course moved on from pure stock investing decades ago and the technological landscape has changed dramatically since his halcyon days.

The Magellan Flagship Fund annual report does make for some interesting reading, but not for the disclosure of investment holdings or the ubiquitous fees that investors must pay. The relationship between the fund and its prime broker (Merrill Lynch) is much more interesting.

The Flagship Fund’s balance sheet (30 June 2013) nets $120 million of borrowings from Merrill against cash held on behalf of the Fund with Merrill ($123 million). Instead of seeing borrowings stated as $120 million on the balance sheet and cash as $123 million higher than stated, you see no borrowings and cash stated as $3m more as a result of netting the $120 million in borrowings against the cash of $123 million. That’s misleading, but perfectly acceptable under our (sometimes bewildering) accounting standards.

However, when we start reading the notes to the statements we discover that Merrill has security over up to $200 million of the Flagship Fund’s holdings. Further, we are told that Merrill doesn’t segregate its own cash from the cash belonging to the Magellan Flagship Fund and that Merrill can use the Flagship Fund’s cash in the course of its own business!

So now we have counter-party risk on a fairly large scale. If Merrill were to become insolvent, the Fund becomes an unsecured creditor and could potentially lose up to $200 million of its investments!

Now these arrangements may be normal with the flashier modern listed investment companies, but any investor casually perusing the Flagship Fund’s balance sheet alone is probably not aware of the debt the Fund carries or the fact that there is significant counter-party risk.

An investment in the Flagship Fund is not the same as an investment in Argo, Milton Corp. or AFIC – these companies have much lower levels of risk (and are generally the preserve of older investors who live in the wealthier suburbs of Sydney, Melbourne and Adelaide).

Institutional investors have poured money into the Magellan Group – billions. But I do wonder why. Are they incapable of making direct investments themselves into the type of companies that Magellan invests in? Nothing Magellan is doing is rocket science, it’s hardly another Renaissance Technologies.

 

Yes, Magellan has achieved good results, but the set of circumstances that allowed them to achieve those results is not readily repeatable. The major factors that assisted Magellan’s results are:

1.    Quantitative easing in the US;

2.    The purchase of companies at knock down prices during the GFC;

3.    The purchase of US and other foreign securities when the $A was very high and the subsequent benefit of the recent depreciation of the $A against the $US and other currencies.

The influence of quantitative easing in Magellan’s results is absolutely obvious to me, there is simply no way their results would have been achieved without it. The Federal Reserve has engineered an American bull market through quantitative easing, but the party must end at some point.

Now I ask you, how many times in a lifetime do you think this scenario will repeat?

The enthusiasm for Magellan also makes me think of Platinum Asset Management circa 2007. The stratospheric prices that Platinum shares got to on its first day as a listed company in May 2007 were silly (and they have never reached anywhere near that level since – more than 6 years later). And no one seriously thinks that Kerr Neilson is an Australian (or dare I say, South African) version of Warren Buffett as some did back in 2007 and earlier.

Now Douglass and Mackay are not versions of Buffett either. They obviously have some skills, but are not in the Buffett league. They may get some more nice “free kicks” from the devaluation of the $A against the $US. Further, Australian domestic funds management businesses should prosper in an environment of extremely low interest rates and an Australian market that doesn’t seem over-valued to me (within the context of current interest rates). But please let’s not think of the folks at Magellan as some sort of new messiahs and value the shares at ridiculous prices. And please be very conscious of what quantitative easing has done for Magellan and what it will mean when it ends.

(The picture accompanying this article is of the famous Portuguese explorer Ferdinand Magellan).

The cost of an Oxford education

Imagine two students living in Australia who are about to enter university, Paul and Peter. Both achieved excellent results in their final year of school. Coincidentally, both also recently inherited $160,000 from a relative.

 

Paul and Peter both live about 15 minutes away from their local university. According to a recent report published by one of those university guides, this local university was ranked 55^th in the world for overall quality of education. When one considers how many universities there are in the world, this is certainly a high ranking.

Paul has decided to attend this university, it is close to where he lives, has good facilities and staff and offers the degree he wants to study for. Paul has chosen to study Economics and History. Paul will use approximately $30,000 of his inheritance to pay for his degree. The remaining $130,000 will be invested in one of the old blue chip ASX listed investment companies and Paul hopes to leave it there as a “nest egg”.

Peter is much more status conscious than Paul. Peter has always wanted to attend Oxford or Cambridge. He is very impressed by the old buildings, the eccentric traditions and some of the well-known past graduates of those two institutions.

Peter makes an application to Oxford as a foreign student. He has decided to study for a BA in History and Economics. After the application process concludes, Peter receives the pleasant news that his application has been successful. As it happens, the cost of Peter’s three year degree (plus living expenses and the odd airfare back home) will equal the amount of his inheritance.

Peter’s successful application to Oxford is a great talking point amongst his relatives and friends. A very bright future is envisioned for Peter. Peter won’t admit it, but he is enjoying all this attention from his friends and relatives.

While Paul’s relatives and friends are happy about his successful application to the local university, it hasn’t been met with the same adulation that has been accorded Peter.

Peter’s time at Oxford is generally pleasant, but he does get a little homesick on occasions. He misses family and friends.

Paul on the other hand has made minimal changes to his lifestyle. He still lives at home and has friends from school attending his university.

Both Paul and Peter complete their degrees at the age of 21.

Now we fast forward 39 years. Paul and Peter are both 60 and about to retire from successful careers.  Paul never did touch that inheritance. He simply collected dividends and enjoyed the capital growth. That inheritance is now worth $2m and pays approximately $80,000 in dividends each year.

Paul and Peter both earned approximately the same amount of money during their careers. Peter (despite attending Oxford) was unable to out-earn Paul. As we mentioned earlier, Paul is just as bright as Peter and also has a similar temperament and personality.

 

So now we can say that the cost of Peter’s Oxford education was in the vicinity of $2m, being the money that his peer Paul now has that he doesn’t. It’s a high price to pay for a “brand name” education.

Obviously, universities such as Oxford rely very heavily on their brand. Oxford’s more recent move into awarding MBAs is a very good example of this. Oxford has no history as a business school. It simply wished to capture a portion of the market for MBAs that it was previously missing out on.

The MBA degree at Oxford appeals to a certain clientele. The applicants tend to be people who have reasonably good jobs in the business world (but not always) and who (in all likelihood) would not have been successful undergraduate applicants but now are afforded the opportunity to obtain an Oxford qualification at a cost which is less than an undergraduate degree. It is very good marketing and I certainly applaud Oxford for it.

Harvard also uses its “brand name” to increase its earnings. The short management courses are a very good example of this. These courses are marketed to executive level people (from all disciplines). They undertake a very short course at Harvard for which they will be awarded some sort of certificate.

It amuses me no end when I see these certificates decorating the office walls of people who have attended these courses.

Once again, the vast majority of these people would not have been successful applicants to Harvard for under graduate degrees. Harvard is simply using its brand name (like Oxford) to charge very high fees for a short course (with relaxed entry criteria) that allows the applicant to say that they attended the university*.

 

* I too have been to Harvard, I visited some years back while on a trip to Boston.