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).