Date of Analysis: 24 August 2020
|Market Cap||$11.23b||Share Price||$61.61||52 Week Low||$30.10||52 Week High||$74.91|
|Revenue||$692.5m||Revenue CAGR(5 yr)||19.9%||Net Profit||$396.2||Profit CAGR(5 yr)||17.9%|
|P/E Ratio (TTM)||28.2||Cash-to-Debt||25.3||Debt-to-Equity||0.02||Dividend Yield||3.5%|
Magellan Financial Group is one of Australia’s best fund managers. Led by the Australian billionaire Hamish Douglass, Magellan manages just shy of $100 billion in assets across a number of private and publicly-listed funds.
Importantly, for any business but particularly for a fund manager, management’s incentives are aligned with the shareholders. Hamish Douglass owns 12.2% of MFG and co-founder Chris Mackay (who now runs ASX listed MFF) owns 10.2% of MFG. So between the two co-founders, they own almost a quarter of the business (22.4%).
The fund management business makes revenue from management and performance fees. This makes the financial drivers a pretty simple equation of ‘funds under management’ multiplied by ‘management fee’.
Over the past 4 years, the average funds under management have increased at 24.7% per year.
|Average FuM ($m)||39,437||45,667||59,034||75,819||95,458|
At the same time the average management fee has remained relatively stable, dropping -1.6% per year.
|Average base management fee||66||66||65||62||62|
There is no question that MFG is one of Australia’s premier fund managers. The market recognises this, and MFG trades at a premier to many of their fund manager peers.
The simplest way to value a company is on a ‘relative basis’ (i.e. compared to similar companies in its industry). With a relative valuation, we are not asking for a specific valuation. Instead we are asking if it is cheap, in-line or expensive when compared to what investors are paying for similar companies.
The easiest way to do relative valuation is using the price-to-earnings ratio.
Where does MFG sit in relation to its peers?
|Company||P/E Ratio(as of 13/8)|
|Platinum Asset Management||13|
|Magellan Financial Group||28|
|Pinnacle Investment Management||31|
|Centuria Capital Group||46|
|Australian Ethical Investment||60|
We can see that MFG sits in the middle of the range of valuations that Australian fund managers enjoy in Australia.
Discount Cash Flow
The DCF calculation is a two-step process where you estimate the future cash flows of a company, and then determine the value of this future cash flow today. To do the first step (estimate future cash flow) we need the current free cash flow per share or earnings per share and an estimated future growth rate.* For the second part we require a discount rate, because the value of dollar in the future is less than a dollar today. For discount rate, both Warren Buffett and Roger Montgomery suggest using 10% (and if it’s good enough for them, it’s good enough for us).
*The future growth rate is often split into growth rate for the next 5-10 years, and then a ‘terminal growth rate’. This is usually at or just above inflation (because projecting beyond 5-10 years is so uncertain).
So for MFG, the information we need to do this analysis:
- Earnings per share: $2.18
- Growth rate in the next 10 years: 17.9%
- (17.9% was the annual profit growth rate over past 10 years)
- Terminal growth rate: 3% (assumed growth in line with inflation)
- Years of terminal growth: 10 years
- Discount rate: 10%
Fair Value: $63.58
This is slightly higher than MCD’s current share price of $61.61.
Reverse Discount Cash Flow
We can flip the DCF process, and ask ‘based on a DCF analysis, what assumptions are built into the current share price?’. We know the company’s current per share metrics, and the current share price. Putting these numbers in – we can ask what growth rate is implied in the company’s share price. Or, asked another way, what growth rate would you need to be in the DCF model to have the current share price as ‘fair value’.
So for MCD, the information we need is:
- Share price: $61.61
- Earnings per share: $2.18
- Terminal growth rate: 3%
- Terminal growth period: 10 years
- Discount rate: 10%
Putting this information in, we ask what would the 10 year growth rate need to be to have the current share price match ‘fair value’ in a DCF calculation.
Required annual growth rate for next 10 years: 17.44%
Using this metric, we can ask ‘Do we think MFG will grow earnings per share at 17.44% every year for the next 10 years?’ To do this, MFG will need to continue the incredible rate of growth in funds under management or increase its management fee.
In building an investment thesis for MFG, there are three questions we felt we needed to answer:
- Can funds under management continue growing?
- Can the management fee on these fees remain stable?
- Can Magellan sustain current profit margins?
Can funds under management continue growing?
MFG is now a $100 billion fund manager, which is a massive number. As the funds under management gets larger, it becomes harder to sustain their existing growth rate. However, there are three reasons we believe Magellan could continue (or even accelerate) their growth in funds under management.
- Return of the active manager
Since the GFC, there has been no better trade than long US large cap stocks. A big reason for the success of low-cost index funds in that time, is that the indexes they’re tracking have been an unbelievably strong asset class. Led by the large US tech stocks (Amazon, Apple, Alphabet etc.) the S&P 500 and NASDAQ 100 indexes have led the world. The strength of the index has made life difficult for active managers. It is difficult to justify your higher fees when you cannot beat the index.
As with everything in life, asset prices move in cycles. After such a sustained period of outperformance it will be hard for major stock market indexes to continue their outperformance. The geopolitical uncertainty caused by the US-China great power competition, the increased threat of regulation for large US technology stocks, the weakening of the US dollar, all point to the 2020’s being a difficult decade for the benchmark US indexes.
If active managers are able to capitalise on this period of uncertainty and beat the index, we expect capital allocators of large institutions and endowments to reallocate capital from their low-cost index strategies to active managers.
- Paying for quality
In a reassessment of active management, quality will matter. Only those managers that are able to generate ‘alpha’ (returns above their set benchmark) will be able to attract fund inflows. We still see Magellan as Australia’s best large fund manager, and expect to see them attract an outsized proportion of fund inflows.
- New products
At the same time, Magellan is building out a new product set to attract new segments of the market. In particular, a set of 3 ETF style products and a retirement income product. These funds will be attractive to two fast growing areas of the Australian investing market. The ETF style products will be attractive to the growing class of retail investors in Australia and the retirement income will suit many older Australians that are heading towards retirement.
Can the management fee on these products remain stable?
In the current investing climate, it is unlikely any fund manager will be able to increase its management fees or performance fees. The rise of low-cost index funds have created a strong incentive for fund managers to cut their management fees. At the same time, we believe asset allocators will continue paying for quality. So while we do not think MFG will be able to raise their management fees, we also do not expect to see a material decline in the management fee.
Can Magellan sustain current profit margins?
The great thing for MFG is that many of its costs are fixed. That as funds under management scale, its costs do not need to scale at the same rate. Over the past 5 years, Magellan has been able to keep a net profit margin of ~60% and there is no reason to expect this will move materially over the coming years.
Magellan’s strategy is to continue growing its funds under management by leveraging its core competitive advantage in equities research across a variety of different funds. These new products, as well as a general return to active management, should continue to sustain strong growth in funds under management and justify the valuation it currently trades at.