A tale of two fundies

A comparison of Platinum Asset Management (ASX: PTM) and Magellan Financial Group (ASX: MFG) could not show more disparate outcomes for two globally-focused Australian fund managers.

On any metric — share price performance, funds under management, financial performance, their funds’ returns — Magellan has crushed Platinum over the past 10 years.

If you look at Magellan’s flagship Global Fund’s top 10 holdings it’s easy to see why. Magellan are investment managers who understand the modern world. They were early to recognise the superior business models of high-growth global franchises, be they tech businesses or the capital-light owners of enduring worldwide brands.

History has shown that these businesses drive superior returns over the long term. Understanding high quality, high growth businesses is in Magellan’s DNA, and that expertise is why we should expect superior investment returns in their funds going forward. With a strong brand and fantastic economics hitched to the continued growth of the world’s best business, paying 21x earnings (ex performance fees) will quickly seem inexpensive.

Platinum, on the other hand, are sticking resolutely to the same strategy which has completely failed them for over 10 years.

Their flagship fund has underperformed over 1 month, 3 month, 6 month, 1 year, 2 year, 3 year, 5 year, and 10 year periods. That’s also against a pretty easy comparison, the MSCI World, which has materially lagged the S&P 500 over the past 10 years.

Platinum are suffering near-constant net outflows, with only investment returns keeping their FUM from declining. At their recent earnings release, Platinum only dug their heels in deeper by further committing to an outdated investment strategy. They appealed to investors to remember their sporadic short periods of outperformance, the most recent of which was 9 years ago.

For those reasons, Platinum trading at 16x earnings versus Magellan’s 21x is entirely understandable.

That’s my condensed summary of the bull case for Magellan and the bear case for Platinum which justifies their valuation disparity. I entirely disagree with it.

I would today pay a higher multiple for Platinum than I would Magellan. That doesn’t mean I’d pay 21x for Platinum — at current prices I consider Platinum (at $4.00) a little cheap and Magellan (at $43.50) pretty expensive.

So what am I looking at that I think the market is missing? In a word, cycles. Platinum looks much cheaper if you consider anything other than a straight line extrapolation of the past 10 years.

Magellan to me is a profound secular success story of marketing, distribution and brand, attached to a highly cyclical bet on growth stocks which has paid off. Platinum shares the secular success story (executed at least a decade or so earlier), but it’s towards the end of a long and painful cyclical downturn.

In my view, investors are extrapolating the past at exactly the wrong time. Let’s take a closer look at Magellan’s top 10 holdings to see why. If you’d bought $1,000 each of Magellan’s current top portfolio holdings back in 2011, your portfolio was then generating a 5% earnings yield.

Over 10 years those earnings are around 4x larger. But the prices have gone up close to 8x. That same portfolio is now only accruing 2.7% in profits to owners annually.

(Lest you think I’ve cooked the books by looking at trailing 12 month earnings for businesses like Yum! Brands and Starbucks during a pandemic, feel free to fact check me here. They are all within spitting distance of all time record earnings. And let’s not forget how well technology businesses have done with people stuck in front of screens for 18 months.)

Magellan has built a business on owning companies as they’ve grown rapidly, while simultaneously going from a 5% earnings yield to a 3% earnings yield. Now, 3% may indeed be a more appropriate multiple for these stocks than 5% was. I won’t argue that SAP isn’t a difficult platform to migrate away from, and I am certainly not about to churn from KFC any time soon.

But even if you think that today’s growth companies truly are different, and that difference should be reflected in profound pricing differentials between high and low growth stocks, it still points to lower returns for owners of these businesses in future.

Multiple expansion contributed more than 40% of the return of this basket of stocks over the past 10 years. Even granting that the growth stocks will grow faster forever, multiples can’t expand forever. At some point, that expansion will stop, and the 11% p.a. tailwind from multiple expansion that this portfolio benefitted from over the past decade will slow, stop and potentially reverse.

I won’t go into details of the value versus growth drawdown (AQR and GMO are good resources on the topic). Suffice to say, if you believe that cycles between growth and value exist, it’s clear that Magellan and Platinum are nearer their peaks and troughs respectively.

I find it quite amazing that the cyclicality of these businesses is not better understood. Growth investors have no problem seeing through iron ore miners for example, many of which are being snubbed at 30% FCF yields today on cyclically high profits. And quite rightly, given the direction of the iron ore price in recent weeks. But for some reason, a fund manager trading their own commodities at similarly extreme pricing has been bid up to 6x the price.

Now that we’re talking relative valuations let’s look at some numbers. Platinum made ~$125m in NPAT in FY21 from asset management (excluding performance fees and investment returns). They have around $350m in cash and investments. With a market cap of about $2.3bn, they’re trading at 16x trailing baseline earnings excluding liquid assets.

I get around $400m of FY21 NPAT for Magellan’s asset management business excluding performance fees, but before ‘transaction costs related to strategic initiatives’. Though Magellan adjust for them, given they’ve appeared in 3 of the past 4 years, have averaged $66m after tax during that time, and are getting larger over time, I’m going to consider these recurring. That leaves $335m in NPAT ex performance fees and investment returns.

Like Platinum, they hold cash and assets in their own funds which amount to about $900m. Against a market cap of $7.9bn, after netting out the liquid assets cash it’s trading on about 21x earnings (while diluting shareholders by about 1% per year).

Magellan is then around 30% more expensive than Platinum. But this is just looking at last year’s earnings. How should we think about long term earnings power?

I see an analogy to banks here. Imagine the past 10 years of earnings for two banks in completely different markets, both focused on home loans. In one market, house prices a decade ago were low after years of flat or declining prices prior to that. Credit availability started off tight due to those poor conditions, but there was little demand for funds anyway.

Around 10 years ago though, prices turned the corner and demand began to spring back from buyers keen to get on the property ladder before they were priced out of the market. Existing homeowners, who previously were struggling to tread water above negative equity, now find themselves with growing equity which they use to upgrade to a larger house or to fund renovations.

Today, people in the region are earning more because of the housing upswing, with tradespeople busy and increasing prices, and plenty of retail spending on big-ticket consumer durables to fill up new or expanded houses. The economy has built up steam.

Meanwhile, banks are now more comfortable with extending credit. Loan losses have been low because collateral values are high, making it clear that the bank left money on the table during its earlier years of conservatism. Provisions are being unwound, boosting profits and expanding capital to make further loans.

This bank has had a fantastic 10 years, and with such favourable prevailing conditions why should we expect anything different over the next decade?

For the second bank though, the feedback loop is firmly stuck in reverse. The housing market peaked a decade ago and we now know that borrowers had over-extended themselves. Too much housing stock had built up and values have been stuck in a slow decline since. Potential buyers, seeing values creep slowly lower over years and with no bottom in sight, are (quite reasonably) unwilling to put 800% of their net worth into a single depreciating asset. Tradies return calls at this part of the cycle and there’s less equity to release to fund new cars and whitegoods.

This bank is seeing no loan growth, stubbornly high bad debts and collateral values falling. It has curtailed credit availability along with its peers, demanding high deposits and high serviceability ratios. There’s nothing suggesting that the cycle has turned and the future looks similarly grim.

If you could find these imaginary banks, I’m almost certain the former would be trading on a higher multiple of book than the latter. But it’s much riskier. Its profits are reliant on borrowers who are stretched to their limits, collateral values that can only be maintained while credit is free flowing, and incomes that are fuelled by credit-funded construction and retailing.

This is as good as it gets for credit growth, bad debt expense and profits. While it won’t necessarily end any time soon, the perpetuation of the best conceivable conditions is necessary just to sustain profits, let alone grow them. Anything less than that, and serious trouble awaits.

The latter bank, with low collateral values, low credit availability, and profits and underwriting based on pessimistic assumptions, is reporting heavily de-risked profits. Things are already bad and they’ve positioned for things continuing to be bad via their provisioning. Profitability can be maintained even if terrible conditions persist. And should the cycle turn, well, it looks a lot like our first bank did a decade ago.

This is exactly the dichotomy I see with Magellan and Platinum.

Platinum’s current earnings, largely devoid of performance fees and the assets of flighty investors, are de-risked. Platinum’s worst investors have already jumped the fence and joined Magellan (probably to return when Platinum are outperforming again). After so many years of underperformance, it’s difficult to imagine what might cause a large proportion of their investors to suddenly leave.

These businesses don’t have assets that accountants would recognise, but in the same way that, all else being equal and with a long enough horizon, an 80% loan is less risky on a house that’s just halved than doubled in value, an investor who sticks with you at a cyclical bottom is a less risky client than one who joins at the top.

Platinum are also investing conservatively, accepting cash drag and incurring shorting losses which further reduces the risk of rapid outflows. Though they’ve had net outflows during 4 of the past 5 years, FUM is holding roughly stable due to investment returns. FY21 profit is about the same as FY19-20, materially lower than the FY14-FY18 period, and not until you look back to FY13 can you find a favourable comparison. But while profit growth has been weak, the risk of a material impairment of future earnings power seems quite low if you believe they’re still good stock pickers.

Magellan is different. They are investing balls to the wall in the most expensive market there is. While performance fees were modest in FY21, profits are boosted by peak FUM. Their profitability reflects both having a large number of clients, and those clients’ balances being high due to years of rapid compounding from big bets on growth stocks. Both of those variables are (in my view) reflective of a cyclical high, and it’s entirely possible that both go backwards at the same time.

So it was that I was unperturbed by Platinum’s results which they announced on August 26. The stock was down -8% on the news. I didn’t think there was much informational value in the results, with performance fees already telegraphed. Instead it appears the market was responding to the strategy slides.

As a shareholder the report was exactly what I would have hoped to read (but then again, who doesn’t love 33 pages of thoughtful charts confirming your biases). Platinum beautifully articulated their commitment to their strategy which has worked over the long term. Importantly, it only works because it’s unpopular a lot of the time. You actually want them to be underperforming when their style is out of fashion. Anything else would signal pro-cyclical behaviour which can deliver mediocrity at best over the long term.

It’s entirely possible that Platinum posts a couple of years of double-digit outperformance if and when the cycle turns, earn some monster performance fees and see a material re-rating on higher earnings. In the meantime, they’ve proven that they can survive in one of the worst environments imaginable for value investors, paying a ~9% grossed up yield while you wait (assuming franking credits have value to you).

Magellan’s price could ultimately turn out to be cheap with even one or two years more of growth stock excess. But one could easily envisage a world where they earn no performance fees for several years, funds flow out and it re-rates to 15x on lower earnings as the narrative changes from one of brand, marketing and structural growth, to one of a cyclical wrong-footing.

It’s a long way down in that scenario. One need look no further than Platinum for that matter, which is more than 50% below highs reached in 2018, 2015 and 2007. Perpetual (ASX: PPT) is another example, also 50% below all time highs struck nearly 15 years ago.

In my view, a fall from grace for Magellan is at least a 50/50. This is not the first time that the market has fallen in love with the largest and best companies in the world, nor the fund managers that buy them. Magellan seems like a recipe for disappointment in anything but a future which looks exactly like the present.