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The ups and downs of December 2021

Magellan: the good and the bad news

Magellan hit the front pages of the Financial Review in the last few weeks of December for a few different reasons. Firstly, the CEO, Brett Cairns, suddenly resigned with little information as to why. Secondly, Hamish Douglass confirmed rumours that he had split from his wife and denied that they were going to sell stock and thirdly Magellan announced the loss of a $23 billion mandate from St James.

These three pieces of news sent the shares plummeting down 30%.

At Valor, we welcome bad news (if it is temporary). Temporary bad news or a company being out of favour provide long-term investors opportunities to buy great businesses at very attractive prices. As per the old investment maxim goes “buy on the sound of cannons, sell on the sound of trumpets”, doing this repeatedly with careful analysis will reward patient long term investors handsomely in the long run.

The reason so few excel at investing is that they are incapable of buying when there are dozens of articles telling you not to. Humans have a survival mechanism which entices us to follow the crowd. This follow the crowd survival mechanism was hugely important for tens of thousands of years when we were being chased by lions on the African plains, however it is the exact opposite of what we need to flourish in markets to create wealth. Quoting Sir John Templeton, “the best time to buy is at the point of maximum pessimism”.

Magellan Financial Group is a wonderful business going through a difficult time. It earns very high returns on its capital, it has a long platform for growth and despite obvious volatility in its business due to capital markets, it is slowly becoming more diversified and less dependent on one fund.

Fund management businesses can be licenses to print money. They can have exceptionally high returns on capital. Some of the wealthiest people in the world are fund managers. The business is somewhat risky. It requires the manager to produce continued outperformance over its respective indices or/ and have outstanding marketing abilities. Magellan has proven both the ability to outperform (despite recent times) and through the less well known, yet equally important head of distribution Frank Casarotti, they have dominated fund flows for active management over the last 15 years.

During times of rising markets, outperforming an index can be difficult unless you take more risk than the market, which can lead to horrible performance during the more difficult times. The recent turbulence in ARK funds highlights the risks that some take during the good times. Often this style of management leads to non-permanent wealth creation.

Magellan takes the other approach, which is to be more conservative during the buoyant times, which usually leads to outperformance during the more difficult times. The last few years have been some of the most buoyant times in history. Magellan will likely outperform when the tide goes out.

Most fund managers have the majority of their funds in what are called open ended structures. This means that the fund can grow or shrink from people putting in or taking money out. The opposite of this is a closed end fund where the number of units are essentially fixed and the only way to withdraw your capital is to sell the units on the open market.

Magellan has a small, yet not insignificant amount in closed end funds. With over $5billion in higher fee paying closed end funds, this should provide a cushion for their earnings. These funds have the ability to attract new units due to options in the coming 2 years.

In addition to their very steady closed end high fee funds, they own other non-core assets. They own units in their own funds, they own 40% of Barrenjoey, 15% of Finclear and 12% of Gusman and Gomez. Their non-core assets are likely worth more than $1billion if interpolating for the last 6 and a half months of growth.

The infrastructure fund run by Gerald Stack is a relatively steady business. The Australian arm of Magellan, Airlie Funds management, run by John Server, Matt Williams and Emma Fisher has had an outstanding few years and is still attracting new funds under management, albeit at lower levels than the outflows from the Global Fund.

Combining their non-core assets and their closed end funds provides us with a base level of value for Magellan which is relatively “safe” for a fund manager. Remember fund managers can have their entire fund withdrawn and can go to zero. Neil Woodford in the UK highlighted just how quickly a fund management business can fail. A fund manager with closed end funds and other non-core assets with no debt cannot go to zero. There is a base level of intrinsic value.

Separate from the non-core assets, we estimate that Magellan trades on a 12.5% earnings yield. It is very attractively priced.

he more recent outperformance of the Magellan Global fund in December by 1.4% and the confirmation that their earnings should be approximately equal to last year’s earnings (this is actually not a declining business (despite what the share price suggests) have yet to entice investors. We are very likely to be long-term holders and we are not fussed if the share price increases. The current dividend yield when grossed up is approximately 13%. In a near zero rate world, we are more than happy with a 13% return. A normalisation in price to what Morningstar suggests is fair value ($38) would produce an approximate 19% to 26% per annum return over the next 5 to 10 years. Investments with this level of upside are rare in this market.

We took the opportunity to add to our position and follow the guidance of Warren Buffett on how to become wealthy, “close the doors, be fearful when others are greedy and greedy when others are fearful.”

Will Omicron ground Safron?

Following on from buying Magellan during a period of distress, we added to our Safran holding during the recent weakness.

Safran is a truly wonderful business which also has some short-term issues. Omicron certainly has caused a reduction in short-haul flights over Christmas as airlines struggled to crew aircraft due to staff contracting the virus.

With an 80% market share for short-haul engines combined with military, aircraft interiors, navigation, landing gear and brakes divisions, Safran is a dominant global business. If you have flown on a 737, you have flown with a Safran CFM engine.

There is much hype surrounding Tesla and its meteoric rise over the last few years. We have been vocal about how difficult the car industry is to predict more than a few years out. In 1906 there were over 500 car companies in the US. All but one eventually went broke. Contrast this to the aviation industry. There is essentially a duopoly in commercial jet manufacturers and only 3 or 4 jet engine makers. The product cycles are between 15 to 30 years. That’s right, the next plane you fly on could be as old as the Hyundai Excel from the mid 1990’s. This lack of competition and very long product cycles makes investing in the aviation industry a far more accurate science than attempting to guess which electric car is going to be popular in 5 years. We know with a moderate degree of certainty what amount of free cash flow Safran will be earning in 5, 10 and 15 years. Many of the hyped electric car companies of today may have zero to negative free cash flows in 5, 10 and 15 years.

Just prior to the Omicron breakout, Safran announced a 50% increase in their expected free cash flow for the year. The recent resurgence of Covid may reduce this forecast, however it shows the resilience of the business during the most challenging times for airlines since the Wright Brothers took flight in 1903.

We expect that the most likely outcome of Covid is one of continual waves of decreasing reactions to the virus over the next year. Omicron appears to spread faster, yet with fewer side effects for most people. Governments have shown a willingness to allow the movement of people with fewer restrictions providing hospital systems don’t become overloaded.

Over the coming years, Safran will likely continue its recovery and our calculations for their free cash flow in 2 to 3 years suggests the company is significantly undervalued. The average broker estimate for the free cash flow yield in 2023 is approximately 4.6%. With solid growth for many years ahead, Safran is a wonderful company at better than a fair price.

Berkshire outperforming: but is that good?

At the other end of the spectrum of price movements is Berkshire Hathaway. Berkshire has performed better than the market over the last year with a 30.88% gain to the S&P500 22.52% gain and the ASX200 12.98%. Our growth portfolios have over 26% allocated to Berkshire Hathaway, so our performance for the year was acceptable considering we own a number of growth companies which have come off recently.

Whilst most consider this significant share price rise fantastic, we are less enthused. The reason for our lack of enthusiasm in the share price rally is that it will very likely lead to reduced buybacks. We have noted that the growth rate for Berkshire over the next decade will range from mid-single digits to mid-teens. The requirement for Berkshire to grow in the mid-teens per annum perversely requires the share price to initially go down so that Warren increases buybacks and the buybacks are more accretive. A higher share price could lead to lower future returns.

High Growth ≠ Competitive Advantage

There have been some prolific “growth” stock price falls since November. Many of these falls are justified and the stocks remain unattractive. There will be select opportunities, however as with the majority of our portfolio, we will generally avoid the capital dependent companies as these businesses can go to the graveyard.

Buying a stock at any price simply because it is growing quickly is proving to be a difficult proposition. This will usually be the case for two reasons. Firstly, nothing can grow at very high rates forever and eventually the slowdown in growth hits the share price. Secondly, high growth does not equal sustainable competitive advantage. Picking a winner in a fast growth industry is like thinking you will be the one in twenty-six survivor as Katniss Everdeen was in the Hunger Games. It is generally a low odds game.

High growth in an established industry is usually at the expense of the incumbent. Whilst the incumbent may come to the party too late like Blockbuster Video stores, more often than not, the incumbent will eventually throw large amounts of dollars at the problem to stymie the growth of the upstart. You generally do not want to own a loss-making business when the incumbent finally realises they are at risk. We see many loss making businesses which we are not sure will survive in a weaker capital raising environment.

Over the very long term, we have found that the competitive advantage of a business is far more important to long-term wealth creation than the growth rate. Occasionally you can find what Charlie Munger calls the lollapalooza opportunities which have high growth, sustainable competitive advantage run by truly outstanding managers trading at attractive prices. When you find these opportunities, swing for the fences.

Of the rubble in the most recent “growth” stock correction, there so far hasn’t been any lollapalooza opportunities that we have seen. We will keep looking.

Hears to 2022!

Rob Shears

Portfolio Manager

December 2021 Model Portfolio Returns

* Returns for periods over 12 months are annualised p.a.

+ Return figures are calculated and provided by Mason Stevens and are accurate as at the date indicated. Performance may be calculated using different assumptions, depending on the administration platform supporting the portfolio. Returns are calculated net of management, performance, administration, custody and transaction fees but exclude any adviser fees and assume reinvestment of all income except franking credits. Actual returns for each client's portfolio may differ depending on factors such as the date of initial investment into the portfolio, timing of transactions, contributions and withdrawals, other fees and any customisations. Past performance is not an indicator of future performance. Each client should take into account their own tax circumstances.


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