Investment Road Test: Magellan Global Fund

PORTFOLIO POINT: Magellan Global’s investment vision, using top-down analysis and bottom-up valuation metrics, has helped the company outperform the market and achieve a 5 star rating.

Australian share investors continue to suffer from the uncertainty prevailing in all global markets – with mixed and confusing macro-economic and political signals keeping a lid on overall sharemarket levels.

Even though Australians don’t have the problem of weak or negative economic growth that is bedevilling most of our developed nation trading partners, we suffer from the two-speed economy that is killing businesses outside the mining sector. Trying to access the resource boom wealth by buying into blue-chip stocks like BHP and RIO is hard to profit from, as these massive stocks are buffeted by the same macro uncertainty that is dampening market returns. (As a side note – look at resource mid caps for strong returns without the dangerous levels of company specific risk of the speculative end of the market).

For most investors, trying to make sense of this confusion is too hard, leading to far higher than usual cash holdings: good as a capital defensive mechanism but one that is entirely unable to generate the required returns for a comfortable retirement, especially if cash is held until market volatility abates (which may still be some years off).

So any investment that is able consistently to perform well in this environment is worth careful attention, and this week we look at the truly outstanding Magellan Global Fund.

Not to be confused with the weaker performance of the Magellan listed investment company (ASX code: MFF) which we reviewed some time ago, the Magellan Global Fund is a stand-out example of a contrarian investment fund managed by uniquely talented individuals with global insights and proprietary investment processes.

The Magellan Global returns have been solid since inception in 2007 with an annual total return since then of 4.12% pa. Considering that includes the terrible years of 2008-2009 and 2011-12, the overall return is extremely good. The value of the approach and style of the manager stands out when the last 12 month’s return is considered – Magellan Global has returned 18.25% over the last 12 months compared to the negative 0.76% return of the broad international MSCI index – i.e. an outperformance of 19.01% compared to the usual benchmark for international managed funds. Unlike MFF, Magellan Global is explicitly empowered to hedge FX risks, and the strong performance over the last 12 months may have benefitted from currency hedging.

The extremely detailed information available on the Magellan website outlines a clear vision for investing, utilising a top-down “thematic” style, which thoughtfully considers the global macro environment to identify sectors and styles of companies that are expected to be resilient from overall economic weakness. Once these sectors and styles have been identified, Magellan uses sophisticated “bottom-up” valuation metrics to identify the best value stocks – and then uses that analysis to time the buy/sell decision (hoping to buy good stocks in the right sectors, at the cheapest possible prices; and ultimately to sell them at the highest prices).

Overlaying these techniques, Magellan uses a deliberately concentrated approach, currently holding only 24 stocks, with 10 stocks accounting for 52% of the total value of the fund. Unlike the illiquidity problems for Australian-only fund managers (where large concentrations in blue chip stocks can move the share prices of those stocks just through manager activity), Magellan Global plays in the massive volumes of the global sharemarket where its size of investment is relatively immaterial.

The launch of the Magellan business made much of the provenance of its founders (Chris Mackay and Hamish Douglass), who had enjoyed successful careers in M&A and investment banking management. Suffering investors in the failed Gordon Fell “Rubicon” businesses can attest to the usual lack of transferability of skills between investment banking and investment management, which ultimately highlights the strength of the Magellan leadership team. Magellan states that it deploys the unique strategic and valuation insights used by its founders in their previous careers – and both the performance track record and KPIs used by Magellan attest to the innovations that they bring to their new roles.

There are profound reasons for the potential outperformance exhibited by Magellan Global, apart from the manager’s stock-picking skill. Magellan Global is overtly “benchmark unaware,” meaning that it does not seek to track or outperform market indices (the relevant index for global managers typically is the MSCI, which allocates country weightings in direct proportion to the share of global stockmarket capitalisation attributable to each component country).

The problem for active managers who are “benchmark aware” is that they are forced to largely track their reference index, owning stocks and country exposure without regard to relative value. In falling markets, benchmark aware funds sell stocks (hoping to do better than would be incurred by holding stocks whose value may continue to fall). Benchmark aware active fund managers are known as being “short gamma” – where the portfolio is positioned such that selling is an inevitable reaction to a falling market.

In volatile markets, short gamma destroys capital because it crystallises losses in stocks which may soon rise in value (leading to the fund buying back those now improving positions, often at prices higher than they were sold at).

By deploying a careful “buy and hold” mentality with highly concentrated holdings of the manager’s “best picks,” Magellan Global can better hope than the short gamma manager to withstand the market ebbs and flows typical of the last five years – and which (as suggested in the Magellan Global Annual Investor Report) may continue as Europe grinds out of its economic mess.

Magellan Global doesn’t shy from the risks of this approach producing negative returns at some point in time – it states this risk explicitly in its investor reports. To help investors gauge this risk, Magellan Global sets out details of the cash flow focused, defendable earnings and cheap valuation approach to investing that it uses. The approach is innovative through the combination and weightings given to some of the investment metrics.

The Magellan Global approach identifies global themes, looks for those sectors which are capable of generating above market growth rates, and then looks to buy the best companies in those sectors.

Magellan’s favourite global themes are:

• Emerging market consumption growth via investments in multinational consumer franchises (Danone, Kraft, Nestlé, McDonalds and Procter & Gamble);
• A move to a cashless society. There continues to be a strong secular shift from spending via cash and cheque to cashless forms of payments such a credit cards, debit cards, electronic funds transfer and mobile payments (PayPal (via eBay), American Express, Visa and Mastercard);
• Internet/e commerce (eBay and Google.
• The eventual recovery in US housing (Lowe’s and Home Depot, Wells Fargo and US Bancorp).

It reflects these themes through holdings in the bracketed stocks.

The bottom-up ingredients show a very well honed focus on earnings and the drivers of its growth and maintainability. That no doubt reflects the real world of successful M&A transactions that Mackay and Douglass worked in. Magellan Global looks for an “earnings moat” – strategic assets that protect earnings, like monopolies or unique dominance, like e Bay and Google; or Coca Cola and Nestle. Read the detailed and perceptive company analysis for Tesco, which is set out in the Global Magellan 2012 Annual Report for a peek into the stock selection process used by Magellan Global.

Magellan Global also looks for good return on equity figures – but uses an enhanced concept which measures returns on recently subscribed equity capital to verify how well managers are performing under current conditions. The “return on recent equity” concept is an approach favoured by Eureka contributor Roger Montgomery, who uses it to separate out often historically good management performance from more recent levels of activity.

To be fair to the legions of scared investors, none of these skills will be of much use if the feared global meltdown appears. The fundamental top-down questions, which managers need to understand, is whether the European sovereign and banking crisis will be cured and will that form part of an emerging global recovery, or whether banks and national economies will collapse in a firestorm far larger than the Lehman collapse?

Magellan Global’s insights here are somewhat unorthodox (ahead of the pack?), with high levels of business judgement involved. Their prediction of Germany’s continued support for a unified Europe and the costs this will entail are in line with the authoritative comments made in Sydney last year by ex Chancellor of the Exchequer, Lord Lamond. Their suggestion that this is part of a broader reform package which Angela Merkel hankers for (and will presumably therefore work hard to achieve) is a perceptive reading from Magellan, no doubt supported by the deep networks that Magellan would benefit from.

Fees for Magellan Global are moderate, with a base fee of 1.2 % pa and an additional outperformance fee calculated as 10% above the twin benchmarks of the MSCI and the Australian government 10-year bond yield. These benchmarks may be set a little low given the Magellan Global’s stated ambition of delivering an absolute return of 9% pa over the longer term; but they serve to align the interests of the manager and investor. Assuming the performance fee applied in a straight line to the last 12 months return of 18.25% pa, this would deliver an additional fee of 1% or more to the manager, certainly not at the top end of the range for managers seeking to deliver “alpha” through concentrated stock selection. The minimum initial investment is $10,000 when forming part of an ongoing investment plan, with monthly further investments of at least $200.

Paying fees for good alpha generators is part of the new practice of “barbelling”, where low fees are paid for beta generators (e.g. ETFs and index funds), and which excludes moderate performing active managers to focus on well rewarded alpha generators: the concept of barbelling and its implications for portfolio construction are a theme to be explored another day.

Magellan Global is a unique and high performance global equity fund, with innovative insights and processes. The stellar performance over the last 12 months sees a manager at perhaps the peak of its powers. For investors wondering how to capture the equity risk premium, this fund provides a powerful answer. Magellan Global receives our coveted 5 star investment rating, the second only fund to do so in the history of producing these Eureka Investment Road Tests.

The score: Magellan Global Fund – 4.5 stars
1.0 Ease of understanding/transparency
1.0 Fees
1.0 Performance/durability/volatility/relevance of underlying asset
1.0 Regulatory profile risks
1.0 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides consulting and financial product services but does not receive any benefit in relation to the product reviewed.