Peak Magellan: What does the share price mean for MFG?

Market’s rebounded overnight as President Trump pulled back on some of his earlier tough talk on tariffs. The Wall Street Journal reports:

Stocks, bond yields and commodities jumped Tuesday as news that the U.S. would delay some tariffs against China rekindled investors’ hopes for an eventual trade truce.

The Trump administration announced it plans to delay and remove items from the roughly $300 billion of Chinese imports facing tariffs on Sept. 1. The development sent investors rushing back into stocks after an extended bout of market volatility and two days of declines for major U.S. indexes. Investors also piled into commodities, while shedding exposure to assets considered relatively safer such as government bonds and gold.

Don’t be confused here, dear reader. This is pretty standard Trump fare. That is, he goes out hard early, then pulls it back a little. But the underlying theme here is that the US is in a soft war with China. It’s not going away.

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Last week, US Secretary of State Mike Pompeo made a brief stop in Australia. It included a talk and Q&A session at the State Library of NSW. As reported by The Spectator:

Mr Pompeo was adamant that not only Australia, but the US and the West in general, had for far too long been complacent about China’s more sinister intentions; citing cyberwarfare, unfair and unprincipled business practices, the creation of large-scale debt in tiny nations throughout the South Pacific, the militarisation of the South China Sea (despite repeated promises from Xi Jinping that this would not happen) and so on. In particular, Mr Pompeo reminded us that we share values that are anathema to the communist Chinese, regardless of how ‘mesmerising’, to quote John Howard, their baubles may appear.’

This current trade war relief rally is but a brief respite.

As if that wasn’t enough, China has its hands full in Hong Kong, where pro-democracy protesters have shut down the airport for two days running. Reports suggest China is preparing a military response.

This Twitter account shows a disturbing military build-up in the city of Shenzhen, which borders Hong Kong.

Bringing the troops and tanks in might quell the riots, but does China really need another Tiananmen Square? The capital flight out of Hong Kong would be very destabilising for the region.

This is the problem with totalitarianism. It rules with an iron fist. It can only shut down protests with coercive force. There is no logic to its imposition, apart from the logic of force.

So we watch and wait while the market gives us some respite.

The MFG ASX Share Price…

Meanwhile, in Australia, I have to ask: Is this another sign that the market has peaked? Or is it just peak Magellan? By that I mean Magellan Financial Group Ltd [ASX:MFG]. Have a look at the chart:

Magellan Financial group - MFG (ASX)- 1 Day Bar Chart - AUD - 14-08-19

Source: Optuma

[Click to open in a new window]

From the December 2018 low to the July 2019 peak, the stock price is up a massive 175%. It trades on a price-to-earnings (P/E) ratio of 32 times forecast FY20 earnings.

That’s because boss Hamish Douglass has made big returns from largely investing in tech stocks, which have been in their own bubble of sorts over the past few years.

Yesterday, MGF took advantage of its hefty multiple to raise $275 million. When your stock is trading on a high P/E multiple, it means your cost of capital is cheap.

For example, a P/E of 10 means the cost of equity capital is 10%. For MFG trading on a multiple of 32 times, its cost of equity capital is just 3.125% (1/32). That’s cheaper than some corporate bonds!

Some of the capital raising will be used to invest in a new retirement income product MFG is in the process of developing.

Now for the hubris (as reported by the Financial Review):

Looking seven years ahead, assuming its funds under management stay the same, Magellan expects to generate 7 to 9 per cent revenue growth a year. That translates to 11 to 14 per cent in total shareholder returns, including dividends, a year, Mr Douglass said, excluding new opportunities that might expand funds under management.’

There you go. In seven years, MFG expects to deliver shareholder returns of 11 to 14%, inclusive of dividends. That’s certainly a possibility, but not if the starting point is from where the share price is now.

For example, MFG is expected to generate a return on equity (ROE) of around 42% in FY20. Let’s say your ‘required return’ is 8%. What would you pay for a share?

To answer this question, a rough rule of thumb is to divide the ROE by the required return. In this case, it’s 42/8 = 5.25.

In other words, to get an 8% return from the business, you should not pay more than 5.25 times the equity, or book, value.

But MFG currently trades on a price-to-book value of nearly 11 times. Shifting the above equation around, that gives you a required return from the business of just 3.8%.

What does that actually mean?

Well, based on MFG’s current price and earnings expectations, and assuming there is no change to the current P/E multiple, the best you can expect to earn from this business is around 3.8% per annum.

Of course, the P/E multiple won’t stay the same, so it is really just a theoretical exercise to give you some idea of the future returns the business can deliver. If the P/E multiple continues to expand, shareholders will earn a better return than the 3.8%. If it contracts, they will earn less.

I’ll leave it for you to decide which way things will go from here.

To me, it’s just another reason to be cautious about this market.


Greg Canavan,
Editor, The Rum Rebellion

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Greg Canavan approaches the investment world with an ‘ignorance is bliss’ philosophy. In a world where all the information is just a click away at all times, Greg believes we ingest too much of it. As a result, we forget how to think for ourselves, and let other people’s thoughts cloud our own.

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