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The problem with Magellan shares

Sebastian Bowen
Should you buy?

One of the best performing ASX shares this year has been Magellan Financial Group Ltd (ASX: MFG). Magellan shares started off the year trading for $23.95, but fast forward to the start of this month and MFG shares were at a new all-time high of $62.60 – a YTD rise of 161%.

Although MFG shares have now pulled back somewhat and are going for $51.35 at the time of writing, there’s no doubt this company has made phenomenal gains and a lot of investors (including Magellan founders Hamish Douglass and Chris Mackay) very wealthy.

Why has Magellan hit the roof this year?

Magellan (as a fund manager) makes money from taking a slice of the total funds under management (FUM) under its stewardship. In addition, it also takes a cut of any profits that exceed the benchmarks that its funds track (as a general rule).

If Magellan’s funds develop a pattern of outperformance (which they have), the company sees a snowballing inflow of new capital as investors want a piece of the action. In its latest results, we can see this process in play, with Magellan’s total FUM up 25% over FY19. In addition, more FUM combined with outperformance translates to a ballooning bottom line. This has been what’s been causing investors to go wild over MFG shares.

What’s the problem then?

There’s no doubt Magellan is a quality company running quality investment funds. But the major problem I see with Magellan is its client’s sentiment. The stock market is driven mostly by fear and greed, and greed has driven the growth in Magellan’s FUM over the last year at least. If there was a major market crash, I can envisage a scenario where a lot of spooked investors sell out of the market at the same time as Magellan’s performance fees might be drying up. A sharp drop in FUM combined with a fall in performance fees will likely (and quickly) lead to bad things for the MFG share price.

Foolish takeaway

Whilst I think Magellan is a fantastic company with a bright future, I also regard it as a highly cyclical stock and one extremely vulnerable to a market crash. Investors are a fickle bunch, and this fact shouldn’t be underestimated. I’m personally holding off on Magellan at these prices

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Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

The Motley Fool's purpose is to help the world invest, better. Click here now for your free subscription to Take Stock, The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. 2019