At the Morningstar Investor Conference last Thursday, 3 February 2022, I interviewed Magellan founder, Hamish Douglass. He was relaxed and chatty before the interview, discussing the renovations to his long-time family home, his love of swimming and gym work, and he admired the surrounding developments at Barangaroo. Although one of his larger positions, Facebook (now Meta), had fallen heavily overnight, he projected a fund manager genuinely focussed on the long-term merits of companies rather than short-term price movements. Such sentiment dominated the interview.
During the discussion, I focussed more on what Hamish thought of current opportunities, how he manages Magellan portfolios, how he judged his 15 years of performance, and the coming risks. While some people in the audience no doubt wanted me to ask about his personal life, I felt there was enough revealed and responded to already in the media, and I wanted to discuss investing. He was also unlikely to reveal price sensitive information without a release to the ASX.
Three days after our chat, on Sunday, the "intense pressure and focus" on his personal and professional lives seemed to reach a tipping point, and he contacted the Board of Magellan to request "a period of medical leave to prioritise his health". The next day, the Board issued a statement to the exchange, including:
“The Magellan Board wholeheartedly supports Hamish taking the time that he requires to focus on his health and looks forward to welcoming Hamish back.
At the request of the Board, Mr Chris Mackay will oversee the portfolio management of Magellan’s global equity retail funds and global equity institutional mandates ... Ms. Nikki Thomas has rejoined Magellan as a co-portfolio manager of Magellan’s global equity strategies."
Here is an edited transcript of the interview, where he admits to mistakes but also explains why he considers his portfolio is right for the times.
GH: It's my pleasure to welcome Hamish Douglass, the CIO and Chairman of Magellan. Welcome to Morningstar.
HD: Graham, it's great to be with you.
GH: I'm not sure whether you remember this but about 15 years ago, you and Frank Casarotti came into Colonial First State where I was at the time, pitching a new global fund to be added to FirstChoice. And because we needed a track record, which you obviously didn't have, we initially knocked you back. 15 years and $100 billion later, a lot has happened. At that time, you were talking about delivering to your investors a 9% return through the cycle. The Global Fund has delivered about 12% since inception. So how do you think about or judge that performance?
HD: Graham, it's very interesting because I remember when we first came out with the 9% return, which was right up front. As you recall, this was in July 2007. And actually, markets had been on a roar because it was before the collapse of 2008 and people were kind of yawning at 9% per annum, saying we're not interested in anything under 20% per annum at the time, and we're going, well we just didn't think that was very realistic.
So have we been happy? You know that the strategies, it's since July 2007 and people recall markets last peaked in October 2007. So we're kind of peak to peak. The equity markets peak to peak have done about 8% per annum, measured by the MSCI World Index, and we've done about 12% per annum over that time. It doesn't sound a lot of difference, 4% per annum, but over 14 and a half years, you would have 67% more money invested with Magellan. So the absolute return you earn over time is incredibly important.
And we've managed to do it with materially lower drawdown risk than markets and people get very caught up with this concept of relative or absolute return. We're not thinking about what the share price will do relative to the market at any point in time and frankly, I have no idea what the share price is going to largely do over the next six to 12 months.
GH: Don't worry, I wasn't going to ask you about that.
HD: But what we're trying to do is assess whether or not those earnings on that company over the next three, five to 10 years into the future will compound at a satisfactory rate and then we measure that against the 9% return. That's our focus in investing. We're not speculating, we make judgments around where the earnings of businesses go over time? And if you get that right, you can deliver very attractive absolute returns over time.
GH: When you're thinking about the portfolio, how much do you weigh up this absolute versus relative return because obviously the market and some of your clients think in relative terms and compare you to a benchmark, so you can't totally ignore that. How do you weigh that up?
HD: Yeah, at the end of the day, Graham, I've never found an individual who's retired on relative returns. Historically, the markets have been doing for the last 30 years about 8% per annum. So just investing in the market has been fine because the return in equities has been attractive, but there have been points in history where markets have delivered for 15 years, zero rates of return.
If we did let's say 2% better than the markets over a period of 15 years and the markets did zero, we would be very unhappy. And a lot of people would say that's a great result. If we don't do 9% per annum even if the markets do zero over an extended period of time, we don't think we've done our job because people don't retire at 2% per annum even if it's beaten the markets.
I would look out from here and caution people because interest rates have been falling and they've been exaggerating equity returns for 30 years. I think equity returns from markets are going to be lower than they've been in the past. Our job is to make judgment in a select collection of businesses that we think can compound people's capital to get us that 9% return per annum. If you can give people 9% per annum over the long term, that means every eight years we're doubling our clients' money. People can effectively withdraw 4% per annum and therefore have their capital still growing in real terms that they can give to the grandchildren.
But if you deliver 2% per annum and the market is zero, you're going backwards, you better lower your lifestyle expectations, you better lower what you want to leave with your children. Over the long term, our 9% per annum I actually think will beat any equity long-term benchmark measured over a long enough period of time. But in the short term, the share prices of businesses can go anywhere.
I don't really pay any reference to what Microsoft share price will do relative to an index of 1600 companies in the next six months but I have very, very high conviction over the next three, five and 10 years Microsoft will deliver a very good return for our investors but do I get caught up if Microsoft underperforms the market in the next six months? I don't even think about it.
GH: We know the market falls by 10% every few years. When that happens with your portfolio, what's your emotional reaction? Do you say, great, this is a buying opportunity or do you think, my clients have just lost $10 billion? How do you manage those big changes?
HD: If the markets drop 10%, of course, there is a mark to market apparent loss. But you only lose if you actually sell anything at that period of time. Do I worry about that? Normally I'll look at it as an opportunity. As an investor, people need to understand when they're invested in equity, the market gets quite emotional. And in the short term, it's this sort of emotional voting machine.
Two weeks ago, Netflix's share price fell 20% after its result. It's recovered its losses over a week. So you know what's happened in the last week of a rollercoaster? If you went away for a week, nothing happened. But during that week it looked like this incredible emotional experience. People need to understand that equities in the short term can be very, very volatile.
It's interesting that people's major asset is their house. Do people ask a real estate agent to value their house every single day? Depending on the mood of that real estate agent, they can tell them it's gone up 5% today and the next day they're told it's gone down 5% and then people are getting worried that their wealth is falling because their house price is going up and down.
The market's an odd thing that is throwing you a price every single day but if you think about it, what you own hasn't changed at all. You still have the same interest in those businesses with the same prospects of those future profits. But day to day they jump around in price and what I'd say to people is you're better switching it off. Equities is a long term investment game. And if you get the right collection of businesses and they compound their earnings, in the end the market's a weighing machine as Ben Graham says and the returns will look after themselves.
So when the share markets go down 5%, do I think we've lost anyone any money? No, I don't, because we still own exactly the same assets which have the same prospects the day before they fell and the day after they fell.
GH: Hamish, you're clearly a stock picker, an active stock picker, but you do make macro calls as well. You change your cash weighting accordingly. And when you speak, you obviously talk about inflation and viruses and macro things. How do you weigh up that stock picking versus the macro call because going to cash means you're out of the market to a certain extent.
HD: Well, let's put it in context. We can go up to 20% cash, so I'm always 80% invested in equities. I think we have to put any decision we make around macroeconomics in context. So we're normally above 90% invested in equities and often above 95%.
Why do we use cash and macroeconomics? It's really risk management. We're very conservative people and if we see risk out there that we think isn't priced in markets, we may for a period step back a little bit. We're taking less risk in order to preserve more capital and to give us a little bit more breathing space and firepower to take advantage if there is a sell off.
I think we've had a pretty successful record, not always but I think our batting average has been strong in making the judgment call of when to put risk on and risk off in the markets but you don't get everything 100% right. But I don't think people should worry about it that much. Because we're always going to be 80% invested in equities while we take a conservative view of looking after people's capital.
GH: As an investor, I would rather you didn't do that because if I allocate some of my portfolio to Magellan, I'm saying that's my equity allocation. That's 100% in equities, and I'll look after the risk management in the rest of my portfolio. I don't want to have to say that actually 20% of that portfolio is in cash. Obviously, you see a different position.
HD: Yeah, we do see a slightly different position at the end of the day, I think we've put an absolute return target on that. And we know if we sit in cash for an extended period of time returning nothing, that's going to make our job of getting 9% per annum harder. We absolutely understand that cash is not going to compound at 9% per annum, we're only doing it as part of our portfolio construction and risk management. We're not guaranteeing by the way the 9% but we have it as the absolute benchmark.
GH: It's tempting at any point in time to look at all the pluses and minuses in the market and heaven knows, we've got a lot of them at the moment, but is it trite to say investing at the moment is more difficult than ever, or is it always difficult?
HD: I don't think it's always difficult because when you find a great business and you want to stick with the business for a long time, it's not that difficult. But sometimes finding them is difficult but once you've got them, sticking with them isn't that difficult.
People need to understand that this environment is potentially different this time, and normally we should never say it's different this time. The valuation of equities relative to economic output is the highest it's been in 100 years. And it has jumped very materially with the stimulus in the last 18 months. Not relative to current earnings because earnings are elevated the moment, but compared to the total output of economies, we are off the charts in equity market valuations and normally that will put a little question mark in your head.
But we're also at the end of the stimulus cycle, and we're about to go into a stimulus tightening and then we've got this threat of inflation out there. And for the last 15 years, every time there's been a correction, the central banks have rescued the market by printing more money. If we have inflation this time around and interest rates at zero, that game's up. I do think the situation is different and that the game book is different. If we get into trouble, it could be much uglier this time because there are fewer things the central banks can do in an inflationary environment to rescue the situation.
GH: You just said that, if we have those factors, this time the 'game is up'. What are you actually looking for in a signal prior to the market going down 30%, that tells you the 'game is up'?
HD: Well the markets being off 30% would be a good result in the 'game's up' scenario, I'd probably put the market off 50% and I'm being serious about that.
In the 'game's up' scenario, where inflation is persistent and the US Fed Reserve later this year has to start tightening monetary policy materially faster than just a sort of a normalisation. I really think we could be in a world of pain if that was to happen. I think there are two things you need to look at to make a judgment call on the inflation 'game's up' scenario. There are very strong arguments about these inflation pressures. The US has just printed 7% inflation, it's staggering having inflation at that level, and Australia is of course going up, but the US is what sets equity markets and we have to watch the United States.
We would expect when economies reopen from omicron we should get a change in demand for goods. A lot of people were at home buying goods, they were buying more televisions and stuff for the next barbecue and gym mats ... we were over-consuming goods at the same time as supply chains were constrained. So you'd expect as we normalise human activity, we'll start switching out of goods and into services, going to restaurants and holidays and that should take pressure off supply chains.
A lot of this wages inflation is because Australia doesn't have 300,000 students here. How many of them work in restaurants? And tourists who come here, many are under 35 and they work at the farms and other places. None of them are here and this is before you even get to the migration debate. So reopening borders should actually get a deflationary force coming through the economy.
So I don't want to paint it's all inflation. I think this is quite evenly balanced at the moment. But we are starting to see in the United States material movements in consumer expectations. You have to think about the US consumer and what they are experiencing, not what economists are publishing. We've got elevated energy prices that the economists strip out, but look at utility bills, up 15 to 35%. Even the standard shopping basket, we have things like eggs and bread going up 30%. All the companies we speak to are starting to put through material price increases, such as McDonald's last year put up prices by 6%. Expectations change and the wages cycle starts moving, that is when the central banks are in the corner. So if we don't get this rollover effect (from goods to services) before people's expectations of prices change, I think we've got a problem in the US.
The other one is China because they are the world's supply chain. And unless China relaxes its zero COVID policy, we are going to have continuous stop starts in the supply chain and that could extend the persistence of supply chain constraints and make the inflation risk more.
I'm not saying the game's up. I'm saying there is a material risk it could be up. I think we're in a world of pain because of monetary policy being tightened, we're ex-stimulus, but if we really have to move monetary policy in the United States, it's kind of 'hold-on-to-your-chairs'. I don't know how these balls will drop.
GH: It's a fascinating time. We have a family business and every week a new letter comes in from suppliers about the rising cost of jars, freight, ingredients. And expectations get embedded into the system.
HD: When people start feeling it everywhere and then they say, well my wages are going up 3% and prices going up 7%, I'm going backwards here.
GH: You recently described your portfolio as having strong defensive characteristics but we see a lot of the leading tech tech stocks, Alphabet, Microsoft, Netflix. What's your argument that it's a defensive portfolio?
HD: We actually have two portfolios in the strategy. So 50% of our portfolio is in businesses like Nestle, PepsiCo, Procter and Gamble - which owns probably the biggest collection of consumer brands on the planet. We own utilities, we own some infrastructure stocks and we have a bit of cash. So half our portfolio, which is much greater than the market, is in very defensive businesses. But you're right on the other side of the portfolio, we've then got some more growth assets. Some of those are defensive but some of them are less defensive but they're incredibly long-term compounding stories.
If you just have a look at what the results from Alphabet were this week, which owns Google, the revenues were up 32%. If you look at Microsoft, their revenues were up over 20% in the last period, absolutely incredible. We've got businesses that are transitioning their business models, in a technology sense, like SAP. That transition is going to have nothing to do with inflation or any of these debates. Their business is about how they transition their 40,000 customers from a business model of on-premise to the cloud. That's their story. It's idiosyncratic to a lot of the issues you're talking about.
We have Visa and MasterCard, they're a royalty on spending around the world. But if we get inflation, they're a royalty on inflation as well, but sure there is economic sensitivity in part of our book. We effectively run about 80% of the risk of markets in terms of the overall exposure to volatility. You have to look at how the whole thing works together.
GH: You recently said, "Why would I invest in turnaround stories when there are so many great companies" and that's actually the reverse of what a lot of fund managers say where they look for beaten up companies, the ones which have problems, where share prices are marked down by the market. They buy the turnaround, but you don't accept that proposal.
HD: It's a difficult way to make money. Buffett has a famous saying that turnarounds seldom turn. Normally, when you're buying into turnarounds, the businesses are going backwards, have been overearning and they're having to reset themselves. And in all of that reset, they're incredibly time dependent. And I would say time is the enemy of a turnaround, because often your rate of return is depending on how quick that turnaround can happen. Because they're businesses that are struggling, they don't compound over time. You're looking for an earnings reset story, margin reset story and then a re-rating by the market.
If you invest in wonderful businesses, that compounding and time are your friends. The longer the time goes on, the more money you're going to make because it's a simple law of compound interest. So we want to be in compounding stories. I wouldn't say we never invest in a turnaround, but it's much more difficult. We believe in the magic of compound interest and turnarounds aren't compounding machines.
As Benjamin Franklin said, money makes money and the money that money makes, makes more money. And that is what investing is all about. It's putting away some money today and letting that money work for you over time. So it is just how we're philosophically wired.
GH: Before we turn to audience questions, last one from me: What question should I have asked you?
HD: Well, the question you shouldn't have asked me is what keeps you awake at night? Because that's a question that most people ask.
I think a great question when you're an investor, is if you had to own one company for the next 10 years, what would you own? How would you go through an assessment in making that decision? You'd first start to ask, what are the competitive advantages of the business? What are the threats to the business? What are the threats of disruption? What do you think their revenues will grow at for the next year? How confident are you? What do you think the competition looks like in that industry? Because you're only making one shot, you don't want to lose your money. You don't start thinking about the stock market and the relative returns. You think about the business. And that's how we think.
And if people ask themselves that type of question, they would think very differently about how confident they are. People get caught up with market movements and everyone piles in at exactly the wrong time.
If I could nominate one company, it'd probably be our largest investment, Microsoft. I think their cloud-related businesses and the diversification have so many advantages and where they're priced at the moment. Over the next 10 years, I would be very confident of putting 100% of my money into Microsoft, and never getting an opportunity to see what its share price is for another decade.
I'd be confident about putting my money in Nestle although I probably wouldn't get as high rate of return. I'd be very confident in PepsiCo, I'd be very confident about Intercontinental Exchange. There are some businesses that I'm probably not be as confident about in the next decade, such as Visa or MasterCard, fabulous businesses but there is some disruption out there.
As an investor, you're not thinking about the market, you're thinking about the business and what type of businesses you want to have your money invested into.
GH: Let's turn to some audience questions. How do you suggest managing equities in a rising rate environment?
HD: Yeah, a rising rate environment is difficult, particularly if rates go up meaningfully. If rates going up 0.5%, it isn't going to make much of a difference but if rates go up 2 or 3% is a very significant headwind. Warren Buffett describes interest rates as the gravity of markets. Asset prices are the discounted value of future cash flows and if you increase the discount rate, the value of those future cash flows go down. That's why interest rates are a headwind.
How do we manage that? We want to have businesses that inherently have pricing power and we want them to have low capital intensity, that hopefully they can be growing their earnings in line with inflation.
The other thing is the multiple of earnings changes. So something that may have traded at 22 times earnings may trade at 20 times with higher interest rates. That change has a short-term impact but it doesn't compound over time. You want the ability to compound real earnings (earnings adjusted for inflation) over time. If interest rates jump up, markets are going down, we're going to get affected and everybody's going to get affected. So as an equity investor, if we get a big jump in interest rates, I can't promise anyone we're going to go up, that is completely unrealistic. I think our portfolio is much higher quality and has much better attributes to deal with that world.
GH: Do you feel you relied too much on the China story, particularly given some of the controls that the Chinese government has imposed on certain businesses in the last year or so?
HD: It's a very good question. I made a mistake on China. I got overconfident in China because I really liked the businesses in Alibaba and Tencent. They're wonderful businesses but I underestimated the Communist Party risk. And it's really a regulatory risk, which happened after the IPO crack down. We bear certain regulatory risks. We bear it in the payment sector, where we bought Western technology companies, we bear it in stock exchanges when we invest in them, and in clearing houses.
So we understand regulatory risk but the biggest mistake on China was owning two technology companies, and they both got caught up in a regulatory crackdown. We now have less than 4% of our portfolio in China. We don't think China is uninvestable, but you really have to think about that sort of risk in China and manage that in your portfolio.
I'll accept completely I made a mistake, but you know, you make a few mistakes in your investing career, it's what you do about it. We've taken action. That China regulatory risk is never going to be material in our portfolio again.
GH: Are you concerned that your US-specific exposure is too high given the particularly high valuations in the US market and are you looking at opportunities in other countries?
HD: This is always a bit of a misnomer. We have 70% of our portfolio in the United States and nearly 60% of the (global) MSCI is US companies. So we're not that much different to the overall market. But when we look around the world and we look at the valuations, the US market as a multiple is higher than other markets, but the United States has many more tech companies than other markets.
When we go around the world, we don't suddenly say, look, consumer staples are much more expensive in America and cheaper in Europe. It's just not factual. We don't find banks more expensive in America compared to banks in Australia or Canada or the UK. So I think you have to be very mindful that aggregate market multiples do not tell you what individual companies are worth.
And whilst we look like we're overweight United States, we are overweight global multinationals. Coke has only 20% of its earnings in America. You might think I'm making a bet on America if I'm invested in Coke, but 80% of their earnings are outside of America. Nestle which is a Swiss company but only 2% of their earnings come out of Switzerland and 34% of their earnings come out of America. So Nestle is much more American than Coca Cola is.
Many of the world's great technology-related multinationals came out of Silicon Valley and Seattle. We invest in the companies, not where they're necessarily listed, per se. We've got very few what I'd call domestic US plays, so we're not taking a particular play on the US itself.
Hamish Douglass was Chairman and Chief Investment Officer at Magellan when he was interviewed at the Morningstar Investor Conference on 4 February 2022. Magellan Asset Management is a sponsor of Firstlinks. This article is for general information purposes only and is not investment advice.
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