Part 2: Hamish Douglass on not swinging for the fences

On 14 December 2021, amid a backdrop of intense media coverage of Magellan’s recent performance and the resignation of CEO Brett Cairns, Hamish Douglass presented online to clients of advice group Stanford Brown. He was interviewed by Stanford Brown Director and Private Wealth Adviser, Hamish Harvey. This is Part 2 of an edited transcript. Part 1 is here.

Note also that in this video update released on 22 December, Hamish Douglass addresses the challenges the business has faced in recent weeks, including commenting on his personal circumstances which have received so much attention. He says: 

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HH: We talk frequently to clients about the concept of sequencing risk. They need to ensure they have dry powder, money set aside for pension payments and the fixed expenses in life. We don't know what's around the corner.

HD: And don't have a fear of missing out in this environment. For example, everybody has a crazy story about housing at the moment. We thought it was crazy a few years ago but now we have extreme anecdotes about a house that sold for double what it was worth 12 months. It doesn't seem like we're in a normal world.

HH: Some of the numbers we're seeing are phenomenal. What do you expect from quantitative easing and interest rates in 2022?

If inflation is sustained, the result is recession

HD: I think Powell is under enormous political pressure because the Democrats are taking a big hit. I think (the Fed) will go very slowly easing out of QE and with a few rate rises on the table. They're going to try not to disturb asset markets. If we don't get real inflation, we will get out of this without a huge effect on markets. The rate rises are in the market’s expectation, but that's not a tightening. It's a modest change to a very expansionary policy although they are well behind the curve of where they really should be at this stage. The problem will be where inflation is in April, May, June next year.

I had lunch with Glenn Stevens, maybe four months or so ago, we were debating this issue, he put a 25% probability on the inflation scenario. He's probably higher today, but I haven't spoken to him. And I said, ‘What is the answer, if we truly get inflation?” And he just looked at me and he said, ‘Hamish, there's only one answer. It's a global recession.’ He said we will be forced to move monetary policy to stop it, and that will stop economic activity.

So the party comes to an end if we have inflation, and you have people going, ‘I should own commodities and banks in an inflationary environment.’ It shows we've been a long time without inflation because they happen to be the most stupid things in history to own if you're worried about inflation. They perform well in the cyclical recovery story. You can't have your cake and eat it too.

HH: Which leads to the next part, portfolio construction. In an environment of higher inflation and interest rates rising, where would you want to be sitting?

HD: We own businesses that are capital-light with very high returns on capital, the vast majority have pricing power and royalty structures. Something like Yum Brands, it's a royalty company. If there's inflation, prices go up and they collect effectively about a 5% royalty on the revenue line. So their actual profitability is indexed to inflation and that's what you want. Netflix, Starbucks, PepsiCo have pricing power and other businesses are capital-light like Visa and MasterCard. They’re leveraged to reopenings and payments, they're a bit sensitive to the economic scenario but people traveling will happen in maybe 12 to 18 months, or only six months without Omnicom having an effect.

Assets are going to be affected but as a sign of how finely things are balanced, consider DocuSign which is an incredibly good business. It gave out some revenue guidance for the next quarter that was marginally below the street estimates and the stock price plummeted 40% in a single day. It is a risk that it is foreseeable if the world changes its view that Tesla could drop 50% in a few days. We have so many of these large companies that are unanchored in terms of valuations that are almost a popularity contest at the moment. Everybody could rush for a door at the same and hit an air pocket and fall through it. We don't have those air pockets in our portfolio if the market plummets 30%. I don't want to mislead people, inflation is an ugly place to be.

Home ownership and affordability

HH: I have a question here on the housing market in Australia. Home loan rates can still be fixed around 2.3% to 2.5% but rates are creeping up a little bit. Do you have a view on Australian housing?

HD: I'm no expert in housing but I do believe it's correlated to two things: interest rates and the stockmarket. We've had a 12-year bull stock market and we've had falling interest rates for 30 years and both have been supportive of housing. If it's an inflationary environment, and rates are going up, while people can fix for five years, you own a house for 30 years. So you're not fixed for the duration of the ownership. Ultimately, the house price will reflect affordability through its life.

If interest rates go materially higher and we have a wealth effect with the stockmarket falling, I think it's almost inconceivable that we couldn't get a major change to house prices. It becomes self-reinforcing to a downside scenario. In the GFC, we didn't see a collapse in housing because China and central banks came to the rescue.

Books will be written on all this stuff such as Bitcoin. Charlie Munger said he wishes he would live for another 30 years just to be a spectator to see how this all ends. It’s one of the most extreme and fascinating periods in history. We’re cautious and we're fiduciaries of all our clients’ money, we're not going to swing for the fences. I can take a dent to my ego and all the press coverage and everything that's coming but I would feel really bad if I started using other people's money to make up my ego by swinging for the fences trying to catch up some short-term performance. It's not my damn money. I'm not going to take risks that I think are imprudent, even if it causes my ego to underperform in the short term.

A mass delusion of modern history

HH: What's your thinking on cryptocurrencies and Bitcoin?

HD: It will go down as one of the mass delusions in modern history. At the end of the day, there's nothing there. There's no value of anything sitting there. Yes, we are going to have digital currencies based on the blockchain and there's a fundamental change in the world. We'll have stable coins. We'll have centrally-banked coins.

But infinite value from a thing that is nothing more than thin air! I'm highly skeptical whether Bitcoins are worth $1 or $50,000, there’s no reference point. Of course, we've got mass crowd-buying of a limited supply of something that they can get any price you want. But ultimately, the regulators will probably end up killing it as it undermines monetary policy. There's nothing stopping people just launching look-alikes, and I can't tell you whether it's two years or it's 10 years from now, but I think it's fairly predictable that these things will go to zero. Who will be left holding the can? It's a great study in human psychology. If you think it's a core part of investing and putting a huge amount of money in it, well, people can do it if they want but do it with your eyes open as you may lose all your money as well. I don't win a popularity contest giving that answer. There's a lot of very passionate people who tell you I'm the greatest idiot on the planet and a dinosaur.

Future returns

HH: That's alright, we can handle that. My kids probably say that about me sometimes. Markets have done so well recently, and we aim for CPI plus 4% to 5% over the long term. Do you think we should have lower expectations of returns over the next five to 10 years?

HD: If you look at peak cycle to peak cycle over the long term, returns are around 8% per annum. The world economic machine has delivered about 6% nominal growth plus dividends. So economic growth is on average 2% real, plus 2% inflation is 4% growth. That's what profits have been growing at. There are then additional returns due to either buybacks or gearing to get you to about 6%. Equities have delivered 200 basis points more for 30 years due to falling interest rates and a real leveraging of corporate profitability.

Over time, I think both those games are up. There isn't much left in leveraging up and interest rates are now at zero or 1%. And if I look out beyond the next 18 months, I am struggling to see how economic growth is suddenly going to be about 4% per annum. China will be less of the contributor just because it's becoming a bigger part and a slower and lower number. And rising interest rates are headwind to equity returns.

If people have been used to 8%, in terms of your wealth accumulation, there is a huge difference over an extended period of time between 6% and 8%. It's about double the difference of the amount of money you would have after 20 years. We're aiming at 9% per annum but we've benefited in the last 15 years from falling interest rates and the job’s got harder.

People need a reality check that they don't get delusional as the world's a lot tougher for asset owners as we go back into a low growth, low inflation world. I don't know what's gonna happen in the next two years. I'm talking about that 10- to-15-year sort of expectations moving forward.

Hamish Douglass is Co-Founder, Chairman and Chief Investment Officer of Magellan Asset Management, a sponsor of Firstlinks. This article is for general information only and does not consider the circumstances of any investor. This is Part 2 of an edited transcript of a client event hosted by Stanford Brown.

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