Hamish Douglass on why the movie hasn’t ended yet
The focus is on Magellan for its investment performance and departure of the CEO, but Douglass says the pandemic, inflation, rising rates and Middle East tensions have not played out.
Mentioned: Magellan Financial Group Ltd (MFG)
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 1 of an edited transcript. In Part 2 next week, the Hamishes will discuss house prices, valuations, cryptocurrencies, corporate profits and future returns.
HH: Let’s kick things off with the change in CEO. Will this have any bearing on the oversight and management of the Global and High Conviction funds which many of our clients are invested in?
HD: It was a sudden resignation but there was no tension at all between Brett and me. Brett had two roles. One was looking after the back office of Magellan, and the other was the development of our listed products but not on the investments side. He resigned for personal reasons and while the timing was not ideal, I respected the decision and the reasons. I'm the Chief Investment Officer and my job's not changing. Three or four years ago, I used to be Chief Executive as well and we decided to take the pressure off and make sure all our back office and risk and compliance were in good hands with good leadership.
Kirsten Morton is our Chief Financial Officer and effectively Chief Operating Officer as operations report to her and she reported to Brett. She stepped straight into the Acting CEO role seamlessly so there is no risk at all for clients. The Board will make a decision in selecting the right Chief Executive which might be Kirsten but it won't be me. I'm not getting diverted because I'm focused on investments.
Wins and losses and fund performance
HH: Let's talk about the performance of the funds which have not kept up with the market over the last 12 months. Can you start by explaining the objective of the High Conviction Fund.
HD: It is a fund of eight to 12 investments that we call our ‘best ideas’. It’s more concentrated, we're holding 10% to 15% positions. We've always said that you can get more volatility in the short term, but let's put this in the perspective of what compounding is all about. If we make a single investment of 10% of a fund, and it goes up five to 10 times, we'll make 50% to 100% return on the entire capital in a single investment. Microsoft is up 12 times since we invested and we've made huge returns on Facebook, Visa, MasterCard, Alphabet and Yum Brands over time.
So if we get a stock wrong and we put 10% of the fund in and it falls 50%, that takes 5% of overall returns. But if we get a series of investments right over five to 10 years, it completely dominates a single stock loss. We’ve probably made two mistakes in the history of the Fund. One was Kraft Heinz a number of years ago and then Alibaba and Tencent. We're out of Tencent, we made money, but Alibaba is down after what happened in China last year and therefore it's affected the short-term return.
Ultimately, we're seeking a premium over the return we from our core Global Equity strategy because we're taking more risk in our best ideas. It's about long-term compounding, it doesn't happen in single 12-month periods. We've just gone into Netflix, which is up in the last 12 months but the previous 12 months, it didn't do anything. We have no idea how Netflix will perform in the next 12 months, I may as well throw a dart at the dartboard. But we have a very high conviction that Netflix over the next decade will give at least 15% compound returns.
The MSCI index is 1600 companies but we've got extreme things happening in that index at the moment. Judging this compounding machine against a stock market that's kind of gone crazy, and if you get caught up measuring 12-month periods, maybe you shouldn't be invested in the High Conviction Fund. But if you want to have the opportunity to compound your capital over the medium to long term, the probabilities are in your favor. We tend to hold these names for a long duration and while we made some mistakes in China in the last 12 months, we've fixed that and it’s not going to repeat itself in the future.
We're probably more closely enamored with China exposure in western world companies like the Starbucks or Louis Vuitton. In direct China stocks, you carry some very particular Chinese Communist Party risk, and our mistake was to own two technology companies in China. When you think about the Chinese consumer, the Western world gross national product per head sits in around $60,000. China sits around $15,000 per head. And there's 600 million Chinese who are dramatically under-consumed compared to Western world counterparts. Chinese consumption will grow materially faster than the West in future in a world where it will be difficult in the next 10 to 20 years to find growth. But we're going to do it cautiously with direct China exposure, although we still own Alibaba because it is ridiculously cheap and we think the risks are fully priced in at these levels.
Omicron is not the same movie as Delta and it may spread more rapidly
HH: Can we turn to your 2022 outlook, especially virus mutations and inflation and the likely impact on interest rates and markets?
HD: I could probably tell you more about mutations than how markets will react. We've always been cautious around mutation risk but when we saw Delta and earlier ones, we weren't overly concerned that they would lead to a major event. When we saw Omicron, even before we got any data, when we saw where the mutations were on the spike protein, with our scientific advisers, we thought this is potentially something really different. But the market thinks it's watching the same movie as Delta.
It is very likely this mutation would escape most of the vaccines and that's what we're seeing. The two-dose vaccines are almost completely useless protecting against infection from Omicron which means this is going to spread rapidly on a global basis. It’s already the dominant strain of new infection in the UK and it's only been there for two weeks. You can see how rapidly this can spread because people don't have immunity. The third booster increases your antibody levels and it looks like those antibodies will give protection. We don't have any longitudinal data yet on how long booster protection will last but over the next say eight to 12 weeks, this is going to absolutely explode around the world and it'll make the level of prior infection look like the teddy bear’s picnic.
We have no idea of the relative severity but with many more cases, even if it's less severe, the hospital systems could get completely choked around the world. We don’t know when hospitals hit their breaking points, and in all likelihood, we're going to take measures to slow the thing down which means we have to go back into some form of restrictions, which everybody will hate, but we're not going to go there until we let it to get completely out of control.
If it's super mild, and it's just a bad flu, we've got nothing to worry about. But we've got an event that is going to take people by surprise. If there is a very big shake in markets, we're ready to go into stocks we might have missed before. For example, it isn't going to affect the longer-term outlook for travel demand but it will affect the next six to 12 months and the short-term profitability. We're probably three to six months away of getting mass vaccinations but most people might get infected before they get the next shot for this particular variant.
Will the market look through this or react to the next wave? It's really hard to judge. I'm pretty confident on the infection levels but I really don't know on the severity point.
Defensive stocks and cash take advantage of selloff
HH: So let's say we do have a sell off, have you got particular investments that you expect to be more defensive that you could theoretically sell and go into something that's been beaten up?
HD: We've done a few trades and we've just increased our cash a little bit as markets bounced back. But we have some investments that are pretty pandemic resistant. You think about Netflix and Alphabet and Microsoft. They are investments that have done well during the pandemic through better engagement and will probably hold up well while travel-related activities could be absolutely hammered. So if this sort of dispersion happens, we may well rotate and we are doing a lot of work to make sure we're prepared if the market panics in certain areas. If it doesn't happen, we will look for the next opportunity.
HH: That’s clear, all of us should have booster shots.
HD: If you're eligible for your booster, I would strongly recommend it and it looks highly effective, particularly for a few months.
HH: Inflation is higher at the moment in the US, but what's the impact of higher inflation for the next few months?
Inflation is the big one, but here’s the real risk
HD: This is really the big issue, much more important than views on Omicron but there is an interplay. We largely sit in the camp that many of these pressures on inflation, which will be very elevated for the next three months or so, are largely temporary and transitory factors. They've been caused by the pandemic when people were locked down and given income but they had few things to spend it on because we couldn't go to restaurants and travel. They missed out on three holidays but they still have the income. And therefore their savings have gone up and there was a massive increase in demand for goods.
People were doing things at home, renovating, buying goods online. And the monthly demand for goods went well above levels seen in the world before. The manufacturing system had to churn out more goods and deliver them. Supply chains were asked to do more than ever but they were disrupted by the pandemic, particularly in Southeast Asia.
We expect a transition from buying goods to consuming services. The demand for goods will come back down and it will start releasing the pressure on the supply chains. And as the pandemic eases, the supply chains will catch up as well. And the same thing in labour constraints caused because borders were closed. We have 200,000 to 300,000 people who work in the Australian economy every year who are not residents. They are students and people under 35 visiting Australia who work in our restaurants and pubs and everywhere else. And none of them are here. So it's not surprising to see a scramble for that type of labour in the world and complaining no one wants to work. It's not that no one wants to work.
The real risk here is in the United States, when we get to their summer, let’s say June, July, August next year. And we don't have this rollover changing demand patterns and reopening of borders. And let's say Omicron is still going. We’ll see more inflationary effects passed to consumers, but if it hasn't rolled over from goods to services by the US summer, inflation will move into expectations.
If inflation takes hold, the game is up
And at that point, I think the game's up. Central banks will be forced to respond by tightening monetary policy, with rate rises next year from the Fed. That isn't a response to the current inflation, that's just a modest tightening as we go through the cycle. But if inflation really is the issue next year, hold on to your chairs. We ain't seen anything. These markets are wound up, there are so many crowded trades. And what happens when they start to materially tighten monetary policy is we're going to have massive asset price volatility. I think I could name 200 stocks that could drop 40% in a day. People are playing with fire.
Even the reopening trade, it's so crowded, if people change their view when monetary policy tightens, you have the whole world in overvalued trades and everyone's running for the same door at the same time. And normally when we've had a shake after a financial crisis, it's the central banks who come to the rescue of asset markets by printing money and buying bonds and driving down interest rates and flooding the world with liquidity. The issue if it's inflation, the central banks are going in the opposite direction. They're actually stopping quantitative easing and tightening monetary policy to stop inflation. They're no longer here to help.
And that's what makes this so dangerous. Central banks can't help us anymore because they're solving an inflation problem. The governments are constrained because rates are going up and therefore how much more deficit spending can they take on? It’s very, very dangerous situation for asset owners. Does it worry me? No, we got an defensive portfolio and we don't own that extremely expensive stuff. It's not gonna be fun, by the way, but the volatility would be our friend.
I put a 30% probability on it. I think it's probably going to roll over. But if it happens, people are getting their shirts ripped off. This movie hasn't ended yet. We've been judged over 12 months of being conservative.
Another black swan, and the risks are obvious
I'll throw another black swan into this, Israel and Iran. Iran is heading rapidly towards nuclear enrichment. It doesn't look like the US will reach an agreement with Iran and I think there's a reasonable possibility in the next six months that Israel strikes Iran. The question is what Iran does in response, such as do they strike the Saudi Arabian oil facilities? The last thing in the world needs is an event in the Middle East.
So this whole thing could be triggered by something we're not even looking at. We're only halfway through the movie. The press has judged the end of the movie, but in 12 months' time, we're either going to get through this with a rollover (away from goods to services), and everything's pretty calm despite a modest tightening. Or we're going to have an event that’s ugly and that's fairly likely, so we're cautious. To us, the risks are obvious.
That doesn't mean they're going to happen but no-one can say, ‘Oh, we couldn't see that coming.’ There's so many warning signs here with extreme behavior going on. And Charlie Munger said at the Hearts & Minds Conference that he believes this is more extreme than 1999. This is one of the most extreme markets he's ever seen in his life, and he's 98 so he’s seen a few of them. There is just some crazy stuff occurring at the moment and we're watching this party of the century occurring at the moment and I feel like the person who is failing the ID check at the door.
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 1 of an edited transcript of a client event hosted by Stanford Brown. In Part 2, the two Hamishes will discuss house prices, valuations, cryptocurrencies, corporate profits and future returns.