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Hamish Douglass on what really matters

with Frank Casarotti

On 13 October 2020, Hamish Douglass (Co-Founder, Chairman and Chief Investment Officer of Magellan Asset Management) held a webinar with Frank Casarotti (General Manager, Distribution at Magellan) called ‘What Really Matters’. The questions were submitted by attendees and these are edited highlights.

 

FC: Why is there such a disconnect between the world economy and the share market?

HD: I often get this question. You have to remember that sharemarkets forecast the future. They are trying to discount all the cash flows of a business from now to Judgement Day to figure out what it’s worth. It’s factoring in what’s happening in the next 12 months but also the next two years and five years and 20 years into the future. When you look at the economy, it's really a very static picture. It’s telling you what's happening today. We could have unemployment or credit losses but that's not telling you what the unemployment rates will be in five years into the future.

So you often get this disconnect. You ask yourself at any point in time whether the market is being irrational. There's so much uncertainty at the moment but the market has had a very strong rally, close to its all-time high. Is that completely irrational? It's reflecting a number of things, such as very low interest rates, and the lower interest rates are, the higher company valuations can be because the discounted future cash flows are higher in a low interest rate environment. We’ve seen an incredible amount of fiscal stimulus and monetary support, and there’s a view in markets that with all these trials, a vaccine will be found in 2021.

FC: On the holdings in your portfolio, how comfortable are you on the valuations?

HD: Well, we wouldn’t be holding things if we weren't comfortable with valuations. We sold Apple recently because we think it went past our assessment of fair value. Obviously, the market disagrees with us, but we think we're disciplined on valuation. It reflects our view on where interest rates are heading which justifies higher valuations than may have been the case five years ago, although some stocks are more fully valued than others.

FC: What's your most profound observation on the markets over the last 12 months?

HD: I don’t think I have many profound observations, but you should never be surprised by what actually happens, or how markets react. You should expect the unexpected. Events like this virus have happened in the past and they're going to happen in the future, although the scale of the economic damage was unexpected. I don't think any of us envisaged the willingness of governments to spend 10 to 20% of annual economic output to manage the downturn. There's almost been an income surplus from the fiscal expenditure. But we want to build resilient portfolios for long-term investors and expect the unexpected.

FC: Does the rising debt matter if interest rates remain low for a lot longer?

HD: It looks like governments don't think that it matters, but taken to extreme, of course it matters. Our own government that was so opposed to debt and deficits is taking on extraordinary amounts of debt. And the argument is, there's no interest cost for this because interest rates are so low. It’s almost free. But if we take this to the extreme, why don't we just get rid of all taxation, and governments just borrow the money. Of course, that isn't sustainable.

This even has a name, Modern Monetary Theory. There will be a day of reckoning. Just because interest rates are super low today, you cannot assume they will always be low. And if you believe debt is free and debt has no consequences, you might as well believe in the tooth fairy. One day inflation will come back and one day interest rates will have to increase.

But this period could last for a very long period of time. And what worries me is the longer this goes on, more and more politicians may start believing in the tooth fairy because they have relatively short election cycles. What are the restraints on them to spend the money today and believe it's a free lunch? I hope there are some rational voices at the table. I think it's been prudent for governments to be aggressive in their in their response in the last six months, but future generations will have a lot to bear. I hope this trend does not get too much momentum.

FC: What are the consequences of this lower interest rate and lower growth environment?

HD: Income and profitability and equity returns will grow more slowly in aggregate and that's going to be a very difficult environment for investors to navigate. They can’t simply put their money in the bank, which means they need to be very selective to find reliable growth.


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FC: What's your medium-term outlook for the FANGs versus the BATs (Baidu, Alibaba and Tencent).

HD: It’s an interesting way to frame the question but I don't regard this as one versus the other. They are subject to different risks. Many of these platforms are highly advantaged businesses and most (except Baidu) have the most powerful business models we've literally seen in the last 100 years. You probably need to go back to the railroad barons 100 years ago. There are very strong network effects in place and they're light in terms of the capital usage, outside of Amazon. I call this ‘capitalism without capital’, it is truly extraordinary. The FANGS are global plays, ex-China, with ecommerce, digital advertising, cloud computing and entertainment. The big Chinese tech platforms are even broader than the FANGS, including gaming, videos and music. They're into payments, financial disintermediation and local services like delivery.

But all these companies will attract the attention of regulators, so the real questions are, what are the risks? And what are they worth? Yes, we want to buy them when we think they're priced at less than we think they’re worth, taking the risks into account. All of them are extraordinary in their own ways.

FC: Does Magellan’s long-term thesis of 9% returns still hold despite the pandemic?

HD: This is a really good question. Overall market returns have been good in the last decade or two because of falling interest rates. As Warren Buffett says, interest rates are the gravity of markets. World profitability is probably not going to grow at 9% per annum and we are probably in a low growth world for the next decade. So equity returns in aggregate will be materially below 9% per annum. But we’re running a concentrated portfolio with unique sources of growth, and we’re not going to lower the bar because it’s harder. There's no guarantees that we will achieve 9%, and we will be judged over a full investment cycle of seven years.

FC: Where do self-funded retirees find income when interest rates are so low?

HD: It's a tough one. We are planning to release a product that will answer part of this question, but people will have to take equity risk. So we're trying to mitigate that risk in the product. But I don't have a single solution. I'd be careful about just reaching for income and going down the risk spectrum.

FC: Do you have any advice for younger advisers who are fairly new to the industry and navigating this pandemic early in their careers?

HD: Well, expect the unexpected. If you’re an adviser or an investor, stay the course, investing is a long-term business, not determined over three to six months. Find the right businesses and the investments that can compound returns over a long period of time. If you find good businesses, you can largely ignore the short-term issues such as in the last six months. I know it doesn't seem exciting for people who want to trade in and out, but great wealth is built out of compounding.

My best advice is to understand the power of compound interest. As a young person, you have a major advantage over the vast majority of people on this call. You have the advantage of age, and time is super valuable. In this game, as Benjamin Franklin famously said, money makes money, and the money that money makes, makes more money. And that's what investing is all about.

 

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.

The full webinar can be viewed here. For more articles and papers from Magellan, please click here.

 

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