Vihari Ross is Head of Research at Magellan Asset Management and a member of Magellan’s Investment Committee.
GH: You joined Magellan in 2007. What’s the same and what's different over 12 years?
VR: So much is still the same, perhaps because many of us are still here. The big difference is that we have many more people.
GH: But not a massive change overall because the business is so scalable. You’re still at only about 130 people.
VR: Yes, but a lot of the additions are outside the investment team. We have many more in sales, operations and corporate advisory that we didn't have at first.
As far as the investment team goes, I don't think Hamish ever intended to run a small business. We never wanted to be in a position where people would say that your performance isn't replicable because you’ve invested in small companies. We always had a focus on larger businesses and the investment process was set up very early in terms of what we wanted to do.
The focus on downside protection was part of the hiring process with Chris Mackay and Hamish meeting each person. I remember talking about the way I approached investing and they were bringing people in that had a consistent thought process. It was thinking about risk and the distribution of risk along a curve and we were followers of Warren Buffett with a focus on indentifying quality businesses in the first instance.
GH: So you never bought into the contrarian approach to investing?
VR: No, we were looking for quality and we still are today. Completely unchanged. And, of course, the next piece is valuation. We built models and as much depth of work as we could. I started on financial stocks and I remember discovering a huge pool of FDIC (Federal Deposit Insurance Corporation in the US) data and it was all free. We were identifying opportunities and checking excruciating detail, including what makes a company a quality business. We have more resources now to access these external data sources.
GH: A lot of fund managers rely on broker reports.
VR: We don’t use brokers to a great degree and we do our own work. That’s why we have a team of 30 analysts, and each of them covers only six or eight stocks or less if a company is complicated. We try to get to the essence of what makes a company tick.
GH: Hamish has admitted to some mistakes, including Kraft and Tesco. What’s the checking process then?
VR: When something goes wrong in a concentrated fund like ours, we spend a lot of time on the problem. With Tesco, the initial error was around business quality and the degree or intensity of competition from the rise of Aldi and Amazon. Eventually, the business turned around but the lesson is that we’d now be less willing to wait around because it was taking up space in the portfolio, or as we say, on the team. Hamish likes the analogy of each company in the portfolio being like the player in a team where each stock has to earn its place.
GH: What's the difference between managing $1 billion and managing $80 billion?
VR: Again, we're doing it in exactly the same way. We've never gone down the company size scale. We always had a focus on liquid, high quality companies trading at a reasonable price. We now have three traders and they are at the coalface of executing the management of the $80 billion.
GH: You must have companies that you like on every other parameter but you can’t get enough money into the market to invest in the company.
VR: That’s true but we’ve always had rules around liquidity, so that’s not different. But yes, we do find emerging companies but if they are small and illiquid, we don’t go there. We also want companies that already have an identifiable moat, not working on building one or where there are significant uncertainties and risk aroung whether they will make it.
GH: You wrote an article recently on the ways the world is changing and especially the projects Google is working on.
VR: Yes, each item I mentioned in the article related to a specific project that is underway. Alphabet's Loon project for hot air balloons intends to deliver wi-fi around the world to even the most remote locations, Verily is a long-term health project with an aim to extend human life, and Wing is their drone delivery service. Better known are Waymo, their automatic cars and DeepMind on AI. It’s all part of Google’s other bets. Many of these feed off Google’s goal of extending the quality of life, not simply prolonging it.
GH: You also wrote that you may invest in companies where the economics are so good, you’re less concerned by the quality of management.
VR: My point was that there are high quality companies that are sometimes not being run as well as they should be. For example, McDonald's between 2010 and 2013 was still a good business but it could have been run better. They ultimately fixed it and the underlying economics didn't deteriorate.
Let me answer this way. I mentioned moats, but we also look closely at business risk and the range of outcomes along a distribution curve. Is it a highly predictable, stable business, or is it consumer discretionary which is unpredictable in a recession? Or are there tail risks like Johnson & Johnson getting sued for the talc problem or BP on the oil disaster. Or Tencent, which makes 70% of its money out of online games, facing a freeze when President Xi said gaming is bad for young minds. We focus on how predictable is this business and we need to build conviction. So that’s business risk.
The third piece is agency risk. Are management good stewards of shareholder capital including governance and the right incentives, do they have a sensible acquisition strategy? So yes, sensible management is one of our pillars of quality and it's held us back from going into businesses in the past because we just can't get comfortable.
The last piece is what we call reinvestment potential, which is the company’s ability to redeploy capital at high rates of return. Some businesses are fine, they don’t need incremental capital to grow. It's wonderful. But some businesses like a utility can invest capital and also do well.
We’ve actually owned most of the things on our menu at different points in time. One we haven’t owned is Richemont. It has an incredible brand in Cartier which makes up the bulk of its earnings. It makes 60-65% gross margins and generates strong returns on capital. However, there has been significant risk following the CCP corruption crackdowns in 2013 which materially impacted the watch component of its business and led to a less than rational response from competitors. This has led to a wide distribution and uncertainty about future outcomes. Ultimately, valuation as well as quality and our conviction around that will determine a stocks inclusion in portfolios.
GH: Your main global fund is already concentrated, but now you’re launching a high conviction fund. What’s the difference?
VR: We’ve run a conviction portfolio since about 2013, only 8 to 12 stocks, as a distillation of our very best ideas with more flexibility and less rules. For example, it can hold more cash and take more risk.
GH: It feels like it will be quite a ride.
VR: It will be, but deliberately so, and it’s for investors who understand that. While it is more concentrated, there is diversification within the thematics of the fund, such as Visa versus Google versus Starbucks.
GH: Many people would consider the Magellan Global Fund is already concentrated with only 20 or so stocks.
VR: Well, maybe this is because I’m a Magellan person, but if you own too many stocks, you diversify your alpha (extra returns) away. Our whole process is about best ideas. Hamish always uses the analogy of a football or the cricket team. Every player must earn their place and each player has a role. Someone might be in the team because they can hit sixes, or give huge potential alpha but with more risk. But there’s another with less risk who will bat through the innings. They have a wide moat with low disruption exposure and a fewer risks if things go wrong. They contribute to the fact that we always hold less portfolio risk than the market level.
GH: In the past, you have personally specialised in franchises, and some of them now have a bad name in Australia due to doubtful business practices. What makes a great franchise business?
VR: What we call franchises are essentially consumer franchises, and there are two key elements: brand and distribution. That's access to the consumer in one way or another. So it’s Yum - which owns KFC and Taco Bell - obviously McDonald's and Starbucks. But we also include fast-moving consumer goods companies like Nestle and PepsiCo, it includes luxury goods and big box retail like Lowes.
But market positions are evolving. For example, historically, large consumer goods companies like Colgate, Procter & Gamble and Kellogg owned many great brands, advertised on nightly TV and then consumers would go to the supermarket which was the only place they bought groceries, and they bought their favourite brands. That reinforced their brand dominance. But now, a big theme is the rise of social media and online shopping. Social media enables challenger brands to come up and disrupt by gaining a following and taking market share and the big brands have in many cases been asleep at the wheel. It’s a bit like Oracle saying 10 years ago that the cloud is a fad and now they are investing heavily.
GH: Like Dollar Shave Club initially being ignored by Gillette?
VR: Yes. All you need is an influencer with a million followers to start talking about you. I call them mushroom brands and not all make it but the ones that do are often genuinely good ideas. We focus on which are the truly resilient brands. In the UK, for example, half of all grocery sales are private label but it is a small proportion in the US because Walmart always sold top brands at lower prices. The big brands are squeezed but even more vulnerable is brand number four or five. There’s a market leader, a challenger brand, a private label, and less and less room for marginal players.
GH: And tying up distribution as well.
VR: Yes, think of Louis Vuitton. Incredible brand but it also has its flagship stores, its beautiful stores in the best locations around the world and they don't sell their products anywhere else. You get the best customer service and you’ll never receive a discount, which is important for brand equity when you’re not selling through Nordstrom or Macy's or wherever at 80% off.
Starbucks is a great story of brand and distribution and a growth story with Chinese consumers. It’s very difficult to disrupt, they will not be hit by technology, they will embrace it. Now they have a great app for ordering coffee so they keep adapting. Coffee delivery is becoming a big thing. Technology is actually an opportunity. You have to work out if a disruption is more a flesh wound or if it’s really going to hurt a company.
GH: A couple of years ago when I would attend Hamish’s presentations, there was a very strong interest rate theme. He quoted percentage possibilities of rates rising and possible impact on equity valuations. That seemed to his main concern. Is that history now?
VS: We still use that slide and going into the end of last year, our view was that risks were still skewed to the downside in terms of the potential impact of rising rates. QE was expected to unwind with four Fed fund rate rises over the course of the year. Unemployment was low and there was talk of inflationary risk. There were lots of reasons to hold cash, then January rolled around and the Fed suddenly says, “We’re done.”
GH: Magellan’s Global Fund cash was as high as 20%.
VS: Yes, then in January this year we were in a different world. We changed our view on the probabilities. Where we thought the risk of inflation was 50/50, we were then more like 25% because the economy was still running hard and companies like McDonald's were saying they were experiencing cost pressure. But we changed our model.
GH: And that change included lower rates and generated higher equity prices?
VS: Yes, but not in a universal sense. We have redeployed a lot of that cash and we’re back to around 10% cash. But the reasons for the Fed change also suggest lower growth as the Fed sees a need to keep the current level of stimulus there. What does that mean for some businesses? For some, it means lower growth as well. But we try to reconcile these positions because not all businesses will have lower growth. The way we've redeployed the cash is into defensive equities and not into cyclicals. For example, with consumer staples, their growth comes from people buying food, it's pretty stable.
But in a DCF (discounted cash flow) model, if you have a business that’s economically sensitive, you might apply a lower discount rate but you've got lower cash flows as well. In a business that has a resilient earnings profile because it's a staple or has a huge structural growth tailwind behind it, you might apply a lower discount and the cash flow does not fall as much proportionally or at all. You will end up with a higher value in that situation. So it depends on the company whether the lower discount rate feeds into a higher valuation. It's important to not just blindly think everything's worth more.
GH: That’s a really important valuation point.
VS: And remember, we’re looking at a very privileged subset of companies. We're not looking at the battling retailer. Those guys aren’t worth any more with a lower discount rate because they’ve got a lower growth rate.
It’s surprising how resilient TV has been but I think that’s next sector to be disrupted. People now watch news on YouTube or online but it’s not some New Age thing. It’s just the way we are all going about our lives. My son said to me recently, “We don’t watch the news.” And I said, “No, we read it online.” There’s nothing sinister going on there. It's just that it is easier to do it that way, and advertising dollars follow the eyeballs. It's as simple as that.
I consider health and wellness is another disruptive trend. People are living better and it has an adverse impact, for example, on the sales of breakfast cereals but it hasn't impacted the sales of chocolate or crisps because people still want a treat. The stuff that is part of people’s daily rituals, you need to bring the health element into that. So we're looking for structural, resilient growth, like people drinking coffee every day. Will that continue for decades to come? I think so, we’re not going to deny ourselves that.
GH: Last question. Do you feel strongly about a theme or trend which generally the market does not recognise?
VS: We are all about big structural trends, to identify them and be exposed to them and then benefit from the magic of compound interest. We’ve recently spent a lot of time on the Chinese consumer. While it might be well known, it’s underappreciated. Everyone talks about the rise of the middle class, going from 300 million to 600 million over five years. But just as interesting, is the growth in the affluent class of Chinese consumers. Okay, we’re only talking between 1% and 3% of the population, but the numbers are big.
And what are they doing? Drinking premium coffee, buying premium cosmetics, travelling overseas, staying in the best hotels, waering high-end fashion, buying good Australian wine, cognac, Mercedes, BMWs. That cohort has been growing at 30% compound annually. It supersedes the demographic headwind of small families and slower population growth. The Chinese are moving up the income curve and there’s a lot of disposable income. That's capitalism at work. It’s entrepreneurial, capitalist and economics in a fully dynamic way.
Graham Hand is Managing Editor of Cuffelinks. Vihari Ross is Head of Research at Magellan Asset Management, a sponsor of Cuffelinks. This article is for general information only and does not consider the circumstances of any investor.
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