The uber-successful manager of Magellan Global Equity discusses the firm's unusual origin story, China, and how to build a cohesive world-stock portfolio.
Our guest this week is Hamish Douglass. He is the co-founder, chairman, and chief investment officer of Magellan Financial Group, a roughly $80 billion asset-management firm with headquarters in Sydney. Among his duties, Douglass is lead manager of the Magellan Global Equity strategy, which is a concentrated portfolio of high-quality growth stocks. That strategy has been very successful since its July 2007 inception, handily beating its benchmark, the MSCI World Index, with significantly less risk. Before forming Magellan in 2006, Douglass was co-head of global banking for Deutsche Bank in Australia and New Zealand. He received his undergraduate degree from the University of New South Wales.
Background
Bio
"The Essential Balance: Independent Thinker, Team Player," by Rebecca Thurlow, The Wall Street Journal, Dec. 11, 2006.
"Learn More About Magellan's Global Equity Strategy," Magellan, July 2019.
"Being a Successful Investor," by Hamish Douglass, MFG Asset Management.
Investment Style and Portfolio Construction
"10 Cognitive Biases That Can Lead to Investment Mistakes," by Hamish Douglass, Magellan, May 2017.
"Business Model Disruption Has Barely Begun," by Hamish Douglass, Firstlinks, Oct. 15, 2017.
"Business Model Disruption--Part 2," by Hamish Douglass, Firstlinks, Oct. 19, 2017.
"Passive Investing and Disruption," by Hamish Douglass, Magellan, July 2017.
“13 of the best: reflections from an investor,” by Hamish Douglass, Firstlinks, July 31, 2019.
"Hamish Douglass' Map for Investing This Decade," by Vesna Poljak, Financial Review, Jan. 24, 2020.
"Hamish Douglass on What Really Matters," by Hamish Douglass and Frank Casarotti, Firstlinks, Oct. 21, 2020.
"What Sort of Economy Awaits on the Other Side? Hamish Douglass Shares Four Possibilities," by Vishal Teckchandani, Livewire, April 1, 2020.
"Magellan to Offer Low-Cost Investment Strategies," by Charlotte Grieve, The Sydney Morning Herald, Aug. 13, 2020.
"China's Clampdown on Jack Ma's Ant Boosts Rivals," by Sun Yu and Tom Mitchell, Financial Times, Feb. 18, 2021.
Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, chief ratings officer at Morningstar Research Services.
Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar.
Ptak: Our guest this week is Hamish Douglass. Hamish is the co-founder, chairman, and chief investment officer of Magellan Financial Group, a roughly $80 billion asset management firm headquartered in Sydney, Australia. Among his duties, Hamish is lead manager of the Magellan Global Equity strategy, which is a concentrated portfolio of high-quality growth stocks. That strategy has been very successful since its July 2007 inception, handily beating its benchmark, the MSCI World Index, with significantly less risk. Before forming Magellan in 2006, Hamish was co-head of Global Banking for Deutsche Bank in Australia and New Zealand. Hamish received his undergraduate degree from the University of New South Wales.
Hamish, welcome to The Long View.
Hamish Douglass: Jeff, it's great to be with you.
Ptak: I know you've told the story behind the firm you co-founded, Magellan Financial Group, many times now, but I would guess a lot of our listeners haven't heard it. And it's unusual as origin stories go. You and your co-founder, Chris Mackay, were accomplished investment bankers and you made the jump to running money. How did that happen?
Douglass: Well, Jeff, it's actually quite a long story and it goes way before 2006 when we set Magellan up. I was very fortunate. I came out of university and I joined a company called Schroders, which had an investment banking business in Australia. Chris is a little bit older than me. And it was just by happenstance that Chris Mackay joined Schroders on the same day that I joined Schroders--a very, very talented individual. He was more senior, as I said. And we got to sit next to each other in the investment banking division. And he actually, within the first week, put about 20 years of Berkshire Hathaway annual reports on my desk, and said, "I suggest you read these." And I did. I went away and I read them, and I became completely enamored. He was obviously enamored with Berkshire, and particularly with Warren Buffett and Charlie Munger. And we went with a whole bunch of friends going to the Berkshire Hathaway annual general meetings for years. So, I then went on a quite a long journey, a 15-year journey in investment banking.
We were kind of enamored with Buffett and investing. And Chris and I used to invest and used to debate all the time. And then what happened in 2005--Chris used to run UBS in Australia and New Zealand as chairman and chief executive and he stepped down because he just wanted to invest, and he recapitalized actually a listed Australian company, which he took a sort of 50% shareholding in. It was called New Privateer. And I became a shareholder and I was actually the co-head of Deutsche Bank's investment banking side, their global banking side, in Australia and New Zealand. And I said to Chris, in the beginning of 2006, "Why don't we actually set up an asset management firm?" And believe it or not, in 1991, Chris and I, on the side, used to run some money for some private individuals. I don't know if we were permitted to do that. Although I think the statute of limitations may have passed now on that. And Chris goes, "It's a terrific idea, but you know there's one thing--you still happen to be running Deutsche Bank and you need to extract yourself." Which took a bit of a while.
And then we raised capital at the end of 2006 in a very unusual way. But Chris and I were lucky. We'd had wonderful careers in investment banking. We were fairly high profile. He was extremely high profile, [more] high profile than I was. But I was actually very well-known. And we really leveraged that capability to set it up. But it came from a very core, long-seated sort of fascination with Buffett and Munger and investing and we kind of went on this excursion in investment banking that was a wonderful career. But we jumped off the edge and we established Magellan.
Benz: We tend to think of investment bankers as somewhat transactional, immersing themselves in relationships and facilitating capital events. As valuable as those skills are, they might not translate to successful long-term investing. Can you talk about what skills or practices you found you could most easily transfer from your former life as a banker to your work as an investor and which you had to leave behind?
Douglass: Christine, what a great question, because there are skills that are transferable but there are other issues with investment banking, that actually we didn't want to be involved with Magellan at all. The readily transferable skills--of course, detailed analytics and valuations is very important. Understanding capital markets and understanding the plumbing of the financial system, we think, was very important. It was certainly very important during 2007, 2008, and 2009 in understanding that risk.
The way we've set up our whole research function isn't regional. We're a global manager. We don't have an Asian team and a European team and a Japan team and a China team. We actually have global sector-based research. And that's how we undertook setting the business models up in investment bank. We were M&A advisors. Chris and I were probably two, at the time, highest-profile M&A advisors in Australia, and we'd spend a lot of time thinking about strategic issues for businesses. And I think thinking about the strategy of businesses is very important when you're an investor. And certainly, we'd had a lot of experience dealing with chief executives around the world and discussing strategy with them. So, it kind of came naturally as investors in probably having quite different conversations with chief executives, than trying to understand what was going on in the latest quarterly report numbers and from investment banks. I think we understand it's a very competitive field in asset management and we understood you need to have great people.
But there were things we wanted to leave behind. And I think you noted that the culture is very different. In investing, you have to be extremely patient and not transactional. And in investment banks, they're more transactional and they're much more individually focused. When we looked at the investment banking systems and how they paid people, which was really set globally, we saw huge issues with how incentive compensations work. So, we started with a completely blank sheet of paper. And I guess our lessons were almost do it completely differently to how an investment bank would reward an individual. We, of course, left behind global bureaucracies, which really takes away accountability, and particularly accountability for individuals that work for you that it's so hard to get things done in global bureaucracies. And we wanted to have no excuses. We wanted to be fully accountable to our people in every decision that we made. So, there are lessons, but it wasn't all bad investment banking. I think we picked up a lot of skills, but clearly on the incentive systems and the culture, we wanted something very different at Magellan.
Ptak: One of the things that's striking about Magellan's start is that you were able to attract, as I understand it, quite a bit of funding quickly, which is unusual for a brand-new asset manager without a record. Can you reflect on how your ability to secure funding from the outset maybe informed the choices you made about how to set up the business? Did it let you pursue your vision in a less compromised way? And do you think there are lessons in that for others who are seeking to break into money management?
Douglass: Well, Jeff, that's a really good question. And look, we were lucky. We did something that was extremely different. And I'm not aware that any asset management firm anywhere in the world has done what Chris and I did when we set up Magellan. We actually, to set the firm up, we listed it on day one. So, here, we're two investment bankers, we had four employees in a serviced office. And we went out and we listed an asset management firm that didn't actually have any assets. And nor did Chris or I have any track record in asset management. We obviously had very high profiles in the finance industry in Australia and New Zealand, and we went and raised AUD 100 million to set the firm up. And at the same time, when we were raising that, we raised a closed-end investment trust, or company, and it raised AUD 372 million. So, in a period of about a month, around October 2006, we went out and raised AUD 500 million to set the firm up with two guys and two other people in the office with no sort of track record.
And we were very lucky that we were able to leverage our previous careers. We really knew how the capital-raising game was done. We had some very high-profile backers. It was all over the financial press in Australia. And actually, it had full-page articles in the FT and The Wall Street Journal when these two guys set this business up. And it was 2006, it was at the peak of investment banking, there were a number of investment banking models that were flying high in Australia. We didn't want to set up an investment bank. But I guess we were kind of in the right place at the right time. And we did it as a listed company. And I'm not aware of any other asset management firm that has listed their business on the stock exchange before they actually had a business. It almost seems like a dot-com startup. But it put us in a very, very unique position because we had $100 million of capital in the firm. And we actually had a closed-end investment trust that was at least paying some fees for some operating costs.
And so, you asked the question: "Did it allow us to pursue our business in a less compromised way?" And the answer to that is, of course it did, because we were in a very privileged position. In some respects, it was the Field of Dreams: "Build it and they shall come." We actually hired some incredibly good people. One of them was probably the most high-profile distribution person in the country. His name was Frank Casarotti. And we built out a retail advisor distribution group in Australia very early on. I don't think that someone like Frank Casarotti would have ever joined Magellan if we hadn't raised that money, because we were able to give him equity in the business, but he could go back to his family and say, "I know this sounds pretty crazy. I'm joining these two guys. They don't really have any money at the moment. I'm leaving probably one of the most secure high-profile jobs in the country. But, don't worry, darling, they've got $100 million of cash in the bank. And I'm getting a material amount of equity in the business." And the equity was backed by cash. And it was listed. So, it had a market price behind it.
But the long-term view is, we knew it was going to take time to build a business. You had to build a track record. It's like a snowball. You'd actually get snowflakes and it gradually builds over time, and you needed time to work. And then, what happened--we launched the business in 2006. And then, of course, in 2008, particularly September 2008, the world started to completely crumble. And without that capital, we may not have survived. And the history may not be here. So, we were lucky there.
And I think you mentioned, Jeff, about what can we tell others from our experience. I think we couldn't say to others, "Look, if you set a business up, you just have to go and list your business before you've got any track record and you have to raise $100 million of capital, you have to have a large closed-end fund to set the business up, you need to go and hire the best people in the market and encourage them to come to this startup with no sort of track record." I don't think that would be a very credible way of telling people to set up a business because I just think we got very, very lucky and it was a whole confluence of factors that happened at the time. But what I would say is, it takes time to set up a business. And resilience really matters, particularly in the early years. And most people, even if they're good at what they do, because of this time frame it takes, most people never get to the promised land, even if they're talented.
And I would say that if we look from an Australian perspective and the lens I would look through, the game has actually got tougher. The avenues to set up a new boutique are harder. We've closed that sort of listed investment company market in terms of how capital is raised, seeding fund managers out of Australian institutional investors quickly is much harder, because they've changed their models. I think it's super difficult to raise capital like we did. To someone starting up, I would probably say capital matters. I'd probably go to the incubators. And if you've got talent and everything else, there are many incubators around the world who will back people with some capital. If you don't have a lot of personal capital--you need capital behind you. And you need patience. You need patience in this game because the snowball starts off incredibly small for most people. There are a few star hedge fund managers who leave somebody and come out and can raise a billion dollars, but most people can't raise money quickly. And they have to build track records and it's going to take time, and you need to prepare yourself for the time and have resilience around your model and have patience.
Benz: One of the other ways in which you seem to break from orthodoxy in investment management and asset management is how you talk about the role of the investment function within an asset management organization. You see it as vital, obviously, but you also say it shouldn't be on a pedestal compared to other functions like sales and operations. You said that that helps mitigate the risk of hubris coming in. Can you talk about that and how that manifests itself, practically speaking, and how you've run the business?
Douglass: Christine, this is a really important point. And when we look at investment banks and we look at most asset management firms, there is a huge amount of hubris in the organizations and you get the superstar-type cultures that occur. And my view is that hubris is the downfall of most successful financial-services business. And how do you avoid this sort of hubris nature, toxic culture? Obviously, when you get success, enormous amount of money can flow into the businesses. And then, how do you stop this what I call this rent-seeking culture and these godlike beings that sort of come into that.
And at Magellan, we started out with a completely flat structure. And when you say that I was intent and Chris was intent that no one on the investment side was going to be any more important in the business to the best people in operations or the best people in compliance, or our stars in distribution or people in any aspect of the business. So, keeping that very flat structure and not putting the investment team up on a pedestal, that they are superior and better because they're not at the end of the day. I think staff ownership is very critical. And we've got a very wide voluntary staff-ownership scheme that the company funds that Chris and I have never participated in. It's completely voluntary. We provide all the funding interest-free to it. And everyone nearly in the organization, right down to the secretaries, all get to participate in ownership. So, we want ownership widely spread to. We actually have an annual CEOs award every year and probably the one I have enjoyed the most. Few people in the investment team, very few people in 15 years from the investment team, have been recipients of that award. Occasionally, but I would say it's about 10%, maybe two or three people over that time have won the top award in the company. The best person and the standing ovation from the company was when it was awarded to our receptionist. She is the person who is the front face of the organization when clients come in, and she's absolutely outstanding. You could just see how much it meant to everybody when she won that award.
The other thing I'd say about hubris is you really need to look in the mirror. Hubris can start to affect any person, particularly when you have success and you start earning a lot of money. And I would say--and you'll probably edit this out--it's very important you don't start believing your own crap at the end of the day. Markets can be incredibly humbling. You have to have people around you who are going to be totally honest. But, most importantly, you have to be honest to yourself, you have to admit your own mistakes. And, critically, I always admit that mistakes publicly and to our team. And you just don't blame others when things go wrong. And you do need some leadership from the top here. I could afford not to do this, believe it or not, but I get the bus to work every day. And part of the reason I get the bus to work every day is the avoidance of hubris. And actually, the signal it sends to other people. Out of 140 employees, I think there's about three people who have a car-parking space that is paid for by the company. And none of those three people are in senior management. They're people where the car is critical to the job that they do, not because you're senior in the organization. So, it's just such an important topic, this issue of hubris. There are things you can put in place to stop it, but it's hard when money and success becomes involved, of stopping people getting caught up in it and believing in it. And it will be your downfall.
Ptak: That's a really helpful thumbnail of the firm and its culture. Now, I wanted to shift and talk about things that are a bit more specific to the investment decision-making process starting with competitive advantage. And I thought I would start by reading something that I think you wrote once. It says, "There's a finite number of outstanding companies in the world. The vast majority of these companies are well-known blue-chip investments. Many people think that you can only earn superior returns by uncovering hidden gems. In our experience the best long-term investments are often hiding in plain sight. They are usually market-leading firms that have superior returns on capital, excellent long-term growth prospects, and wide economic moats." My question for you: It seems a bit odd in a way to think that these widely followed names, which sit near the top of the major indexes, would misprice and confer superior returns. So, what does the market fail to impound into the stock price in these cases?
Douglass: Jeff, this is just a really interesting question and a really interesting observation on markets, and it shows from time to time markets are inefficient. So, your question is why can the market be so wrong, sometimes, on some of the world's most researched companies. You'd expect if they're the largest companies and have the most people following them, they're the companies, if any, are going to be efficiently priced and it's going to be some obscure small cap or something that wouldn't be efficiently priced. But that's just not what we observe. We have earned some extraordinary returns in some of the world's largest companies. We bought, in 2014, Microsoft at $28 a share. We bought Apple when it was $94 a share. We've made enormous monies in Alphabet and Visa and Mastercard and Facebook, and I'm only picking the super large-cap ones. I could give you other companies that aren't large caps were to happen.
So, why is it that sometimes something happens in a company? A good example I would give you: Microsoft, when we bought it. They clearly missed the shift to mobile. And people thought that Windows operating system was dead and was being priced for that. And we saw something very different of what was going to happen around their office franchise and ultimately to the cloud. And actually, the stickiness of the operating system in terms of how difficult it would be to get the operating system out of enterprise here. And I would argue maybe something similar is happening at SAP at the moment--is they're shifting away from an on-premise model with their clients to a cloud-based model, which is disruptive in the short term.
And so, why does this happen from time to time? And I would say the real issue when these events happen, why markets misprice is something I would call is duration arbitrage here. The market then gets very good at assessing what's likely to be transpiring, and I would say often in the next three to six months, but really isn't focused what will change in maybe three to five years. And Apple, which was just such a great point in case when we were doing it, the market was incredibly focused on the iPhone cycle and the sales that were happening in the next few quarters. And they were in between upgrade cycles and the share price was coming down. And we were very focused notwithstanding there was volatility in the short-term iPhone cycles that the installed base was increasing and our view as recurring services revenues were increasing as a share of the company as a whole, and in five years would become material and that would lead to a large re-rating of Apple as that happened over time, notwithstanding we saw that the market saw what was happening and likely iPhone sales in the short term. And the reality is, we were right on that and the market was, because they were focused short term, just weren't able to see the longer term. And I would say occasionally--and it's important, occasionally--when the market is looking at the six-month view but something fundamentally could be changing in a five-year view, we occasionally see a very different picture, because we're looking through different lenses. We're looking through a telephoto lens and the market is looking through a standard lens. And sometimes a picture is quite different between the cameras you're looking at the same stock through. And I would say there, there are actually very, very few investors who are really taking that five-year view. People talk about it, but their behavior is very, very different.
Benz: Your flagship Growth Equity strategy has had about 10% in cash on average. Even if that's a residual of your stock-picking process, it has helped to cushion performance when the market is sold off. Do you find it has also made your team better at stock-picking because they're likelier to focus on long-term horizons and outcomes, knowing that there's cash there, and that it will take the edge off a little bit of performance and when the market sells off?
Douglass: Well, the first thing I'd say is, it's not at the analyst level. The analysts cover what they cover. And actually, our portfolio is actually a combination of two different portfolios. We have a defensive portfolio and the cash sits there and we can run between anywhere between zero and 20%. We're probably averaged, as you said, around 10%. But that's a combination of also our defensive assets. And we actually invest in a growth portfolio, which is about half our portfolio we have, which we can have a lot of volatility in that side of the book. So, we've got analysts who are covering growth stocks, but we've got analysts who are covering defensive stocks.
But the way we construct our portfolio--we construct these two subportfolios of defensive and growth combined together, and we actually cap the total risk that we run in the portfolio and as a broad rule, we call it like 80% of market risk. So, what that enables us to do, because we have these defensive assets in cash providing this cushion in the portfolio, it dampens the overall portfolio volatility risk, which enables us to take at an individual stock level, quite a lot of volatility risks. Like, we are happy owning Alibaba at the moment despite what is going on with Jack Ma and the regulatory environment. We've owned Facebook during the Cambridge Analytica situation and added to the position during that. They're very volatile periods. But when you look at the portfolio level, it actually doesn't really matter because of the way we construct the portfolio. Cash is part of that, but it's actually this sort of barbell of having a defensive book and a growth book in the same portfolio and having a total cap on the risk. And therefore, we have to actually offset volatility risk. But at the analyst level, it depends. We don't tell the analysts, but in the portfolio construction level, when you're looking at it as a portfolio manager, I'm very happy to buy a very volatile name. But I know I have to offset that volatility risk with a utility holding or something in the portfolio.
Ptak: Is that barbell style you described, has that been there all along? Or is that an approach that you evolved toward? And a related question is, I guess I'm somewhat unaccustomed to hearing managers talk about their portfolio construction as lucidly as you just did, where there's balances and counterbalances that you build into the portfolios. A lot of managers just pile into what they would consider to be their highest-conviction names. In your case, it would be names that are endowed with maybe structural growth advantages--that could be a choice to make, where you just pour all the money into the Alibaba's and leave the defensive names behind. So, how did you come to decide that it made sense to use the two in tandem the way you do?
Douglass: It did come from the beginning of our process. And we started with two objectives. And we started with objectives--the first one was a return objective. And we set a return objective way back in 2007 when we launched our flagship Global Equity strategy of return through the full cycle of 10% per annum before fees. And we thought, world growth and markets and everything else that that would deliver long-term alpha versus market. So, we set a return objective. But then we also set an objective is we want a capital preservation. And what we meant by that is, we wanted to have materially lower downside volatility in adverse market conditions. And if you look over time that any three-month period where the markets have had a negative return, we have on average experienced 50% of the downside risk that markets have had, which is kind of almost unheard of unless you're a hedge fund who's shorting but in long-only manager, it's in the extreme top percentile in terms of downside volatility experience.
So, when we set those objectives, we really started with a blank sheet of paper. We didn't come out with an asset management firm and saying, this is how it's been done by our people who taught us. We started with a blank sheet of paper. And therefore, we really thought about risk. We wanted to have a portfolio that could do both: deliver us returns but also give us volatility dampeners on the downside, and that's how it's come up. Of course, there's been sort of nuanced modifications for how we measure risk and how downside risk measures work and how we analyze that. We've got something very proprietary we developed called a combined risk ratio that we tweak from time to time when we get more data and experience. It's a volatility and actually a drawdown measure. We've got a lot of analytics we do on that. And that just feeds into how we think about stocks. And we actually split out whole stock universe into two different universes. So, we think about stocks, and we put them into different buckets and how we measure those stocks. But it came from a blank sheet of paper, but it all started from objectives of what we were trying to achieve for our clients.
Benz: You mentioned Jack Ma earlier and I wanted to follow up on that. What have you learned about China, investing in China, from the episode with Ant Financial and Jack Ma that you didn't know or perhaps underappreciated about the Chinese market and the partnership between private business and the government there?
Douglass: They are certainly on our risk-management side, and I mentioned before that we tweak things from time to time. We have actually put some new risk controls around all technology platform companies that are subject to regulatory or government intervention risk, and tightened them from our individual stock limits. And they would apply to an Alphabet or Facebook or an Amazon or an Apple, and they apply to the Chinese tech companies. And that was kind of a bit of a lesson coming out of that.
But what have we learned specifically in relation to China? And this is something we've thought about a lot. It highlighted the, I call it the CCP intervention risks--that when companies in China do something against the integrity of either the party or the direction of the country, the government is going to intervene and could intervene in a heavy way. We always had assumed that the government would intervene and is the ultimate determinant and it can be a guillotine like, there's not a right of appeal like you get in the West. But what we actually got wrong on Alibaba? I don't think we got the risk around government intervention in circumstances like this. Had you told me what the facts would be, the outcome of pulling the Ant IPO was probably predictable. But what was unpredictable in this case, or maybe not totally unpredictable, but what we got wrong in our assessment is how Jack Ma would behave.
Back in 2017, there was actually a precursor to this where Alibaba, which owned the South China Morning Post, put out an article in Hong Kong that did an exposé of some officials in China, which caught up part of President Xi's family, and about the wealth that they had. They weren't calling them corrupt, or I think they were pointing out the wealth that people had. And that didn't go down too well. The article was pulled. And Jack Ma was forced to step down from his role as Chairman of Alibaba Group. And we thought that Jack actually got this risk and would act in his own self-interest. So, we were flabbergasted when Jack--just before the Ant IPO was going--would directly take on the government on regulation in a public forum and actually be highly critical of the regulators themselves. Once that happened, were we surprised that the government and presidency acted like they did to send a warning to anybody else: do not criticize the party or the regulatory authorities. Because if they'd let that go, then what signal would that show? So, I guess the risk has just been highlighted that the risk is very, very real around government intervention risk. I suspect for many other companies this will send a very clear signal. Probably the risk has gone down somewhat.
But from the China point of view, I would add is, China is going to become one of the most important, if not the most important, investment destinations in the world. It's going to become the world's largest consumer market, hugely innovative in their market. And as global investors, you need to have an allocation. But we're in very early days. Most people don't understand the risk. The system is very opaque, particularly around the political side of the system. And you need to have risk management but also you need to really build up some detailed expertise and we're doing a lot in terms of experts and things in building up that knowledge. But I would admit it's even early days for us, and China is a relatively modest part of our book and we're in the best companies. But as you say, from time to time, there's risk. But we've owned Facebook during periods of regulatory risk and many people have panicked and we haven’t. And if we see deep value there, and we actually see deep value in Alibaba at the moment, but risks in China are real.
Ptak: I wanted to talk about another type of risk and maybe do so in the context of a few names that you own or have owned, that being Facebook, Amazon, and Microsoft. They're examples of firms that have acquired or built formidable franchises and done so almost as a second act--you think of Instagram, AWS, and Cloud, respectively. Those successful examples, they probably do embolden some management teams to experiment or branch out in similar ways that might have been frowned upon before. Given that, how much rope are you willing to give a management team, and how has that changed for you and your team over the last decade or so?
Douglass: Well, the first thing I'd say, Jeff, it's not up to us to give management rope per se. It's up to us to decide whether we want to be partners as investors when management teams are embarking on diversification or M&A. If we're not happy with what management is doing, we could jump up and down and tell them not to do it. But the reality is, our choice is to sell if we're not there or not to invest. There are some businesses which we just would not be happy with them expanding. And often, it's geographic expansions. When Tesco, before we held it, it expanded into the United States and Target was trying to go into Canada. Those are pretty high risk--in a lot of examples, those do not work out very well. But when Microsoft was backing Azure and going after that, and Google was going after the cloud infrastructure with Google Cloud--we couldn't be happier with the capital they were putting in that or with Starbucks rolling out 600 stores in China. We viewed that very differently to Tesco trying to do a startup in the United States.
And we've just built a meaningful position in Intercontinental Exchange run by extraordinary management team, and they've just put a lot of capital into digitalizing the mortgage industry in the United States that has never been done before. So, that's kind of a case where, is this going to work out? And actually, that is a major driver of our investment case. We think it is absolutely genius. And we have a huge regard for the management team. We think the pieces they've acquired are just extraordinary. And we genuinely believe they're going to create a very large business and ICE is worth about $60 billion. Our numbers tell us that over time that that mortgage opportunity is going to be in value I think equal to what the total market cap of the business is today.
So, the reality is, each case needs to be assessed on its merits. You do need to be wary when companies are committing significant capital to new areas or new markets. I'm probably more wary of if people are committing capital into existing markets, like Tesco going into the United States, a market was already in food retailing, hypercompetitive, and therefore that's really hard. But many of these other examples, they're committing capital into the creation of new markets, like Amazon did with AWS and Microsoft is doing and Google is doing in their Cloud business. We think they're going to be enormously valuable for all of those companies. What ICE is doing in the mortgage market is creating, its digitalizing and analog process into a digital process and it's probably going to end up being close to a monopoly when that is finished. So, you get visionary managers creating new businesses. But if you just try to commit capital and go into an intensely competitive market already, or do large M&A, we would probably be much more wary of that type of activity. We'd probably just take our capital elsewhere rather than lecture management not to do it.
Benz: You've said that you think mean reversion and investing is broken. That the days of buying something at a price/earnings ratio of 15 when it's normally trading is a 20 P/E, and waiting for the multiple expansion to happen, that those days are more or less over. So, can you explain why and then elaborate on what you think the implications are for classic value investors who have made this style of investing their calling card for many years?
Douglass: Yeah, it's a very good question. And there's difference between markets mean reverting and individual companies mean reverting. So, at the end of the day, markets have cycles and markets will get overpriced and they may misjudge where the economic growth or where interest rates may be and may extrapolate that and then, of course, when growth comes down and interest rates go up, markets should mean revert to where that new tide is at. So, I don't want to say there is no cycles and no mean revision in markets. But when you get it at a stock level, what I would say is most companies via the capitalism process lose their luster over time. And that's just a fact of capitalism. And, therefore, if you're in a business that was worth 20 times earnings a decade ago and now, you're looking at a 12 times earnings, and assuming that the average multiple was x, y, and z in the past, that if I buy it now, the multiple will go up because it's just underappreciated. I really refer that to as sort of revision mirror investing.
You need to really think about where the business is headed in the future, not where it's been in the past. And often the multiple in the past was looking at the competitive positioning and the earnings profile and the growth outlook of the company in the past. And what you have to look at is where the positioning and the growth profile of the business is in the future. I think a lot of deep-value investors are stuck in the past. They're stuck in the rear-vision mirror. Of course, there are some businesses that get oversold when the market gets it wrong and there will be a mean revision. But just the general thing of it used to look like this and it will look like this again when the market mean reverts, I just think that the track record of that happening is pretty poor. And great managers, I always say, they look out the windshield. They don't look in the rear-vision mirror for where you're headed. And you have to appreciate what capitalism does. And as I said, it takes the luster off most businesses over time and the multiples should reflect that.
Ptak: That makes sense. And I had a follow-up for you. Given this view at the individual company level, what do you think the implications are for capital allocators at firms? For instance, it's become almost writ among CFOs and treasurers that they should repurchase shares when the stock price falls below a certain level. And so, the question naturally is, is it maybe a mistake for firms to repurchase because the multiple looks tempting? And, if so, if they are making a mistake, how should they approach that if they were to use a model like yours?
Douglass: It's a very interesting question on sort of capital management and what CFOs or treasurers should do. There is no doubt that many companies buying back shares don't actually add value. The only way you add value from a share buyback, because at the end of the day, the enterprise value does not change. You either borrow money or you use cash. The total value of the firm shouldn't change. If you buy that asset at fair value and use your cash or borrow money, net, the total value of the firm hasn't changed. The only way you incrementally add value in a share buyback is to buy back those shares when they're trading at a price at less than their intrinsic value. And if that happens, share buybacks can be incredibly good uses of capital and very, very positive for the remaining shareholders.
I think the test that gets applied is will the share buyback increase earnings per share? And I think it is because a lot of managements have incentive compensation based on earnings per share. And when interest rates are nearly zero, it's very easy to borrow money and increase earnings per share. But what you haven't realized on the other side of this is the debt burden has gone up. And if you buy those shares back at more than their intrinsic value, even though you're increasing earnings per share, you're actually decreasing value per share. And you've seen classic cases like IBM and others who have embarked on massive share buyback programs to drive EPS, but their stock prices kept going down notwithstanding they're buying back enormous amounts of shares.
So, you have to look at the enterprise value here, the equity plus the net debt, to actually work out what's really going on. I think a lot of this fault is… And I think very few chief executives and CFOs, believe it or not, are highly educated in corporate finance in simple valuation and they're looking at simplistic measures like earnings per share. And actually, their compensation systems will pay them more money. They don't get paid whether they buy shares back at a discount to intrinsic value. They get paid more money often simply if the earnings per share go up. But there are people who really understand this well and the ones who then really load up when the share price is undervalued, like Apple did when it was undervalued, Tim Cook and Luca have added enormous amounts of value in pursuing their buyback when the share price was low.
Benz: Given the increasingly widespread availability of data and information, the pace of technological innovation and a surplus of capital, do you think the investment cycle has gotten shorter? You seem to refer to an investment cycle of seven years, but we're coming off a year 2020 in which markets experienced a really steep drawdown and a snapback in the space of months. Is that an indication that cycles have become more compressed? And, if so, what are the implications for investors like yourself?
Douglass: The simple answer is no. I don't think the investment cycle itself has become shorter. Twenty-twenty was just an extraordinary period where we had just these extreme risk-on and risk-off periods. But we had a one in 100-year global pandemic that's hugely complex. We've had the largest fiscal stimulus and the most unorthodox monetary policy we've almost ever seen in history at the same time. So, of course, we've got extraordinary cycles that are happening within a year. But that doesn't mean the long-term investment cycle has fundamentally changed. And I genuinely believe, and it's a core of what we do, that the long-term focus of taking a five- to seven-year view is our competitive advantage in finding mispriced opportunities and short-term volatility. Even like we've seen in the last 12 months, shouldn't distract you from the journey that you're on. At the end of the day, our business is all about compound returns. It is compounding that gives people excess returns over time, not trying to dodge around events that happen in three and six months. They can be important if you're on the right side of those, but ultimately, the consistency of returns is through compounding. I don't think that game has changed.
Actually, on compounding one of my favorite quotes of all time, he's actually from one of the founding fathers of the United States, Benjamin Franklin, and he said, “Money makes money and the money that money makes, makes more money.” And I actually think that's what investing is all about.
Ptak: Shifting gears, when you thought about innovation and product development, you've no doubt considered addressable market, a dimension of which is investment capacity. Can you walk us through how as an analyst and business person you've assessed how much money could be run in a given style in an unfettered way and talk about how you've applied those principles in practice? For instance, in estimating how much headroom you'll continue to have in the global equity strategy?
Douglass: At the end of the day, Jeff, it's all about risk management and liquidity. So, liquidity is a multifaceted issue when you think about it from risk management. We think liquidity at a client level. What do our clients look like and if they want to liquidate, take their money and totally liquidate it, how quickly could they liquidate that entire holdings that we'd have even for our very largest clients? And what we run and what we do is--that's just not an issue, but we analyze that. We then look at portfolio liquidity. We're probably not as quite concerned about the tail of liquidity if we needed to liquidate the entire portfolio in a single short period of time, because we have got like 500,000 underlying retail investors, we've got 140 institutional investors in our main strategy. The probabilities of every single investor wanting to redeem on the same day is almost nil. But what we do look at the portfolio level is how quickly can we move risk in the portfolio? If we really wanted to get out of markets, how quickly can we move to say 20% cash, which is our maximum cash holding, within a very short period of time? And we're really talking about within a couple of days--two, three, four days--that we could move if we're at zero cash to 20% cash and how would we do that and we analyze that a lot in terms of our capacity and liquidity analysis, and that's a guardrail that we use.
And then we look at individual stock liquidity at moving--if we wanted to move individual stock positions. And actually, it's different between what I would regard as a very low risk, defensive equity that doesn't have a lot of economic volatility compared to something that has a lot more economic volatility exposure. We have different liquidity and speed measures at a stock level, and we measure all them, we monitor it constantly. We look at maximum ownership sizes across the whole firm, as well. And when we add them all up, we've got guardrails. And then, we assess that about what the total capacity of the strategy and the firm in those names would look like. Actually, a number of years ago, we closed our flagship Global Equity strategy to new institutional investors on the basis of overall capacity and liquidity management. We're managing over USD 50 billion in a concentrated Global Equity strategy. And from a liquidity and risk management point of view, it's kind of closed to new institutional investors. We've got some mutual funds still open with some limited capacity. But we're very comfortable within all the liquidity guardrails. But it's a risk management question you're asking and it's very, very important.
Ptak: Well, Hamish, this has been very enlightening. Thanks so much for your insights and perspectives. We really enjoyed talking to you.
Douglass: Jeff and Christine, it's been an absolute pleasure.
Benz: Thank you so much.
Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.
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Benz: And at @Christine_Benz.
Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
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