Weekly update on the impact of COVID-19 on the financial markets
Hamish Douglass - Magellan - Tuesday 21 April 2020
Paul O'Connor (POC): Welcome to the Netwealth portfolio construction podcast series. My name is Paul O'Connor and I'm the head of investment management and research. Part of my role at Netwealth is to manage and govern the investments that we make available to you through the Netwealth investment platforms and today I'm... well and I'm very fortunate to have a lot of ongoing interaction with the fund managers. Today, we have Hamish Douglass, co-founder and chief investment officer at Magellan, and lead portfolio manager of the global fund. Welcome Hamish, and thank you for your time this morning.
Hamish Douglass (HD): It's a pleasure, Paul.
POC: Magellan have a number of international equities and international infrastructure equity funds available on the platform. We're fortunate to have Hamish as today's guest on Portfolio Construction Podcast Series and given the heightened level of volatility in markets, we'll be interested in Magellan's views on the global economy and the impact on company earnings.
I must admit, Hamish, that only seven weeks back, I didn't think I could work officially from home, let alone our whole company. But Netwealth really, it's almost BAU and I think we've got over 300 staff working from home. How are you coping working from home?
HD: Well, Paul, I'm actually enjoying it, believe it or not, it's gone very smoothly. We're lucky. We all operate in an industry which is very conducive for technology. We do a lot of reading and obviously video conferencing has turned out to, we've always spoken about it. We did it occasionally, but now we're living with video conferencing every day as you know, we're very pleased to have Microsoft Teams at work, a bit of plug for one of the companies we invest in. But I'm doing lots of video calls each day with the team, and the teams themselves are doing calls. We're doing a lot with clients as well. We're doing audio recordings from home like we're doing at the moment.
And to some respect, it's more productive than when you're in the office because you're not spending that extra sort of hour or more a day getting to and from the office. You're not lingering around at lunchtime. So really, you're creating a lot more time in the day. I'm sure we're going to learn new ways to work and I'm sure this sort of work from home will enable businesses like ours to give people more flexibility in the future, but there are benefits of face-to-face dialogue as well. So there are some downsides but overall, coping pretty well.
POC: Yeah, I tend to think we're all changing our workplace behaviours as a result of COVID-19, and like yourself, I'm now quite proficient in Microsoft Teams. And only eight weeks ago, I didn't know how to use it really. So yeah. Yeah, it's all just an example of the changes of behaviours that we're all experiencing.
COVID-19 is firstly a human tragedy that's certainly impacted on the global economy. I'm receiving many varying views from fund managers about the damage being done by COVID-19 but what is Magellan's view and do you think a recession is inevitable?
HD: Well Paul, the first thing I would say and probably why you're getting a lot of views, we truly are in uncharted waters here. There is no playbook from our investing lifetimes and I would say there's no playbook in the last 50 years that really tells you how this is going to play itself out. We still know relatively little about the virus itself. We don't know how long it's going to be until a cure is found or a vaccine is operating. And of course, the mitigation of shutting down the economies has the potential to cause enormous economic and social damage here.
When we think about and your question about, is a recession inevitable, the first thing we think about this sort of shutting the economies down and how long this could go on for, there's sort of four possible outcomes. We could see a V-shaped economic recovery, that when we open, the economy's back, everything bounces back. We could have a recession, you could either get a U-shaped recession, or you could actually get a very prolonged and quite severe recession. At the other end of the spectrum is a depression. You have opinions all the way along that spectrum at the moment.
And as Charlie Munger was interviewed in the Wall Street Journal, he said, "Everybody talks if they know what's going to happen and nobody knows what's going to happen, because this is so unusual." We would actually say on that spectrum, a V-shaped recovery and a depression appear to be the least likely scenarios around... particularly around the developing world. Unfortunately, a recession is likely in our view, we just don't know the depth or the duration of this at the moment.
POC: What regions or countries concern you the most about the impact of COVID-19 on their economy?
HD: Well, first of all, I would say that there's going to be a economic impact everywhere. So I don't think we should suddenly get complacent because we can identify where it's going to be worse potentially, and where it's going to be worse, what we've been most concerned would be in emerging markets outside of China. They simply don't have the healthcare systems to handle this pandemic and really don't have the fiscal firepower to respond like many of the Western world economies have. They also have a lot of US-dollar denominated debt and some of these emerging markets are very exposed to the low oil price here. So they've been hit with a sort of a triple whammy. Here, if I had to point out sort of areas of the world, I'd be most concerned about Africa, India, Latin America and certain parts of Asia and maybe certain parts of the Middle East here. Some of these economies could potentially face depression-style scenarios.
So we're very conscious of where we may be picking up additional amount of exposure in our portfolios through some of our multinationals in those zones. And we've actually been taking action to change our portfolio to reduce our exposure in those zones. The only hope in those emerging markets is that they have younger populations, many are operating in milder climates, and they may be able to get to herd immunity quickly and possibly without a huge human tragedy. But again, we're just speculating about that. It's difficult to see, as they go through that, that there isn't going to be long-lasting economic damage.
POC: Yeah, it's interesting. I guess my observation would be that the emerging markets have not got a lot of coverage in the financial media. It's been mainly around, I guess, China and Europe and Australia obviously. But yeah, it is obviously a concern, the fact that the healthcare and the whole infrastructure, society infrastructure, in these emerging countries is not at the level of the developed countries. So we can only hope, to your point, that having a average younger population will assist with battling the COVID-19 virus.
Geopolitical risk also appears to be on the rise with many commentators starting to question China's openness and reporting on the number of deaths due to COVID-19. Given we are also in a US election year, there's no doubt President Trump will try to use this political there's no doubt President Trump will try to use this political friction to his benefit. Do you believe we are facing a period of heightened geopolitical risk?
HD: Well, Paul. It's a very interesting question you ask. Of course, an economic downturn is not conducive to being reelected. I think there are very few presidents seeking their second term in an economic downturn. I think there may have been six presidents who went into an election year in an economic downturn, and five of the six lost the presidential election after their first term. This isn't positive for Trump, but of course, there's a lot of water to pass under the bridge between now and November. Trump is an absolute master of confusing the story and diverting attention and blame, and we really would expect Trump to pass the blame for this crisis and the economy to China, as you mentioned in your opening remarks, and also we're starting to see him pass it onto the state governors for their health care response. It's going to be very interesting to see leading into this election, how he decides to turn up the heat on China.
He's already branding Biden as soft on China. Will he go as far as ripping up the trade deal? Will he seek retaliation? The accusation circling and conspiracy theories that this was a manmade virus coming out of the Wuhan P4 facility, which is a virus studying facility in Wuhan. There's actually two facilities. Is that going to be thrown in the mix here? China's obviously in the firing line. It's going to be very interesting that as he turns up the heat, we have to watch how China then responds here. Are they going to respond or are they just going to wait for the outcome of the election and actually use their soft power to help out nations around the world in responding to this and almost ignore Trump? But certainly you would think the risk is increasing.
If it's going to turn into a major issue, I think we're going to have to wait post-election to see who's in the White House there. But also, I would note that any extreme economic downturn increases the risk of the rise of radical governments and potentially extreme anti-capitalism movements around the world. That's been a lesson of history when you get very deep down to it. So I think it goes beyond the China, Trump U.S. issue, is where we get political movements rising up if we get into very high unemployment scenarios. And, of course, we don't know that at the moment.
POC: Yeah, it is an interesting observation you make around, countries typically become far more protective in economic downturns to their economies and I've thought in the back of my mind, what impact will this have on globalisation, which I guess globalization's had a number of headwinds over the last four or five years. I suspect this will be the major challenge to continuing globalisation of the one global economy, ultimately there. I think that will certainly be put back and slowed down. Mainstream Australian, mate, you were stating, or starting to report on a gradual wind down of the isolation restrictions in place across Australia, which does appear to the mainstream to be a positive for our economy. But even if we get up and running, ultimately Australia depends on the global economy. It [inaudible 00:12:53] our exports. So how do you believe the impact on Australia will be from COVID-19 and how deep a recession do you think we will experience?
HD: Well, first of all I'd say, Paul, is I don't know the answer to that, and the first thing I'd say to people, let's not get ahead of ourselves here. We have done a great job in flattening the curve, the government, the health officials, when I use the we. But it's also the behaviour of people in the country has done a great job, but the virus isn't cured, and we're about to enter winter. We could be 18 months away from the vaccine. We may get a therapeutic cure earlier than that, which would be terrific, and just because we are looking at we're going to open up the economy, it doesn't mean we're suddenly going to lift all restrictions and certainly it doesn't mean we're going to avoid a recession here. You have to understand that the longer this goes on and the more restrictions we have to the economy operating, we can start to feed into some very negative feedback loops.
Once you have high unemployment for an extended period of time, you'll get an extended loss of demand. Of course, we've had a collapse in demand because no one's allowed to go out at the moment, but even when we people start going out again, if people are fearful around their jobs still, we're going to have a very subdued consumer environment and they still may be fearful of their health consequences of moving around before we actually get a cure to this virus. You could start to see, as this protraction goes on, starting to feed into house prices. As house prices start moving down, that creates another feedback loop around a wealth effect and people tightening their belts. Further, as you tighten your belts, demand goes down. Again, more businesses will fail. The more they will start to turn to cutting their expenses and laying more people off.
In this episode, we discuss the current state of the Australian economy, including the impacts of a potential recession and Government stimulus-response, the present value of Australian equities and the winners and losers from a falling Australian dollar.
You start to then get bank stress. We've got high consumer debt. So I just think we have to be cautious here. That it's very good news that we're flattening the curve, but let's not extrapolate that out that there is no risk here. Do I think they could be a deep recession? Yes, I think that is clearly within visibility. Do I think we could have a shallower recession because we can effectively get people confident to start moving around? Yeah, that's a possibility as well. But of course we are going to have an impact. Our export industries are going to be hit hard. You think about travel industry. It is going to be hit very hard for an extended period of time.
Our education industry, our export education industry is probably going to be hit during this period as well, and our commodity industry is going to be hit. Our LNG export industry, the prices we receive on that LNG gas is going to be hit and, of course, we don't know how China is going to respond with their fiscal stimulus. Is it going to be like 2008/2009 where commodity prices stay strong like iron ore and coal, or is it going to be softer? We still don't know these things, Paul. So I would say some caution. It's great news refracting the curve, but let's just be a little bit cautious when we're investing here about knowing what we think the next 12 to 18 months looks like, even in a country like Australia.
POC: Economists view economic slowdowns and recessions as a normal part of the market cycle and almost necessary to cleanse questionable business models and practises. What behavioural impacts do you think COVID-19 and a resulting economic slowdown, will have on business models?
HD: Well, what a great question this one is, Paul, because when you get very, very severe downturns, we have seen in the past behavioural changes. If you went to big ones like the Second World War and you went to the depression, we had generational changes in consumer behaviour. We all know our grandparents consumption patterns were very different to our parents and ours, and heaven forbid our children's consumption.
And ours and heavens would be to have children's consumption patterns who never seen any form of downturn. So really how big these behavioural patterns could change. It really depends, how deep and prolonged day and ensuing recession is and we don't know the answer to that at the moment. The longer this lasts, the deeper the behavioural impacts will be. We could think about those impacts in different styles or businesses.
POC: Are there any new and developing business models whose growth you think will be fast tracked due to the current economic uncertainty?
HD: Well, probably. We just had a discussion about working from home at the beginning of this.
POC: And our expertise in Microsoft Teams now.
HD: Yeah, so productivity software, we see Zoom and we see Teams. The importance of cloud computing to business continuity planning here we could think of video streaming for entertainment, online advertising, online commerce. We can see the spike that's happening with Alibaba and Amazon's business models. So absolutely an event like this is probably creating an accelerant to certain business models and therefore the take up and adoption of these services is getting fast tracked because of this force change in behaviour.
POC: And on the reverse, are there any older and well established business models that you think their a demise will be fast tracked? And certainly all over the mainstream media today we're seeing the news of Virgin going into voluntary administration.
HD: Well for first of all I'd say Virgin, it may fail, but I don't think the airline industry itself will fail. I think we will get new airlines up and running, but individually airlines could fail. But I don't think the industry or the business model will fail, but there may well be business models that fail. You could think of some traditional retailers that were under pressure that may well this could be their final blow. You could think of department stores. Here is we get the accelerant to online commerce and the whole environment, but those businesses were already under pressure. This may be the final thing with those business models were failing and this causes them to fail.
We could think of some traditional media organisations who were already under pressure. You could think of newspapers, particularly regional newspapers. But you could also think of pay television and broadcast television that they're going to have a very severe impact potentially on their revenues and they may get to the point where their business models simply don't work. Because people have shifted too much to video streaming behaviours. And when it comes back they just don't have an economic model that works anymore.
And then there's going to be industries that won't fail but could take a very long time to recover. We could think of travel related industries. You could think of cruise liners how long is it going to take the people to get back onto floating Petri dishes after this world? We could think of oil and gas companies here, the oil and gas industry won't fail, but we could be in a period because of reduced demand that we have very, very low oil prices. And we could have certain areas of the world that literally shutting their oil production for a decade or so forth.We could also think of some real estate businesses like shopping malls where their business models might have to fundamentally change because of this. But the businesses themselves won't fail. We'll still have shopping malls, but the business models may have to shift very materially.
POC: Yeah, I guess I'm still trying to get my head around how oil could actually have a negative price per barrel. So we are seeing some amazing things going on in the markets there. You've been increasingly tapping the urbanisation growth story in China, so is this positive view unchanged? Or do you have any concerns given the current volatility and the economic slowdown?
HD: Look, Paul, this is a 20 to 30 year trend of increasing urbanisation in the country. They're at 55% or so urbanised at the moment. They're headed to sort of 70 to 80% urbanised over a sort of 20 or 30 year timeframe. I don't think this, whether they have a recession during this period is fundamentally going to change the longterm trend. It may change the speed of the urbanisation in the short term, but the longterm trend is not going to change.
POC: The trailing one year return from Global Equities. The MSEI world index is down 3.7% over the last 12 months to the end of March and I've noticed a strong performance from the healthcare and the consumer staples sectors. Given your comments on the outlook for the global economy, what's your view at the moment on company earnings and valuations? Are markets just reacting to daily news? Or do you think they're actually looking through to the longer term impact of the economic slowdown?
HD: Well you got to figure if the market's been down 3.7% on a 12 month basis, that's hardly a major correction if you went into April, it would be up.
They probably up year on year. So I would say the markets aren't reflecting a very negative outlook at all. We obviously did February and early March, but with the markets come back very strongly. In terms of when we look at valuations of businesses, the outlook is so uncertain in terms of what the economy could look like, it's quite impossible for many businesses to predict what their revenues will be over the next five years. Because we simply don't know what the economic situations are going to be. There are some investments that we feel actually very confident about, where their revenues are actually very resilient.
Even in quite severe recession scenarios, we believe that interest rates are going to be low for very extended periods of time, so there are businesses which we would have high conviction on the evaluations at the moment. But businesses which have more sort of cyclical related revenues that that is very dependent on what the shape of the economy is, there's actually a wide range of outcomes in terms of evaluations at the moment. And therefore you need to have that range of valuations in mines. And certainly those businesses that are more cyclical, I would argue that the markets are not pricing in the downside risk at the moment for those types of businesses.
POC: So, what sort of at a high levels stock changes have you implemented in your Global Equities portfolios over the last couple of months? And I'll know your global fund has significantly increased the allocation to cash.
HD: Yeah, well Paul. That's correct. We have, we've increased our cash from around 6% at the sort of beginning of the year over the last sort of three weeks to over 15% of the portfolio. This has made the portfolio a lot more defensive. We use a proprietary tool called a combined risk ratio. We've dropped that from 0.8 to less than 0.7 so we're running maturely low of volatility and draw down risk. The markets, we've reduced our risk to companies that are more exposed to the economic cycle, companies that are more exposed to things like travel expenditure. We've also reduced our exposure to companies that had high financial leverage and also companies that are more exposed to emerging markets we've produced.
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HD: We now have over 60% of our portfolio in companies that are very defensive and resilient and our cash. These include the US utilities consumer staple businesses, pharmaceuticals and enterprise software businesses like Microsoft. And also to the large Chinese technology companies who have actually increased their exposure to those parts of the portfolio. We've sold down other areas including moving to cash. So interesting pool. The portfolio actually held up very well through the initial settle down before we even moved to cash. And that is by design. We designed portfolios to be that is by design.
POC: Would it be fair to say your portfolios are the most defensively positioned they've ever been?
HD: I'm not sure I'd be in the zone as the most defensive. We were very defensive at the end of 2008 in our portfolios, but outside that we would probably be the second most defensive style of the portfolio but they look different. We've still got a number of technology companies in our portfolios. We actually think they're going to prove to be resilient, where previously we held consumer staples in our portfolio almost wholly in our defensive bucket. The shape of what we're owning is different. We've got more growth in our portfolio even though it's very defensive than we had in the 2008. We think that's the right shape given the circumstance at the moment.
POC: What sectors and themes is your research team spending its time on it at the moment? Are there any opportunities that you believe is starting to present themselves?
HD: Well Paul, it's a nice try. I'm not going to foreshadow to anyone what we're going to do or what specifically where we're looking at. I'm sure that people would love to know. All I would say is we have through each of our sector teams, a list of companies that will perform differently in different environments.
We've got different forms of investment views and depending on how the situation plays itself out, we may invest our cash in different forms really depending on that. We tend to be very forward thinking around different scenarios. Then we've got different shopping lists. I just said some we were looking earlier, we've just gone to cash and given the huge uncertainty, we're tending to rotate things within our portfolio rather than utilise our cash at the moment.
POC: Yeah. I was going to ask you about the health care sector and whether that was uncovering some potential opportunities there given you've got one health care stock in the top 10 of the global funds. Have you got any thoughts or musings on the health care sector?
HD: Well there are numerous very high quality health care companies in the world that clearly sit in the zone at the top of things Magellan would invest in. There's a number of very powerful trends underpinning healthcare. We could think of demographics. It's probably the most powerful trend in healthcare, but healthcare does come with risk, particularly government policy risk. The governments are the large payers for the system here so you really have to think when you're investing globally, what government policy is going to be around the payment model for healthcare.
Whether or not we're going to own more of these high quality healthcare companies really simply depends upon the opportunities across the entire portfolio. I can't predict what the most attractive things will be in six months and 12 months. We don't have any portfolio model that tells us we have to have X percent of the portfolio in healthcare stocks. It's just not how we think at all. Are there healthcare topped? Absolutely that are very high quality. Will they be in our portfolio? It will depend where all opportunities we're looking at are priced at the time, not just healthcare.
POC: Okay. We usually finish these podcasts, Hamish, with asking for any personal investing tips you can share with the listeners. Do you have any words of advice that I guess is part of your own investment philosophy that has been long held with you since you were young and any specific thoughts that could assist our listeners with navigating the current financial crisis?
HD: Well, first of all, if you're younger and I would say if you're 60 or under, the first thing people should do is stay the course here. It's important to understand while there's great uncertainty ahead of us over the next few years ahead of us, the world's not going to end here. Ultimately there will be hopefully a cure for this virus or we'll get to herd immunity and this will pass us by. But we have to expect there's going to be more volatility ahead of this.
Volatility should be your friend and not your enemy. You should use the volatility to exit things that are most at risk and some of the things that we think are at risk had been rallying very strongly in the last four weeks. We've actually been using that volatility rallies to change the shape of our portfolio.
One thing I would say to people is buy businesses that are very high quality and have great long term futures. If you buy the right businesses that have great economics and great competitive advantages, time is going to be your friend here. The markets will come back and they typically will come back before the economies recover.
One of the most important things that I learned very, very early on was the magic of compound interest. Here I used to look at compounding tables. I used to think a lot about the mathematics of compound interest and there's two things that really matter in compound interest. One is the rate of return you could generate and the second one is a factor of time and time is your friend in investing. In the short term things is think to the long term and stay the course.
One of my favourite quotes of all time is from Benjamin Franklin, who was one of the founding fathers of the United States of America. On compound interest he said, "Money makes money and the money that money makes, makes more money." At the core that's exactly what investing's all about. It's putting money down today and letting that investment work for you over the long term.
POC: Some very good comments there. I think for our listeners there and certainly around for the time and trying to make sure it's a longterm game investing there. Also I laugh because it takes me back to university where I remember doing a subject at university. I think it was called compound interest, the eighth wonder of the world. Thank you, Hamish for participating in today's podcast and thank you to the listeners.
I hope you found today's discussion interesting and of some value. All the best to you and your families during this difficult time and have a great day.