Hamish Douglass: 'The Best Long-Term Investments Are Often Hiding in Plain Sight'
The co-founder, chairman, and CIO of Magellan Financial on "duration arbitrage" and how he's built his flagship global-equity portfolio.
In a recent conversation on The Long View podcast, we spoke to Hamish Douglass, who is co-founder, chairman, and chief investment officer at Magellan Financial Group. Hamish runs Magellan's flagship global-equity strategy, which he has steered to an excellent record since its July 2007 inception.
In this excerpt of our conversation, we ask Hamish how it's possible that some of the world's leading businesses could become mispriced by investors. We also delve into the somewhat unique approach he has taken to building the global-stock portfolio he manages.
The complete podcast recording and transcript also cover a number of other topics, including Magellan's unusual origin story; what lessons Hamish took from his previous life in investment banking; the public-private partnership in China; "second acts" at already successful franchises; and more.
Ptak: 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 maybe 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, and I would add the word 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 sort of 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 is recurring services revenues were increasing as a share of the company as a whole and in five years will 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 then 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%. But 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.