Magellan’s bargain hunt

Coronavirus won’t stop Hamish Douglass flying to Los Angeles this weekend. But he will be packing a face mask.

Magellan chairman and co-founder Hamish Douglass. Picture: Britta Campion

Coronavirus won’t stop Hamish Douglass flying to Los Angeles this weekend to meet institutional clients. But he will be packing a face mask and antibacterial wipes, purchased from Aldi.

The chairman and co-founder of Magellan Asset Management figures he has as much chance of getting coronavirus in Australia, and it shouldn’t pose much threat to a healthy 50-year-old.

But as for the sharemarket, it’s too late to sell after the sharpest ever correction in the S&P 500.

Instead Mr Douglass is waiting for bargains in high-quality stocks which are still too expensive.

While allowing for a further 10 or 20 per cent fall in the US sharemarket, he doesn’t see another financial crisis but is keeping a watchful eye on the credit markets for any sign of a crisis.

Overall, he expects a relatively short-lived but sharp hit to economic growth and markets.

Eighteen months ago, Magellan had 20 per cent of its flagship Global Fund in cash.

Stocks looked expensive at that time as global economic growth faltered and Mr Douglass expected the Federal Reserve to keep tightening, potentially at a faster rate if inflation started to pick up.

“In 2018 we knew the Fed was raising interest rates and we knew this would ultimately have an impact on asset prices and we do not want to be fully invested through this part of the cycle, so we went to 80 per cent invested, lowering our risk ratio to about 0.7 per cent,” Mr Douglass said.

“Through 2018, we picked up 10 percentage points on the market through that decision.”

Five months later, Magellan put the extra cash to work in shares after a sharp correction — caused by the trade war and US interest rate hikes — which led the Fed to indicate it had finished tightening.

That began a major pivot toward interest rate cuts by central banks globally.

Fast forward a year and central banks are cutting rates again — because of the virus.

But this time Mr Douglass isn’t yet buying more shares in response to the rate cuts — apart from topping up some shareholdings in recent days. That’s because it already has a low cash weighting of about 6 per cent, and also because the coveted stocks on his watch list are still too expensive.

He feels that the coronavirus pandemic will have a “moderate-to-severe short-term economic impact” on global economic growth and markets, more because of its effects on human behaviour.

But the simple fact is that if Magellan had kept a large amount of cash aside for years to plan for such a Black Swan or “known unknown” event, it would have sacrificed far too much performance.

Instead, its portfolios are designed to fall less than the market — even when fully invested. Historically they’ve captured only 50 per cent of quarterly drawdowns because of decisions taken along the way.

“We’re aiming to have materially less downside risk than markets,” Mr Douglass says.

“The reason we would go to cash is we pre-emptively see some data that tells us we want to have even less risk, so that’s normally a macroeconomic call on what we can see — not the pandemic we can’t see.”

Last month the fund lost about 3.5 per cent versus 8.6 per cent for the benchmark.

“If we haven’t got data on something we will largely stay fully invested and use our 0.8 per cent (drawdown ratio) cap to be the buffer, effectively, that will protect us. When we get a big shock, particularly an economic downturn, we have a lot of downside protection.

“If this sell-off continues and gets exaggerated, we would hope that the design of the portfolio will give us a lot of protection relative to the market.”

The idea will be to reposition the portfolio into beaten-up stocks after any further sharp sell-off.

“The real question now is now that (the pandemic) is out there, do we now decide ‘this is going to get much worse, so let’s go to cash’? My view is that’s just purely speculative,” Mr Douglass says.

“The markets may well sell off another 10 or 20 per cent, or we could get to a point where the data starts to improve a bit but we have more rate cuts and all the losses get rebounded.

“The market is expecting this is going to get worse, but to me that is a bit like throwing a dart at a dartboard — it’s kind of unknowable exactly how the market is going to play out to new information.”

He feels the opportunity will come if stocks fall enough to allow him to tweak the portfolio.

“If things move enough — and we don’t think any of the valuations of the stocks we hold have been impacted, though their share prices have — then we may make changes in our portfolio.

“A lot of these companies are signalling that their demand will be hit severely in the next quarter.

“They don’t know how long it will go on and I don’t know, other than I would say it is most likely to be three to six months because it’s a flu and within 12 months we will probably have a vaccine.”

Mr Douglass stresses that the extent of the economic impact will depend a lot on human behaviour.

But importantly for share valuations, he argues that interest rate cuts will be “very hard to reverse”.

“It’s much easier to cut than lift, because they (central banks) know that lifting is going to have a very dramatic impact. Once you’re down at zero, any way up is very painful for asset prices.

“So pushing rates down is probably cementing us more in this low rate environment and if it’s a growth shock it’s probably taking off inflation risk further down the track.” In his view, high-quality companies like Apple, Starbucks and McDonald’s will be more valuable after the pandemic because the interest rate environment is lower for longer.