Why Magellan is holding a 50% defensive allocation

Hamish Douglass remains largely optimistic about the vaccine-led recovery for financial markets around the world, but he’s not betting the house on it.

The Magellan co-founder and CIO believes too many investors are ignoring the risk of a bumpy recovery that could result if the virus continues to mutate and vaccine efficacy and rollouts aren’t straightforward.

“I’m not holding heaps of cash, but I’m also not placing a lot of pointy bets that the vaccine holds,” Douglass said during a webinar on Tuesday.

Around half the portfolio of Magellan’s flagship global equities strategy is held in utilities, consumer staples and cash, which currently sits at around 6%.

Referencing the famous Warren Buffett investing adage, Douglass said: “This is the time to be cautious when others are greedy.”

“I don’t think it’s a time to be fearful when others are greedy, but until we have some clearer scientific evidence around the mutation risk, there is just no margin for error in markets on this at the moment.”

A large part of his discussion addressed a potential scenario where “mutant strains” of coronavirus evolve, side-stepping the vaccines that have already been developed and which are already being administered in limited rollouts in many developed nations. This was also addressed in a recent interview, where he discussed three possible pathways for markets in 2021. 

As examples, he pointed to the situations in Brazil and in South Africa, where the major “big pharma” vaccines are only between 10% and 60% effective in preventing infection.

“There is 100% evidence, and I don’t use that lightly, that copying errors are occurring and the virus has already undergone significant change. And it is also 99% likely the virus will continue to mutate and change,” Douglass said.

“We have no idea if an escaped mutant is going to emerge. And we’re certainly not saying this is going to happen, but we just don’t know.”

There has been a massive swing toward COVID recovery plays by equity investors since the first successful vaccine, from Pfizer and BioNTech, was announced in early November. This widespread investor ignorance of the still-present virus threat is a risk that Magellan isn't ready to take.

That alone is enough of a threat, said Douglass, without adding additional risks including another current fixation of markets: the potential for rising inflation.

“If we really get inflation, markets will get pole-axed,” he said.

“But if you overlay this with the mutation risk of the virus, and overlay this again with some clear speculative frenzies, and this is a really, really difficult environment to deal with.”

There's no bubble…yet

While Douglass stops short of calling the current market environment a bubble, he draws comparisons with the tech wreck: “Some elements of what’s going on in the market really reminds me of the dotcom boom at the end of the 1990s.

“There’s clearly a speculative frenzy in certain assets on the market.

“What we’re seeing here is the classic fear of missing out; but you have to be prepared to step away from the crowd, and it’s really difficult to do when everyone seems to be making easy money and it appears to be a turbocharged fair bet.”

But Douglass doesn’t believe the pandemic has set in train a permanent shift in market dynamics, or that any rise in inflation will be a structural change. Instead, he expects a low inflation world will re-emerge in the next 18 months.

“If it is a new inflation cycle coming, the Fed is going to have to change course and start to raise rates. And if they raise interest rates abruptly, hold onto your chairs,” he said.

“Do I put a huge weight on that? I think this will prove to be transitory, that fiscal stimulus will pass through and we’ll be back to lower long-term structural growth.”

Douglass also doesn’t believe the rise of speculative investing seen since the March sell-off is part of a structural change. He referred here to the Bitcoin buying frenzy, Tesla’s nosebleed valuations and also to the GameStop saga.

“Are they large enough, like sub-prime mortgages, that they become systemic, that they cause an overall market crash? I don’t think we’re there yet.”

“But the larger they get, and the assets that get captured in this ‘at scale gambling frenzy’ – it worries me that it could have a compounding or domino effect in the market.”

How is Magellan positioned?

Perhaps the biggest risk to Magellan’s portfolio over the next 12 months is that “markets continue to roar,” said Douglass.

“But if I take a three-year view on the portfolio, I’m not losing any sleep over that, and I’d probably hold the hand I’m holding anyway, even if I wasn’t constrained by our portfolio construction process."

Douglass emphasised he and his team are avoiding any “frenzy activity” in the markets, for example, they aren’t selling out of utilities and buying travel companies.

“We’ve been very prudent on valuations, selling things and trimming things that we think are getting caught up in some of this rotation," he said.

“And if you look at our portfolio today compared to where it was one, three or five years ago, everything we hold are stocks we’ve owned for 13 or 14 years in different flavours.”

“We hold great companies and we hold them for duration, and I’m very comfortable that with less risk than other people are going into, we’ll deliver satisfactory returns.”

Related coverage: Hamish Douglass identifies 3 possible pathways for markets in 2021

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