Independent thinking - an interview with Hassan Elmasry

Macquarie Professional Series IFP Global Franchise Fund Independent thinking - an interview with Hassan Elmasry

macquarie professional series Hassan Elmasry is a founding partner and lead portfolio manager at Independent Franchise Partners (IFP). He has 25 years of investment experience. Prior to founding the Firm in June 2009, Hassan was Managing Director and lead portfolio manager for Global Franchise portfolios at Morgan Stanley Investment Management. The IFP Global Franchise Fund is part of the Macquarie Professional Series; an exclusive range of managed funds created through partnerships between Macquarie and institutional investment managers from around the world. Previously known as the Morgan Stanley Global Franchise Fund, the fund was re-named in June 2009, following the decision by Hassan and the entire franchise team to leave Morgan Stanley and establish IFP. In this article we talk to Hassan about the team s motivations for becoming independent, and the enduring qualities of the franchise investment approach that saw the Fund outperform the MSCI World ex Australia index by over 17%* in the year ending July 2009. You recently made a big decision to leave the relative comfort and safety of Morgan Stanley and set up an independent business. What do you believe are the key benefits of independence, both for investment managers and their clients? For us, and our clients, our employee-owned, partnership structure supports three very clear benefits. First, it allows us to focus solely on the Franchise investment discipline for institutional clients. This enables us to concentrate on servicing our clients investment needs by delivering the best possible Franchise portfolios. Second, our structure directly aligns our interests with our clients portfolio returns. Our reward structure requires that the partners invest a significant proportion of their net worth alongside clients, and that their investments are deferred over the long-term, even if they leave the company. The partners have also invested a significant amount of their own capital to get the business up and running. Having our own money invested in the business acts as a terrific incentive for us to deliver the very best for our clients. Finally, this long-term alignment of interests also ensures ownership stability, which should give clients a good deal of comfort at a time when there is a lot of change in the industry. It also ensures the consistency of our commercial priorities. We have no plans to diversify or sell the business, or to engage in any other strategic initiatives or launch other investment strategies. This strategic focus and longterm commitment to the Franchise approach is very important to us and to our clients. Looking back at the transition period and the establishment of IFP, are you happy with the progress made since you first announced your intentions back in February? Absolutely. The fact that all team members from MSIM are founding partners of the Firm has helped ensure the continuity of the investment process and a smooth transition to the new business. It s a strong team with a deep understanding of the Franchise discipline and the nuances of Franchise investing. We ve brought on one additional person to help us with the business side of the firm and have put in place a very strong * Past performance is not an indication of future performance. Returns are calculated gross of fees and assume the reinvestment of distributions.

suite of service providers to help us with back office, technology and other functions, such as compliance. These service providers have helped us move very quickly from concept to launch. Their best in class service provision also allows us to focus on our own areas of expertise investment research, portfolio construction, trade execution and client service. The structure is scalable, resulting in sufficient investment capacity and infrastructure to enable us to manage not only the current asset base but also the full available capacity for the strategy. But it is also very robust in that it allows us to properly manage operational risks, which we know is at the front of our clients minds. We have moved things forward quickly and we are seeing healthy interest from a range of institutional investors. Have you made any changes to your investment philosophy or process since becoming an independent firm, or as a result of the difficult market conditions we have experienced recently? In short, no. We haven t changed our approach, or, for that matter made substantial changes to the portfolio. We review our investment process and evaluate our investment tools on a regular basis and constantly look for ways to improve or enhance our approach based on the lessons we learn from both good and bad investments. However, we continue to use the same Franchise investment discipline that has been employed since 1996. We invest only in companies whose primary competitive advantage is supported by a dominant and durable intangible asset be it a powerful brand, exclusive patent, highly defining trademark, license, distribution network, or copyright. These are hard to replicate, non-physical assets, and can lead to companies delivering sustainable returns for investors. Every company we invest in must demonstrate exceptional quality characteristics, including sustainable and high returns on capital; a reliably recurring revenue stream, which supports high free cash flow; and organic growth potential. We also need to be sure that these companies represent compelling absolute value. We compare the free cash flow yield of prospective investments with 10-year government bonds and only invest when a company s free cash flow yield substantially exceeds that of the risk free alternative. This helps build in a margin of safety and provides a degree of downside protection. The recent downturn has opened up opportunities to buy into a few more good businesses at attractive valuations, but Jayson Vowles, CFA, Founding Partner and Portfolio Manager Michael Allison, CFA, Founding Partner and Portfolio Manager From left: Michael Allison, Hassan Elmasry and Jayson Vowles

IFP Global Franchise Fund that hasn t changed the way we assess the quality of these businesses. If anything, it has provided us with a good opportunity to examine the resilience of these businesses and the durability of their franchises. Relative to global markets, the Franchise strategy has performed well during the recent downturn. What are some of the characteristics of the companies in your portfolio that have helped them to cope with the difficult economic conditions? Our investment returns have benefitted from our investment discipline and the structural biases built in to Franchise investing during the challenging market environment of the last couple of years. preservation, and that can be seen not only in the recent market downturn but also over the longer term. Over the long-term the franchise strategy has delivered higher returns and lower volatility than global benchmarks. What do you think are the critical elements of the franchise philosophy that have led to its success? We are, and have always been, focused on identifying high quality businesses that earn high returns on capital without having to significantly leverage their balance sheets. We invest in businesses that have recurring revenue streams, have wide margins and that generate high and stable free cash flow. Importantly, these companies must You and your clients can access the expertise of Independent Franchise Partners via the IFP Global Franchise Fund. To learn how IFP might fit in your clients portfolios speak to your Macquarie Professional Series Business Development Manager, or visit macquarie.com.au/professionalseries Our consistent focus on exceptional quality and compelling absolute value produces a bias to certain industries and sectors: branded consumer goods (food, beverages, tobacco, household products, cosmetics and personal care products), pharmaceuticals, media and publishing, broadcasting, and information services. We are structurally disposed to avoid low margin, highly leveraged or highly capital intensive businesses, so we have no exposure to financials, commodity-oriented businesses, telecommunications, utilities, motor manufacturers, shipbuilders, transportation and chemical companies. We also avoid companies that do not have resilient franchises or that face continuous obsolescence risk such as computers, software, semi-conductors, and communications equipment. These structural biases helped returns, especially during the challenges of 2008, when compared with broader equity markets, but they have lagged behind more aggressively positioned portfolios when markets were going up more recently. Our strong absolute value orientation also results in a bias towards capital have an attractive absolute valuation. There are very few companies that meet these stringent criteria, so our portfolios tend to be concentrated. Unilever is a great example. Based in the UK, they produce branded, household goods that are typically resilient to downturns in the broader economy, thus making the revenue stream reliable. The brands create consumer loyalty and help protect margins from competition, and the business requires relatively little in the way of capital. Even if share prices on strong brand leaders fall, their consistent cash flow should keep their dividend yields high, or enable the company to buy back shares. They can also use their cash flow to grow organically, without using a lot of capital. If they are going concerns, trade buyers are likely to take an interest. This is something that can support these companies, even in challenging market conditions. Inevitably, our portfolios will sometimes lag the broader market, particularly when companies or sectors we avoid experience booms. In the long run however, booms attract

macquarie professional series excess capital, which leads to margin erosion and eventually capital destruction. Our disciplined approach limits the potential exposure of our clients capital to catastrophic loss when these booms end. Over the recent market cycle, we have kept pace with the rising market but preserved capital better than the overall market. This pattern of returns results from our disciplined application of the franchise philosophy and tends to result in lower overall volatility. What are the most important considerations in structuring a portfolio for long-term investment? For us, it s about focusing on the quality and value characteristics of individual companies and being true to a long-term view. We deliberately ignore traditional benchmarks when we build our portfolios, because there are a lot of average companies in those benchmarks. Cyclical stocks, for example, do not usually represent good long-term, buy-andhold investments; the volatility of their earnings and cash flows results in only average returns for shareholders. In an ideal world, we would hold a stock forever, as long as the company s valuation remains attractive, its free cash flow grows in line with the appreciation of its stock price, and it continues to demonstrate strong franchise quality characteristics. This has resulted in an average holding period of somewhere between 6 and 8 years for our portfolios, compared to an industry average of around 1 year. Longerterm returns tend to be driven by dividend yield and the compounding effect of growth in earnings and dividends. Our substantially longer than average holding period, when coupled with the high quality of the franchises, creates a time arbitrage against that short term bias and allows the compounding characteristics inherent in the businesses we select to contribute a significant portion of our return. Remaining true to these investment principles, rather than being distracted by shorter-term noise, has been the key to delivering compelling investment returns to our clients over the long-term. What do you think are the biggest risks facing equity investors in today s markets and conversely, where do you see the greatest opportunities? We don t look at the world from a macro point of view, and we don t profess to be able to predict how markets in general will perform. Certainly, the economic downturn has hurt companies that manufacture big-ticket, discretionary items such as cars and computers, but recent market falls have also opened good opportunities to buy into solid businesses. We focus on the absolute risks that can threaten a company s long-term success. These risks include the quality of management teams and their ability to re-invest in their businesses, financial risks such as overly leveraged balance sheets, the durability and sustainability of a company s franchise and competitive position, and, of course, valuation risks. We are not economic or market cycle timers; we are looking for businesses that sell products people will use, and that will continue to sustain their competitive position and to generate free cash flow, almost regardless of the prevailing market environment. These are the companies that will deliver long-term sustainable returns for investors. Franchise strategy has delivered strong returns (value of $10,000 invested since April 2002) $15,000 $14,000 $13,000 Global Franchise MSCI World $12,000 $11,000 $10,000 $9,000 $8,000 $7,000 $6,000 Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Source: Morgan Stanley Investment Management. The Morgan Stanley Global Franchise Composite (Composite) is an aggregation of all fee-paying fully discretionary portfolios managed according to a similar investment strategy (individual portfolios may have differing investment guidelines). For this reason the performance of the Composite is not the performance of the IFP Global Franchise Fund. The performance of the Composite does not take into account fees and expenses. Past performance is not an indication of future performance.

How to contact Macquarie Financial Advisers 1800 005 056 Master trusts and wrap operators 1800 214 616 02 8232 9435 Prospective investors Call your financial adviser or Macquarie on 1800 236 141 Macquarie Professional Series PO Box H111, Australia Square NSW 1215 professionalseries@macquarie.com macquarie.com.au/professionalseries Macquarie Professional Series is a registered trademark of Macquarie Group Limited. Macquarie Investment Management Limited ABN 66 002 867 003 is the responsible entity of and issuer of units in the IFP Global Franchise Fund ( Fund ). Investments in the IFP Global Franchise Fund (the Fund) are not deposits with or other liabilities of Macquarie Bank Limited ABN 46 008 583 542 or of any Macquarie Group company and are subject to investment risk, including possible delays in repayment and loss of income or principal invested. Neither Macquarie Bank Limited, Macquarie Investment Management Limited nor any other member company of the Macquarie Group guarantees the performance of the Fund or the repayment of capital from the Fund or any particular rate of return. This information is for advisers only. It is general advice only and has been prepared without taking into account the objectives, financial situation or needs of any particular investor. Before making a decision to invest in the Fund, investors should read the Fund s Product Disclosure Statement (PDS), which is available from us, and consider, with or without their financial adviser, whether the investment fits their objectives, financial situation and needs. Applications for units in the Fund can only be made on an application form contained in the current PDS. FLY2557 08/09