Doing it differently

Rising inflation is the hot topic for financial markets, with fund managers set to notch up huge gains if they make the right call or suffer devastating losses if they do not.

Currently, the market is split between those who think an inflation spike will be temporary and those who predict a sustained period of rising prices which will affect fast-growing stocks.

Lachlan Hughes, the founder of Swell Asset Management and its investment chief, is betting inflation will be transitory and will disappear with the removal of supply chain blockages. He cites a Bloomberg interview where experts were debating the definition of transitory. "So, you know it's a hot topic," he says.

He is not worried about making the wrong call since the fund has bought into companies that can lift their prices with inflation because they deliver more value to their customers than they charge.

"We own Amazon, Microsoft, Netflix, Alphabet, and Facebook. Not only do they have pricing power, but they benefit from their exposure to long-term trends such as the shift to the cloud."

Fears of inflation have triggered massive sell downs of the FAANG companies - Facebook, Apple, Amazon, Netflix, and Google - as their future earnings will be less valuable.

Hughes disagrees.

"Unlike most companies, these investments do not rely on the macro to do the heavy lifting; they will grow irrespective of the economy," he argues.

The Squid Game

He is a big fan of Netflix. It is the dominant name in streaming, with over 200 million subscribers and reaching close to one billion people globally.

As he sees it, management has a clear value proposition and a long track record for delivering good content. In 2021 the streaming service dominated the Emmys nabbing 44 awards. "Some investors balk at the valuation, but for long-term investors, it still represents value."

"There are always risks. However, with Netflix, we believe the risks are largely within management's control. " The big opportunity for the streaming service is when subscribers grow to 500 million over the next decade.

As an aside, he notes that Lee Jung-jae - the lead actor in Korean blockbuster The Squid Game - went from having 500,000 Instagram followers to 15 million in five days. "This highlights Netflix's engagement and desirability as the number one platform for content creators," adds Hughes.

Boutique firms like Swell attract private investors looking to put money in funds run by managers who have a vested stake in their performance, have more freedom constructing portfolios, and are long-term investors.

Hughes understands the appeal of investing with managers whose interests line up with their clients.

"I didn't want to invest clients' money unless we invested alongside them," he says.

"I'm completely invested in Swell; I'm all in."

Swell's portfolio construction is never dictated by what others think. "We're unfettered and have the flexibility to buy what we want when we want.

"We don't have clients telling us we should be holding this stock or that stock - we just have a clear process which guides our investment decisions.

Additionally, private investors want managers who understand each stock position in their portfolio. Unlike many managers who hold 90 to 100 companies, Swell has invested in just 14 companies. He mainly buys large-cap stocks because Hughes focuses on competitive advantage and big corporates tend to have the strongest moats.

Central to Hughes' dream of setting up his own fund was shaping the investment process.

"I get a lot of enjoyment out of architecting our investment process. I would rather much prefer to do that than inherit someone else's process."

That meant taking a different approach.

In his view, asset managers like to say they think long-term, but in reality, few do. Either their bonuses are tied to short-term performance, or they are constrained by the investment process which prioritises short-term gains over capital preservation.

"I've got friends who run funds and who would love to be long-term investors but either they have inherited a short-term focused process or their investors want quarterly updates," he says.

"Investors claim to be long-term investors, but they want to meet each quarter and grill managers about why they are still holding a particular stock. Some investors do not understand that this approach costs them long-term performance.

Hughes concedes that most active managers are doing a lousy job. He cites surveys that show that most are generating index returns yet charging high fees.

But, by his lights, there is every reason to think that high-conviction funds will beat market benchmarks over the long run because the managers take a concentrated approach.

"Then you give yourself the best opportunity to outperform the benchmark. But you must be sure that you're genuinely taking a different approach."

Although Swell takes a conservative approach, the returns are up 170 percent since inception compared to the benchmark that returned 105 percent over that seven years.

"What that tells me is that is an opportunity in taking the long-term view."

Lawyers not welcome

Setting up shop is not easy. "But if you pursue a better investment process and have conviction, the right people will find you. It is very satisfying. Having started a career in law, he found it hard to get a job as an asset manager. After applying for a role, he would get through to a final interview only to miss out for lack of investment experience. He was told repeatedly that a legal background wasn't right for funds management.

"That why there are so very few lawyers running funds."

Yet, Hughes has found that he approaches investment differently because of his legal background. He has a risk first approach. "I have always gotten comfortable with the risks and made sure they're manageable before moving to the growth side of investing.

Incidentally, Alphabet, Microsoft, Netflix, and Facebook have all reported in the last week, with each company delivering strong revenue and profit growth.

Netflix reported on 19 October with revenue growth of 16.3 percent and operating profit growth of 33.4 percent.

Easy to see why Hughes doesn't want to bail.