Idea Brunch with Michael McGaughy of Fusion Wealth Management
Welcome to Sunday’s Idea Brunch, your interview series with great off-the-beaten-path investors. We are very excited to interview Michael McGaughy!
Michael is currently the head of research at Fusion Wealth Management, a Hong Kong-based asset manager. There, he manages Research Alpha, a long-only absolute return fund he established in 2017. Research Alpha invests globally, focusing on quality companies in out-of-favor markets. Michael has a diverse background spanning equity research, private equity management, and funds-of-funds management. Most of his career has been spent researching and investing in emerging and frontier markets, primarily in Asia.
Michael, thanks for doing Sunday’s Idea Brunch! Can you please tell readers a little more about your background and your role at Fusion Wealth Management?
Thanks so much for having me on.
I started my investing career in 1989 as a sell-side analyst covering Indonesia when it opened to foreign investment.
At the time, I was based in Hong Kong, having moved there after quitting my job at Chase Manhattan in New York. Previously, I was an exchange student at HK’s Chinese University, and my buddies who stayed in Asia seemed to be doing well. I saved up USD 1,000 – a lot back then – bought a one-way ticket for USD 400 and started to look for a job. It was at the beginning of the first emerging market ‘boom,’ so several firms were looking for native English speakers to write company research. I sweet-talked my way into a job at an independent research-oriented broker called Crosby Securities.
The next decade was spent helping them enter markets opening to foreign investment, such as Indonesia, Pakistan, India, Sri Lanka, and China. It was a great experience.
To understand the new markets I was studying, I tracked who owned what and the connections between business families and the government. This turned into several longish reports, a lifelong passion, and now the basis of Research Alpha’s methodology.
Can you tell us a little more about your research and investment process? What makes you different than other funds?
I was downsized after the 2008/09 financial crisis, so I had a lot of time to contemplate what works and what doesn’t. I whittled this down into three things we emphasize—people, structure, and value. We look for companies owned and managed by quality people, have a corporate structure that aligns minority and controlling shareholders, and trade a generational low valuation.
First is people. Management and quality owners are probably the most essential aspects of any business. Major decisions, particularly those regarding capital and resource allocation, are made by those at the top.
However, the people behind listed companies are not well-researched. The sell-side can’t do it as they don’t want to tick off potential clients. Most of the buy-side is trying to second-guess each other, programming an algorithm for short-term gains, or matching an index.
Few look critically at the controlling shareholders, which is a good source of alpha, hence our fund’s name, “Research Alpha.”
We ask ourselves questions such as: Are the controlling shareholders good or bad stewards of the company? Do they respect minority shareholder interests, and what’s their track record? Is the company their primary focus, or are they doing other things and not that focused on the listed company? Is their reputation good enough to attract and retain top talent?
Second is structure. We are very sensitive to the possibility of controlling shareholders extracting cash or something of value from listed companies to the detriment of minority investors. Like our deep dive into people, corporate structure is another thing few look at, but it is core to our investment philosophy and another source of ‘Research Alpha.’
Outside the US, listed companies are often majority-owned and controlled by large families, conglomerates, or business groups. It may be just one of their many assets, so their attention and resources could be focused elsewhere.
There’s also the strong possibility that the controlling family will transfer profits and cash from the listed company into their 100% owned and controlled entities. This is stealing from minority shareholders. It is easy to do and tough to prove. For instance, a listed candy company may buy packaging material from the controlling family’s wholly owned packaging company. By controlling both, the family can raise the packaging price to shift cash from the listed company – where they own, say, 30-50% - to their wholly owned entity.
One of the more interesting structures was an Indonesian cement company that transported its raw materials via a conveyor belt to the kiln. The controlling shareholders owned a sliver of land the conveyor belt passed over and charged the listed company a sizeable rental fee.
Third is value. We like to buy at what appear to be generationally low prices. We do this by investing when and where there’s a financial crisis or significant devaluation. This mostly leads us to emerging and frontier markets simply because they’ve been out of favor since we started the fund; we have lots of experience researching and investing in them, and there are more of them.
MSCI says there are 23 developed markets. Our database tracks nearly 100 markets, so there are roughly three emerging or frontier markets for every developed one. And there are many markets that our database doesn’t include, such as Uzbekistan’s Republican Stock Exchange and several secondary boards, such as those in Nigeria, Egypt, and Pakistan.
We measure value using longer-term indicators such as CAPE or its dividend yield, price sales, and EV/EBITDA equivalents. These are used for both the overall market and individual stocks and are very helpful during a financial crisis to help us determine long-term value when others see nothing but losses.
Another point is that, during a crisis, almost all stocks are good value. This allows us to concentrate on our quality metrics of people and value.
We then hold for a long time, reinvest our dividends, and let compounding do its magic.
Can you provide examples of how this works?
The most recent clear-cut example is Sri Lanka in the spring and summer of 2022. Print and TV media noted the country’s political and economic crisis while showing footage of numerous protests. When we went there, almost everybody told us that it was Sri Lanka’s worst-ever financial crisis, even worse than at any point during their 26 years of civil war!
More importantly, valuations were super low. Sri Lankan equities were trading at a CAPE of about 5x. Anything below 10x is attractive, and at 5x, it’s almost a no-brainer if foreign exchange remains free and the politics are not too crazy. Since we invested our Sri Lankan portfolio is up over 85%.
And how do you get comfortable with investing in management teams in developing countries?
At the risk of repeating the above, it’s getting comfortable with the owners and determining if there’s an incentive for them to work to improve the listed company or an incentive to abuse it. Greed is a powerful incentive, and if there’s an easy and ready way to extract cash, it will probably be used at some point.
Can you share some stories of investments you or others have made that went either very well or very poorly and what you learned from the experience?
Our biggest holding is a good example of what went well and an example of our biggest mistake.
We invested in Vista Energy (NYSE: VIST — $4.87 billion) in late 2019 after our Buenos Aires trip. Vista is an oil and gas exploration and production company concentrated in the Vaca Muerta shale area. It has ADRs listed in the US and also trades in Mexico.
What got us on the very long trip from Asia was the dramatic drop in Argentina’s stock prices and currency when the Peronist opposition leader unexpectedly won a preliminary election round. The peso dropped 25% the day after, and equities fell 55% in August alone. This left the market at a compelling CAPE ratio of just 3x, an average EV/EBITDA of 2.9x, and an average dividend yield of 6.5%. In other words, it was butt-cheap.
According to locals, one bright spot is the country’s oil and gas industry, specifically the opportunity around the Vaca Muerta shale basin. One of the only things all political parties agreed on was strengthening the country’s oil industry, which they need as a source of foreign exchange.
Vista has quality people and groups behind it, a structure that aligns shareholder interests and was very good value.
Miquel Galuccio, its Chairman, CEO, and MD, is the key founder and a large investor. He has a good reputation from those I talked to and appears well-connected as he sits on the board of directors at Schlumberger. He was previously the chairman, CEO, and EVP at YPF and brought many ex-YPF colleagues into Vista. I was told that Vista picked up some of the best drilling areas due to the knowledge he and his team gained while at YPF.
Other investors also have good reputations. In addition to the founders and management having sizeable stakes, other early investors included firms that seemed to know much more about energy than we ever will. This includes two energy-focused private equity firms, Riverstone and Deep Basin, and the Abu Dhabi sovereign wealth fund. What also got us interested was Baopost’s 7% almost day one investment. I learned a lot from Seth Klarman’s book Margin of Safety, and I like their independent way of thinking. Baupost was a very early investor but has since sold out. This was due to them shutting or losing their oil and gas team and not due to changing their mind about the company, according to Vista’s IR department.
Vista has a distributed shareholder base. No single investor makes up more than 50% of equity, so adverse related party transactions are less likely to occur.
Vista was trading at a very attractive valuation. It was what I like to call a “double-negative.” This is where the country and industry are out of favor. Argentine shares had crashed, and nobody seemed to be looking at oil and gas companies with so much emphasis on ESG. Its ADRs started trading in July 2019, less than two months before the market crashed. In the crash, its shares fell 60%, which is when we first heard about it. When we went toward the end of 2019, it was trading at an EV/EBITDA ratio of just shy of 5x and a CFO/EV yield of close to 18%.
It hasn’t been easy to hold. Its shares fell another 60% during the COVID crisis when oil prices briefly went negative and we were underwater for a long time. Since the end of COVID, it’s been smoother sailing, and we’re up some 11x since our initial investment.
Vista Energy is also an example of our biggest mistake: selling too soon. A few years ago, we sold one-third of our position on technical factors as it reached a long-term double top. Subsequently, the price went down by some 30% but then rallied. Over the next three years, it rose by 6x due to excellent execution by the company and a more business-friendly government. While the technicals worked well, there was fundamentally no reason to sell. Despite the trimming, it's done so well that it’s our largest position. However, every day, I think it would be even more significant if we just chilled out and let it run.
What are some of the common misconceptions investors have about emerging market investing?
It’s a fallacy to group so many diverse countries into one basket, such as emerging and frontier markets. For example, MSCI classifies China, Qatar, and Brazil as ‘emerging markets’. We don’t see much similarity between them, especially from an investment standpoint. Treating each country on a standalone basis is another source of potential alpha, as few seem to be doing this.
And what are the most promising markets today?
Nigeria probably has one of the best set-ups in the world. At some 6x, it’s one of the cheapest markets on a CAPE basis, its government is making significant reforms under the newish president, and there’s momentum in its equity market as we enter 2025. Some of our Nigerian stocks have doubled in the last 5-7 months.
Most importantly, local entrepreneurs are starting to invest, mainly having sat on the sidelines under the last administration. From what we’ve heard and seen, the local smart money is getting back into Nigerian equities and other assets.
Everybody is talking about Argentina’s reforms, but few are looking at similar significant changes in Nigeria. Nigeria is especially attractive for US-dollar, Euro, and Yen investors due to last April’s nearly 45% currency depreciation vis-à-vis the USD.