James McDonald’s high-conviction bets yield rich rewards for an ethical strategy (AFR)

(Vesna Poljak)

Biotechnology and healthcare discoveries have been some of the richest sources of returns for James McDonald’s 20-stock best ideas strategy, which capitalises on a fascination with science and somewhat uniquely, a lifetime immersed in agriculture.

Oslo-listed bladder cancer diagnostics group Photocure has soared 86 per cent in 2018 as its $US1000($1430) treatments capitalise on success in Europe with a move into the US market. Photocure is 12 per cent of the Pengana High Conviction Equities Fund that McDonald oversees, and which is up 28 per cent over one year after fees, with a 28 per cent allocation to the health sector.

“The market cap is $US130 million and it’s got $US25 million in revenue but I expect that to double over the next, say, two years. It’s a $US1.3 billion market in the US, there’s a huge amount of potential for this thing so it’s a very exciting time,” McDonald says.

His enthusiasm for the stock is matched by his interest in advances in science and technology, which are arriving with great frequency. For example, gene therapy treatments under trial have led experts in the field to claim that haemophilia is curable. A smaller position of his, Nasdaq-listed Sangamo, is the developer of a platform for genomic medicines.

“Investors shy away from healthcare because of the complexity but there’s great potential, and if you put in the time and the effort, there’s great returns to be made as well.”

The fund manager grew up in Mount Isa on a cattle station, part of a family-owned agribusiness that he is a director of to this day, and where his family still live. But for a self-described “nerdy kid” the world was never that far away because his mother’s work as a chemist and his father’s interests in business, politics and the community meant a constant stream of interesting visitors.

McDonald’s grandfather on his mother’s side, George Fisher, was the boss of Mount Isa Mines, and his grandfather on his father’s side, Jim McDonald, founded the family business with his sons having lost both parents at 16. He is regarded as one of Australia’s greatest cattlemen. “Both of my grandfathers were really inspirational to me,” McDonald says. “It stays with you.”

Lessons from tech bust
He joined BT’s Japanese equities team in Sydney in 1997 and progressed to US TMT (tech, media and telecoms) right before the bust.

“The mistake everyone made was extrapolating growth rates that they thought would continue forever and it just didn’t happen,” he recalls. “You had a lot of loss-making internet companies, which is quite different to what’s happening now.” Potentially, “there’s a bubble in unicorn-type capital raisings” today, but when Cisco was trading on 100 times earnings in 1999, and Google is on a mid-twenties multiple, inviting parallels can be clumsy.

McDonald took over the strategy from the well known investor Peter Hall after Pengana acquired Hunter Hall last year. McDonald joined Hunter Hall in London in 2003 and regards Hall as a great influence for his contrarian instincts.

“There’s a solid cashflow underpinning quite a lot of the investments in the portfolio and those that don’t have cashflow or revenue, they generally have huge cash balances. I’ve got two biotechs that have 40 per cent of their market cap in cash.”

While he buys stocks that are deeply undervalued, the fund manager deliberately seeks out businesses with the safety net of a healthy balance sheet.

“I’m just trying to find companies that I think will do well irrespective of the economic cycle,” he says, emphasising those that possess a technological lead or a competitive edge. “You’re always assessing, is this the best 20?” That being so, he has followed Photocure for 15 years and became a member of the nominating committee that revamped its governance, alongside an esteemed healthcare fund, Polar Capital.

About 20 per cent of the fund is intech, including a position in the maker of optical lasers used in face ID applications by Apple, the Nasdaq-listed Lumentum, which he first became familiar with from its days as JDS Uniphase, a dot-com era casualty. He has added Tencent and Alibaba following the market’s indiscriminating growth rout, and exited China Mobile to take a position in the robotics maker Teradyne whose $US50,000 robots can be programmed quickly to perform basic tasks. NYSE-listed Teradyne was trading on 14 times earnings.

Most people would know the American drugmaker Merck, but McDonald owns Merck KGA, the German-listed and family-controlled business that the fund manager describes as steady growth (trading on 15 times). “They developed morphine and LSD, but about 60 per cent of the value of the company is these bioreactors that you need to make all of these new biological drugs. You don’t have to be going and taking a lot of risk, there’s not much debt, and it’s got a couple of interesting immunotherapy drugs.”

‘You’re not paying much for it’
Bavarian Nordic, a vaccine maker in Denmark, fell 70 per cent in value on account of a negative outcome linked to a cancer vaccine. But it has $US300 million of cash and makes a smallpox vaccine the US government is buying strategically. “They got rid of smallpox in 1984 but a university about two years ago showed how easy it is to recreate, so the US government has so far ordered $US1.2 billion of smallpox vaccine and they want to order another $US6 billion.

“It’s a really fascinating business and you’re not paying much for it.”

McDonald acknowledges the volatility that can come with unfavourable clinical outcomes lending itself to short-termism, which he tries to resist. His strategy also has an ethical screen, which means he can’t own anything harmful to society, animals or people. He’d love to invest in a business like Boeing, but its military interests rule it firmly out.

“You’re no worse off with an ethical investment process than without one, I don’t think you give up any long-term gains, and it just makes good business sense. I’m proud of that, I think it’s a good thing. Where my family live is going to be impacted by climate change terribly and reducing carbon emissions is very important to me.

“I do understand that fossil fuels are a big part of our export industry so it’s a really difficult balance. In one sense we’ve got to take a leadership position in the world, in another sense it’s economically painful for us.”

With this year’s drought, McDonald observed that it was so widespread farmers were restricted in their ability to move cattle to unaffected areas.

“We were fortunate where we were, but so much of the country has had such a devastating year,” he says. “Australia has always been a dry country and you do as a farmer have to manage through that process and I think, at least in our family’s view, you have a strong balance sheet to survive those tough years. In any primary industry whether it’s mining, whatever, you need to have a good balance sheet.”

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