Phil King: Equities as cheap as they were in the GFC
Philip King is the Co-founder of Regal Funds Management, a leading specialist alternatives investment manager with an impressive track record. Phil recently sat down with Koda Capital's David Clark for a podcast that was published on Livewire.
You learn something new every time you hear Phil and I enjoyed this interview. If you missed it, it's worth a listen in full. I've also pulled out some of the key points from the discussion for you below.
These include why equities look as cheap today as they did in the GFC, how the growth in passive investing is creating opportunities for active managers, why Regal has bulked out their in house research capability, and why they still like Appen and Zip.
Equities as cheap as they were in the GFC
"I think the big change in markets over the last year or two has been the collapse in bond yields. Bonds have rallied hard, and I think that makes equities cheap in comparison.
On our numbers, equities have only been this cheap relative to bonds in the two previous crises, the Greek crisis and then the financial crisis. We think equities are very cheap relative to bonds. Some people think that's not important.
We do think it's important. It just creates opportunities that will mean that some investors will switch from bonds to equities, but it also means great opportunities for corporates as well.
I think Australian corporates are borrowing money cheaper than they've ever borrowed it before. I think there was two deals announced recently, Kathmandu and SeaLink. Both those stocks rallied very, very hard, because there was huge earnings accretion that came partly through releveraging the balance sheet. I think that's a great opportunity for corporates at the moment, using this cheap debt to buy stocks at good prices".
Regals’ four-step process
"We follow what we call a four-step stock selection process, and so like many investors, valuation is very, very important to us, and our first and most important part of our process. We use different valuation metrics. We look at stocks in different ways, and we're always trying to work out what we call the true intrinsic value of a company. One of the benefits of Regal is that we have, I think, one of the strongest research teams in Australia. We have two medical doctors, for example, doing our health care research. We have a veteran of Glencore doing our mining research. I think we've got some very, very good research specialists.
We have another three steps in our process after valuation, and that's macro, catalyst and edge. We want to invest with our eyes open. We're not trying to choose stocks from the top down. We want to be aware of what risks are in the world. We want to know what's happening with the trade war, et cetera. We choose stocks from the bottom up but with our eyes open, and ideally we have tailwinds for our long positions and headwinds for our shorts.
The third part of our process is the catalyst and it's vitally important to get the timing right, and we don't want to just hold and hope something goes up. We want to actually identify why something might go up.
Then finally as part of our process, we try and identify why we're different from the market. We want to be a little bit contrarian, and we want to avoid getting stuck in consensus trades".
Investing in in-house research
"That's probably one of the big trends that I've seen over the last 20 or 30 years. When I worked on the sell-side in the 90s, the world was very, very different. Just like the internet has destroyed the newspaper classifieds, I think electronic execution is having a huge impact on the brokers. It's putting a lot of pressure on their margins. As a result, a lot of brokers are cutting back on their research teams. That's making a big challenge for a lot of sell-side research teams to remain relevant. In addition to that, I think electronic dissemination of information has in some ways levelled the playing field.
In addition to that, you've had regulatory changes such as MiFID II in Europe, which has separated what clients pay for research to what they pay for execution. That perhaps has exposed, made some clients think they're paying too much for research. One of the big trends I think we have seen is just the pressure on the sell-side.
I think there are two ways buy-side firms like Regal can respond. We can try and compete at the low-cost end of the market, and there's a lot of inflows into the passive funds at the moment. What we've chosen to do is very much try and differentiate ourselves by the quality of our returns.
We very much have invested in our team. We are probably doing more of our own proprietary research than we've ever done before. As part of that, we're using independent experts and we've invested in our own team, and that's why we've got a headcount that's close to 50".
Active opportunities from passive investing
"I saw something on Bloomberg recently where the amount of money in passive funds has got larger than the active funds for the first time ever. That's an interesting trend. I think it's creating great opportunities for active managers like Regal.
Because we know when those passive funds have to buy something, they buy it when it joins the index, and we know when they have to sell. They sell when it leaves the index. That creates opportunities.
I think the impact of stocks joining the index in Australia is larger than it ever has been before.
I think there is a bit of a trend, a bit of a bubble developing in a lot of stocks as a result of the inflows into passive funds. A lot of stocks in Australia are roughly one third owned by founders, one third owned by the growth managers, and then one third are perhaps owned by index funds and quant managers. When those index funds and quant managers buy that third, there's really no one left to sell. Stocks can keep trending up for an extended period of time.
I think there are some stocks in Australia that are quite expensive as a result of the passive flows. Some people say: is active management dead? I say no, but all forms of investment go through cycles. At the moment, active management and active managers are finding it a bit tough. I think this will be cyclical, and I think at some stage the money will start to flow out of the passive funds, and then active management will come back to the fore. That will provide great opportunities for active managers like Regal, but especially active managers who can short".
Why we still like Appen and Zip
"We still own Appen, because we think the valuation's very attractive. We're looking forward a few years, and I think that's fine. If a company has got a very strong market position, I feel comfortable looking forward a few years to see where that stock will be in a couple of years. There are other similar growth stocks out there as well. I think one reason that we've been very successful this year is that we've focused very heavily on small growth stocks.
We're very much in a low interest rate, low growth environment. If we can identify earnings growth, organic earnings growth before the market discovers it, then not only will we benefit from that EPS growth, but we'll get a strong rerating in that stock as well.
We've had a number of stocks double or triple this year as the market discovers the EPS growth and rerates them. I think a lot of stocks, as I said earlier, will go up heavily as they enter the index as well. That's something we're very focused on, stocks before they get too big or big enough to enter the index.
Well, investment is all about making forecasts. Making forecasts always involves a little bit of uncertainty, but I feel a lot more confident forecasting Appen's future cash flows than many cyclical stocks in Australia. I think stocks that rely on the economy for earnings growth can disappoint, and I think there have probably been more value traps in Australia over the last six months than I've seen in a long time.
Whereas something like Appen, if we do the research, explore the competitive landscape, if we talk to suppliers, if we talk to customers, we talk to management, we get very, very comfortable. They're in a very strong spot, and their growth is almost accelerating at the moment. They've established themselves as the go-to for their customers, and the main criticism they used to get was that they were too reliant on one or two customers. They've very much diversified their customer base.
A few years ago, they took out one of their large competitors, and I think they've very much established themselves as the go-to for their machine learning speciality, as well as speech recognition.
When we bought Zip it was on a valuation that was about 10% the size of Afterpay. As I've said, the first step in our process is valuation. We just thought all the hype was on Afterpay, and we thought people hadn't really discovered Zip.
We made a large investment in Zip and that's been very, very successful for us. That stock I think is up two or three times since we invested. We think in the buy now pay later space there'll probably be two or three winners. I think the merchants have an incentive to have more than just Afterpay on offer.
Just like most merchants accept two or three different credit cards, I think most merchants will accept two or three different buy now pay later providers. We think Afterpay and Zip will be certainly the two winners. We just prefer Zip on the valuation".
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