Education

One of the most anticipated IPOs of 2019 is set to kick off at the end of April. Regal Funds Management is seeking to raise $500 million for a new Listed Investment Trust (LIT) - the Regal Investment Fund (ASX:RF1) with Equity Trustees as Responsible Entity. Why is there so much interest in this float? 

Regal is a highly awarded alternatives manager with a long and impressive track record. However, Regal's investing prowess has been strictly the domain of Wholesale Investors able to lay down a small fortune. The proposed LIT will open up Regal's strategies to a broader investor base and with a hard cap of $500 million, the limited supply is likely to be met with strong demand. 

I recently had the opportunity to interview Philip King, Chief Investment Officer of Regal Funds Management, to get a sense on his approach to investing and current market views.

Q: Can you give me some insight into your influences as an investor?

I've always had a strong interest in the stock market. I bought my first shares when I was about 14, and I thought it was useful to get different sorts of experience, so I spent seven or eight years working as an accountant. Then I spent five years on the sales side and seven years working for a buy side manager in London.

I often tell investors that on the sell side, you learn about how to make money. On the buy side, you learn how not to lose money. And those lessons about risk management are the most valuable that you can learn.

Q: What is it about long-short investing that appeals to you?

I think a long-short manager is a true stock picker. I think a lot of long-only investors describe themselves as stock pickers, but most of their returns, when you analyse the numbers, come from beta, which is the market going up, whereas we are long-short.

So, we choose longs. We choose shorts. And we want to identify longs that will outperform our shorts, and that's how we capture returns.

Q: What are you on the lookout for when you identify opportunities in the short part of your portfolio?

I've been shorting shares for close to 20 years, and just as we have portfolio construction on the long side, we have portfolio construction on the short side.

I think a common mistake for less experienced shorters is that they look for a home run every time they short. Just like we're not looking for a ‘50 bagger’ every time we buy a stock, we're not looking for a home run every time on the short side.

The most important thing for us is valuation. We want to short expensive stocks and we want to buy cheap stocks. There are some stocks that are possible home runs or zeros, as some people call them. And they are the ones where you look for red flags.

And there's obvious things like management that are probably spruiking the story too much, and weak balance sheets. They're some of the most obvious red flags.

Lesson #1 Valuation and balance sheets matter. Watch out for spruikers!

Q: You describe Regal as having a slightly contrarian approach. What is a practical example of this?

A few years ago, a lot of analysts who were a lot younger than I was were suggesting that we buy BlueScope Steel. They were saying steel prices were going to go up and the Aussie dollar was going to go down, and that's very much a Goldilocks scenario for BlueScope. But in my experience, it was unlikely.

Often, if steel prices are going up, commodity prices are going up, and that's generally quite positive for the Australian dollar. We took a contrarian view and we shorted some Bluescope, and that proved to be the right call as import competition eroded Bluescope's margins.

We spend a lot of time talking to the market and reading research, but often we're looking for opportunities where the market's getting it wrong.

Lesson #2 Do the work so you can confidently go against the herd

Q. What are some current examples?

There are a number of consensus trades and we like to question them. 

I think one of the biggest consensus trades at the moment is that the market is tired and needs a correction. 

What happened in February last year and December last year, the market tried to go down, but just the power of buying pushed it higher. I certainly think that it's too early to get too negative on the market. I think with bond yields where they are in Australia, it makes the equity market look very, very cheap.

On our analysis, the last two times there's been such a disparity between earnings yields and bond yields have been very good times to buy the market, those being 2012 and 2009.

I think that's one area where we are a little bit different. We're not getting too negative on the market at the moment.

Two other consensus trades now are: interest rates have got to go higher, and volatility has got to go higher.

Interest rates in our view may go higher, but I don't think that's a "lay down misere". I think debt levels in China and the U.S. are very similar to Japan 25 years ago. And over the last 25 years, debt levels in Japan have risen a lot and interest rates have continued to fall. I think we easily could see a similar situation in the U.S. and China where interest rates stay low or fall over the next five or 10 years, and debt levels continue to rise, which is a natural response to lower interest rates.

The other area is volatility. I think there's always going to be macro factors driving volatility. As a humble bottom-up stock picker, I look at the profit and loss statement, and there's less leverage in the profit and loss statement than there has been for a while. There’s less operating leverage and there's less financial leverage. That would suggest from a bottom-up perspective, low volatility is here to stay.

Q: Where does your market exposure sit right now?

Our long-biased funds are still long-biased. We think the market is trending higher. With interest rates as low as they are and no sign of interest rates going up in the short term, I think you've got to stay with the momentum and stay long.

There will be a time to short, and I think sometimes people ask, "Well, what's the best thing to look for in a short?" And it sounds a bit flippant, but the best thing to look for is stocks that are falling.

In my experience the best shorts are those ones that are going down, whereas the temptation for many people is to short something that's going up.

Lesson #3 Don't try to pick market tops

Q: Regarding the Regal Investment Fund (ASX:RF1) that you're hoping to bring to market, how have you thought about constructing this strategy?

People have been knocking on our door for many years to do a listed product, and we've always been a little bit reluctant. We realise it can be a little bit of a distraction, and as high conviction investors, we don't want to scare people off with our volatility.

So, we have invested a lot in the team in the last few years, both in the front office and the back office. And the product that we are proposing to bring to market is a blend of some of our strategies.

It's corner-stoned by our flagship market neutral strategy, that has annualised around 15 percent over 12 years with little correlation to markets. But we're also introducing some of our other exciting strategies such as Global Alpha, Emerging Companies, Australian Small Companies and Australian Long Short. 

I think there are three things that Regal's known for in the markets. First is our ability to generate attractive returns with limited correlation to equity markets.

I think the second thing Regal is known for is our ability on the short side. The alpha we generate on the short side is twice the alpha we generate on the long side. That makes sense to us because it's just less competitive on the short side. 

Thirdly, I think what Regal can offer investors is just some exciting growth opportunities in small and emerging companies. We have great relationships with all the brokers and bankers in Australia, and I think we really get to choose the best opportunities there are in the market.

Q: EPS growth and free cash flow are two of the most consistent metrics that you use to find good stocks. Is there a stock that passes the filters that you apply on the long side at the moment?

I think it's important not to get too focused on one single metric, because some stocks we like are amazingly cheap on traditional earnings metrics. Stanmore Coal (ASX:SMR) is one stock that on our numbers is trading on 1.5 times EBITDA, three times PE and is just very, very cheap on traditional metrics.

On the other hand, another stock we like is accounting software company Xero (ASX:XRO), which has just come through a period of start-up losses and will enter profits over the next few years. The profit growth over the next few years is quite spectacular. Trying to value that on a traditional earnings multiple is hard.

One thing I look for in growth companies is: How many years forward do I have to look before it comes back to a market earnings multiple? With Xero, it's certainly a lot less than some of the other highly priced technology companies in the market at the moment.

Lesson #4 Be mindful when using textbook valuation metrics, they don't always work in the real world

Q: What keeps you up at night at the moment?

The beauty about running a market neutral portfolio is that most of our risk is stock-specific, and so even though there are risks in the portfolio, it's not usually one big risk that's going to kind of blow us up. I certainly try and get out there and do as much research as anyone else and work as hard as anyone else, but to be honest, it's probably just like everything else... It's just the kids that keep me up at night!

Lesson #5 Market neutral strategies can reduce the uncertainty that comes with equity market volatility

Q: What gets you excited?

Technology and mining are the most exciting growth areas for us at the moment, and it's a huge contrast, because the mining sector, which traditionally has been a cash drain, is actually returning cash to investors at the moment for in the first time in many decades.

The technology sector is absorbing cash, so that's the opposite. However, the technology sector is providing those exciting long-term growth opportunities, and I think that's certainly one sector you need to embrace rather than to avoid.

Q: If you were able to take a couple lessons you have learned back to when you started your career, what would they be?

I think one of the biggest lessons I've learned in investing is the benefit or the value of liquidity. If you make a mistake in a liquid stock, it can sometimes cost you nothing. If you make a mistake in an illiquid stock, it can blow you up. So, I think the benefit of liquidity is very important, and that's both on the long side and the short side. So we've got strict liquidity limits, and we're very focused on the liquidity of our portfolio.

Lesson #6 Avoid illiquid stocks. One mistake can blow you up

Important Disclosure

This article should does not constitute as advice and is not a recommendation to purchase any of the securities mentioned. Readers should be aware that Regal has, or is likely to have in the future, a position in the securities which are mentioned in this article

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Comments

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Andrew O

RF1 costs are very high, with a significant performance fee based on RBA cash rate which is not appropriate given the type of fund this is.

Ramon Vasquez

What exactly is the MER and the Performance Fee , please ? Best wishes , Ramon Vasquez .