Cuffelinks: Phil King on the long and short of investing

Philip King interview with Graham Hand. Graham is the Managing Editor of Cuffelinks, and Regal Funds Management is a sponsor. This interview is general information and does not consider the circumstances of any investor.

 

GH: I’d like to focus on ‘long short’ investing because that differentiates Regal. What’s the skill difference in going long, which most equity managers do, versus going short, which few do?

PK: The main difference between longs and shorts is the fact when a short goes wrong, the problem gets bigger. When a long position goes wrong, the problem gets smaller. Some managers are good at investing on the long side and then they become traders on the shorts. And that doesn’t always work well. I think you’re either an investor or a trader.

We are investors on the long side but also investors on the short side. We take a longer-term perspective and we’re valuation driven. We follow a similar investment process but the main difference between how we treat our shorts versus our longs is in risk management.

GH: And in theory there is potential for unlimited losses on shorts.

PK: Stocks never actually go to infinity but yes, you have to risk manage your shorts very differently. There are times when you have to reduce positions because they are going against you. Sizing is important and you should size your shorts a little smaller.

GH: Is there a difference in the time frame? Would you tend to keep your longs for longer than your shorts?

PK: I think that’s a bit of a misconception. We’re successful because we’re happy to take a longer-term perspective on both longs and shorts. We have held many shorts for five to 10 years. I don’t usually feel comfortable talking about my shorts, but there are certain manufacturing companies for example that we have been short for 10 years. They face such structural headwinds in Australia that you can’t really see how they can succeed.

GH: So although it’s a short, is a long-term view on the merits of that business.

PK: Yes, but you can’t expect to make great profits on your shorts in a raging bull market. Anyone that’s trying to make absolute profits in a strong bull market will be disappointed. Bull markets generally mean everything goes up, although there are always stocks that fall. That’s why there’s this misconception that you need to trade your shorts more aggressively.

We view our short book as insurance although we generate alpha (Ed. outperformance) on the short book. We run a long book as well and we don’t have to worry about what the stock market is doing. We don’t worry about tweets coming out of Washington or the Chinese economy. We focus on what we’re good at and that’s stock picking rather than all the macro factors.

Even the best stock picker who’s long only generates most of their returns over time from the market going up. But in our market neutral fund, we generate all our returns from stock picking. We generate around 4% to 5% alpha from the long side but twice as much alpha on the short side because it’s less competitive. Anyone can buy shares before they sell them but it’s only a small minority of investors that can actually sell shares before they buy them.

GH: But one of your main funds is the 130/30 fund (Ed. 130% long, 30% short), so that faces the same influences as 100% long. You have the same overall market exposure.

PK: Yes, and the 130/30 takes advantage of the fact the market goes up over time. Since inception around half of the returns have come from market beta (Ed. the level in the overall market) and about half has come from alpha. We generate returns from the market going up but we also run the short book to give the opportunity to generate more alpha than a typical long-only investor.

GH: What are the constraints on your shorting capacity?

PK: As I said, position sizing and risk management in case things go wrong. Shorts are smaller and ideally more liquid than longs. So there is a natural constraint. We have one of the largest short books in Australia, short a billion dollars of Australian stocks, and we think we can double that. But we probably wouldn’t want to get much bigger because of the liquidity needed when things go wrong.

GH: How are dividends on your funds affected by your short book?

PK: On a stock that pays a dividend, the share price normally drops by the amount of the dividend. So we have to pay away to the lender the dividend on borrowed stock but we usually capture it in the company’s share price. We pass through franked dividends on our long positions to our investors.

We generally borrow stock from international shareholders and therefore we only pay them the cash amount of the dividend and not the franking credits as well. The investors that we borrow shares from are usually index funds and large institutions based offshore. Occasionally, if we’re very bearish on a stock and sometimes all the foreign capacity is utilised, we do use domestic stock. Then we make a judgment call about the timing of any dividends and whether the stock price justifies paying the extra franking credit on a dividend.

GH: How do you feel about the term ‘hedge fund’? Do you think it compromises some of your marketing?

PK: There is a misconception about hedge funds in some minds. I think that’s unfortunate because we are trying to provide attractive returns uncorrelated with the markets. It’s simply trying to buy the cheap stocks and short the expensive stocks. It’s all about valuation.

Often when we are shorting expensive stocks, we have a lot of respect for both the business and the management. It’s not a reflection on the quality of the company, it’s a view on valuation and people misinterpret why we’re short.

Some people think hedge funds push stocks down and manipulate share prices. I think that’s very rare and it’s not certainly something we would ever do. In fact, I think there’s more share price manipulation (as I call it) on the long side and more people talking things up than talking things down. There are more participants in that market with more to gain.

There have been some well-publicised short reports over the last few years by both international and local managers. This is a welcome trend. People should be allowed to express views and not get criticised for having a different view. Too often, the broker research is just cheerleading for the company. There are too many cheerleaders in the market and it’s good to have true independent research.

Where we feel a bit uncomfortable is where some of the research becomes personal and we have the philosophy that we want to play the ball not the man.

GH: So the reputation that shorting has, such as during the GFC when some types of shorting were banned, such actions discourage liquidity in the market?

PK: The experience in the GFC told us that banning shorting doesn’t help stock prices. They continued to fall after shorting was banned and it was not the hedge funds pushing stocks down. It was more the circumstances at the time and the lack of confidence and the fact that financial markets were closed in some areas.

Hedge funds which are short a stock are often the investors who can cornerstone a capital raising. They can provide finance to allow a company to survive. Sometimes, we find management is the last to admit they have a problem and need to raise equity. They must accept the truth.

GH: I was looking at your long short fund over the last five years. 2015 up 21%, 2016 down 6%, 2017 up 18%, 2018 down 6%, then in 2019, Jan and Feb up 17%. Strong results but up well one year and down a little the next. Are there any common characteristics in the up and down years, or do you sometimes give a bit back after strong performance?

PK: Two points. Firstly, we carry the same market risk in this fund as long only investors with exposure typically around 100%. So, some of the weak years coincide with weak years in the market. For example, in 2018 the ASX200 was down 7% and this Fund was down 6%. Secondly, we are what some people call a ‘double alpha’ fund because we generate returns from both the short side and the long side. Sometimes, alpha is hard to find and we look like a typical long only manager. And then there are periods where alpha can be realised and we do well.

GH: Can we finish up with some questions around the listed vehicle you planned for a few months ago? What was the reason for not doing it at the time?

PK: We are experienced enough to know that it’s always harder to do a new issue when the market is falling, although we plan to have a LIT that we hope will perform well in all environments. It’s harder to ask investors to write a cheque when the market is weak such as in the December quarter. It’s all systems go now and we expect to lodge a PDS in April and go on the road, with a listing planned for June.

GH: Do you expect any differences in the way you manage the listed versus the unlisted funds?

PK: The main thing we will do differently is to have a diverse portfolio of some of our strategies in one LIT. We realise that some of our unitholders will be retail investors and we want to reduce the volatility of returns. We think we can build a diversified portfolio and a lot of our strategies are not highly correlated with each other. We hope to provide a compelling product for Australians who have too much property and equity exposure in their portfolios.

GH: So it will not simply replicate the unlisted retail 130/30 fund?

PK: No, in fact, it will be cornerstoned by our market neutral strategy which has low correlation with the equity market, plus we’ll include our emerging and small companies strategies which I personally think are exposed to exciting parts of the Australian market at the moment with good earnings growth.

People have been knocking on our door for many years to encourage us to list a vehicle and I’ve been reluctant to pull the trigger unless we could do it well. We only wanted to go down this route once we had the team in place.

GH: How you got your head around some of the structural issues that LITs face, such as drifting into a discount which disenfranchises some investors? Even going into a premium can be a problem as people buy expensive shares and drift back to NTA.

PK: That’s true and we would prefer not to see a lot of volatility in the discount and the premium. We will have the ability to implement a buyback if it trades at a discount for a significant period of time. We will be judged on the quality of our returns but also the discount or the premium our stock trades at verse the NTA and we’re very focused on those two factors.

GH: Finally, when I’ve heard you talk, you use a lot of sporting analogies. What’s behind that?

PK: I’ve got three kids very involved in sport and I spend a lot of time watching them play soccer and basketball and surf. I love all sports actually, playing and watching, and having a family with three kids keeps me busy on weekends.

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