Phil King - Don't get too bullish too early

As part of the COVID-19 Special Episodes, David chats with Phil King of Regal Funds Management. Late last year when David last spoke with Phil, Phil believed that it was a great time to invest. However, throughout this episode, Phil argues that it's important investors change their portfolios as the facts change. Investors should constantly ask themselves, "Is my thesis still valid?" and as we have seen, Covid-19 has largely disrupted everyone's thes

Despite the recent bounce in markets, Phil thinks that it will be a while before we see the true bull market return, however, he highlights the opportunities presenting themselves in the small to mid-cap space of Australian equities compared to the traditional high yielding value traps that many Australians have typically favoured.

Since inception (Feb 2015) the Regal Small Companies fund has returned 18.4% p.a. (as at April 2020).

Transcript

David Clark:

Welcome to Inside the Rope, a podcast where we speak to the leading minds in wealth management. In today's episode, I'm speaking with Phil King, the Chief Investment Officer and founder of Regal Fund Management. We're talking specifically with reference to the small companies fund that they manage.

Phil talks to us as part of our special series that's designed to give listeners updates on the rapidly changing COVID-19 situation that the global economy finds itself in. The small companies fund that we're talking about has returned 13.3% since inception to the end of April, but it hasn't always been a steady journey or a straight forward set of results. For instance, the fund was down around 44% for the three months to March, and it was up about 27% in April alone.

Phil shares with us what they have done through the COVID-19 crisis, how he's looking at markets at the moment and how he's repositioned the portfolio, and his outlook for where investment markets are going next. I think you'll find this to be a fantastic podcast and I hope you enjoyed it. I really enjoyed listening to Phil. His views are always forthright and he will never be accused for sitting on the fence.

Please remember that this podcast isn't, nor is it designed to be specific advice or recommendation of a particular investment. We encourage people to listen to the disclaimer at the end of the podcast. Also, don't forget to keep your feedback coming in. You can email me at david.clark@kodacapital.com. Thanks a lot and stay safe.

Phil King, welcome to Inside the Rope.

Phil King:

Thanks, David.

David Clark:

Well, Phil, obviously we're in some very unusual times. We're doing this over video conference, which is remote, which everyone's getting used to. I think you, you haven't seemed to have grown a isolation beard, although you may be working on it. Firstly, how are you, how are you going and how are you coping with the situation?

Phil King:

Yeah, incredible times, David, incredible times in our daily lives and incredible times in the markets. As a firm, I think we're coping well. We have implemented the working from home policy. We've always had the ability to work from home, so it wasn't a big change for us. That seems to be going well. There's obviously pluses and minuses about that. Certainly, in some ways, it does allow us to focus a little bit more on what's important.

But certainly interesting times in markets as well. We've just seen one of the shoppers sell-offs in history in February and March. And then I think we've seen one of the sharpest recoveries that we've had. So there's been a lot of volatility in markets both over those months and also into... and each day. So yeah, very interesting times, David.

David Clark:

Do you want to maybe dig into, I think many of our listeners will remember we spoke to you it may have been in January, February, I want to say this year. We were talking about with such low interest rates and the Trump re-election coming along, can you maybe give us a little bit more description in your words what we've seen happen and specifically in reference to the small companies fund, which we're focused on in the past? I guess, in your words, what we have seen happen to markets and how they've reacted?

Phil King:

Yes. Well, as I said, we're seeing one of the sharpest sell-offs in history. I think the sell-off was so sharp because of three reasons. Firstly, there was so much uncertainty around the coronavirus pandemic. The markets don't like fear and uncertainty, and there is still a lot of uncertainty around this crisis. So that was probably the first factor to drive the sell-off. Secondly, the shut down that most countries around the world have implemented has meant that the negative economic shock is going to be huge, and we just don't know how bad this recession is going to be. Then thirdly, I think there's been a lot of computerised trading strategies that have exacerbated the impact of this sell-off. These sort of strategies have a stop loss mentality, which sells as the market goes down and buys as the market goes up. I think this has contributed a lot to the volatility in markets.

So we've had a view and we still maintain the view that the best investment opportunity's in Australia. They're at the small and mid cap end of the market. A lot of the large caps in Australia don't have much growth. I think this has been vindicated by the fact that the Australian stock market underperformed many overseas markets. Last year when the market was going up and the Australian market actually underperformed as well when the market fell. So I think that reflects the fact that there's the large caps in Australia are largely growth constrained, whereas there are many, much more exciting opportunities at the small and mid cap end of the market.

The negative of this is that sometimes these smaller mid caps carry more risk and less liquidity. So when the markets sell-off, these stocks can get hurt a little bit more. I think our small companies fund probably suffered from this, too much small and mid cap exposure compared with maybe the small cap index, and as a result, it probably did worse than we expected in the months of February and March. But pleasingly, we've had a very strong recovery since then and we remain very comfortable with the outlook.

David Clark:

So I want to say that for roughly, and correct me if it's not right here, is for the first three months year-to-date, so to March year-to-date, the fund was down roughly 39%. And then in April, it might look like it's something up around the 27% mark.

Phil King:

Yeah. Those numbers sound about right. I don't have them in front of me, but, yeah, it's very strong recovering [crosstalk 00:06:33]- ... very strong recovery in May.

David Clark:

Can you tell me what in the small companies fund you did and/or what was the process that you employed when we have such a dislocation like this?

Phil King:

Well, I think it's very important that investors change their portfolios when the facts change. I think when something changes, you've got to ask yourself, "Is my investment thesis still valid?" And there's been no larger change in society and in the economy than the coronavirus pandemic for many, many decades. So I think it's right to question every stock in the portfolio. And one of the lessons we have learned in previous crises is that it's important to take your medicine early and reshape the portfolio.

So that probably cost us some performance in March, but I think we're seeing the benefit now in April and May. So we very much asked ourselves the question, how is this stock going to be affected by an economic lockdown? So any companies which lacks liquidity that have weak balance sheets, we tended to exit. And we tended to concentrate our exposures to those stocks with strong balance sheets. I also think that where this crisis might differ from the GFC is that this crisis is very much starting at the consumer level, so whereas the GFC started at the finance or the financial sector.

This crisis, I think, will affect a lot of companies a lot more. As a result, I think it could last a little bit longer. So we have tried to reduce our exposure to any companies that are very exposed to the consumer.

David Clark:

Phil, how have you gone about determining whether companies are going to get through these period, given that most companies have provided or not provided much data or forecast because they just don't know? Have you been focusing on particular industries like travel or tourism or hospitality and steering clear of those, or are there other research methodologies that you've been employing?

Phil King:

Yeah. We're very much trying to avoid those companies that can't provide guidance or are suffering huge downgrades. We've tried to gravitate towards those companies that are largely unaffected by the crisis, and even some companies are benefiting. I think it's very important. Many investors are just assuming this is a one or two year crisis and then things return to normal. I think in some sectors, say travel, things may never return to normal. I think working from home will become a lot more popular going forward, and that's going to change the way many office box, et cetera, operate.

Yeah, we're very much tried to anticipate what's going to happen to many companies. And as a result, I think we're largely trying to avoid those companies that are getting very affected by the economic slowdown.

David Clark:

Now, Phil, you talked about one of the factors contributing to the selling down. I suspect you might say the opportunity in the small caps area may be even greater than in the large cap, not only because they've got ongoing growth, but because there weren't many buyers in that area and some of them may have gone below what their technical value is because people were just looking for cash. But have you seen any evidence? We saw written up in the paper of some of the industry funds and some of those funds with people who may need to get access to their superannuation, like Hostplus, I think of in hospitality area, or Rest in the retail employers or so forth. Have you seen much evidence in the small cap area of funds or what you believe may be selling to fund that need for liquidity that's come about in this unusual time that may present an opportunity for someone like yourself?

Phil King:

I think this is largely overplayed, David. There's been a lot of chat. There's been a lot of focus in the newspapers, but I think this has had very little impact on the Australian stock market. It's obviously affected one or two industry funds, but I think most funds on average have probably been net buyers of the market over recent months, especially considering the fact that with the 30 odd percent fall in the market, their equity weighings are probably a long way below where they want them to be. So I think most industry funds have probably been biassed, but there certainly has been a few well publicised industry funds that have probably had to sell equities for liquidity purposes. But I think this just hasn't had too much effect on the market as a whole.

David Clark:

So you've flagged, if you think there's been a net buyer in to the market. Do you think valuations have got ahead of themselves given the lack of clarity that we've had from companies? And many people are saying, "Look, until there's a cure in somebody's hand here, there's just a huge amount of uncertainty." And we have seen a very meaningful rally, if you'd like, in April.

Phil King:

Yes. Look, it's interesting. It's always hard to generalise. But what I would like to say is that some companies are largely unaffected by the whole economic shutdown and the pandemic. Other companies are benefiting from the pandemic while other companies are hugely disrupted by the pandemic. So I think you've got to look at each type of company separately. In terms of valuation, we had the view the valuations were very reasonable compared with interest rates. In some cases, we've seen interest rates fall even lower. So for those companies that aren't affected by the pandemic, we think valuations remain good for those stocks. I think some of those stocks are cheap relative to interest rates. And that's why, for example, we're seeing the Nasdaq be so resilient in the US and I think we can say the same thing about many tech and healthcare stocks in Australia.

On the other hand, we are concerned about many of the so-called value stocks in Australia, where many investors are assuming things return to normal in a year or two, and then you're looking through the crisis. I think these stocks are at risk. So we're very, very cautious. So many of those, what we call value traps.

David Clark:

Phil, you've spoken publicly about Afterpay in the past and there's been some corporate activity with 10 cent buying into Afterpay. How have you positioned your involvement with that particular stock?

Phil King:

Yeah, Afterpay has been a huge winner, even though some investors have concerns about how their loan book is going to hold up if unemployment spikes in Australia as it will and as many millennials haven't suffered this sort of economic recession before. We're probably not going to know the answer to that until the government stimulus, until the job seeker and the job keeper packages wear off in September. So it's probably too early to work out how Afterpay copes in that sort of scenario. But we very much prefer Zip, especially at these sort of prices. Afterpay has got a market cap of around $10 billion. Zip's got a market cap of a billion dollars. Even though Afterpay is a lot more advanced in its US and UK expansion, we think Zip has many opportunities there as well. So we very much prefer Zip at these sort of prices. And we think the Zip share price should do extremely well over the next six to 12 months.

David Clark:

Phil, we have seen a lot of companies cut their cashflow guidance and boards really pulling back. How long do you think it's going to take until we see a more average level of dividend flow out of companies?

Phil King:

Yeah. I think the crisis has shocked everyone. I think investors, governments, regulators, and even boards have been shocked by the crisis since that's a natural response to try and conserve cash and improve liquidity. So we've seen many companies cut dividends. I think payout ratios will stay reduced for many, many years. The last captain of the market we've seen National Australia Bank cut their dividend, and we've seen ANZ and Westpac defer their dividends. That, I think, will shock many investors who like to hold these stocks for their dividend yield. And many investors have historically compared them to term deposits and say it's better [inaudible 00:16:01] and receive term deposits.

Then on the other hand, many people called stocks like Transurban and Sydney Airport bond proxies because they thought that they were very resilient to an economic downturn, and they thought that the dividends were very secure. And I think at some stage, we'll see Sydney Airport and Transurban cut their dividends. Again, that could surprise many investors.

I think we're seeing a similar scene at the smaller end of the market. Many of the stocks that did pay good dividends are cutting them. There is a huge move to improve liquidity, but the stocks and the sectors that we really like, like healthcare, like technology, and like mining don't really trade on yield. So we haven't seen many changes there, whereas many of the, what I call the so-called value traps have been trading on yields. So I think a lot of investors could get disappointed when yields get cut, when dividend payout ratios get cut. And I don't see dividends returning to their current levels in many of these stocks for many, many years.

David Clark:

Now, Phil, you've flagged earlier on that you've managed these investment portfolios through quite a few crisis to date. I must say, my recollection is that those funds have performed very, very strongly coming out of those crisis in the past. What are the main lessons you've learned through those past crisis? And what of those are applicable to today's situation, do you believe?

Phil King:

Yeah. Firstly, I think it's important to accept that things have changed. We certainly have done that. We've taken the medicine, as we said in the months of March and we have repositioned the portfolio. We've tried to expose the longs to companies that are largely unaffected or benefiting from the crisis and the shorts to companies that have been greatly disrupted by the crisis.

I think it's very important not to get too bullish too early. A lot of people get sucked in the... stuck at rallies and dead cat bounces and things like that. And even though we are seeing a decent bounce in the market at the moment, I think it's going to be a while before we see what I call a true bull market returns. I think we really need to get through the economic recession before we can get too excited about the markets.

So I think it's important not to get too carried away and assume that the crisis is all over. I think we're also seeing a lot of single stock dispersion. So some stocks going up, some stocks going down, and that's great opportunities for traders and people that can take advantage of these opportunities and provide liquidities to the market. I also think that we're going to see a huge spike in corporate actions. That's a great opportunity for investors like Regal, who can take advantage of these corporate actions.

Yeah, I think it's important to maintain liquidity in the portfolio, not fall in love with stocks, maybe try it a little bit more than normal, and then eventually not get too scarred by what's happened, but at some point, not now, but at some point, get a bit more optimistic about the future.

David Clark:

Now, Phil, in previous times where we've talked, you've spoken about creating an environment within Regal, where you have a huge capability in-house and you want the best and the brightest wanting to work at Regal and coming into Regal. And I think the analogy was the Barcelona of the world, where Barcelona is the best and everyone wants to play for Barcelona. So it's self-perpetuating. I had to be corrected. Tom Oryl who works me, I used the Real Madrid, and he said, "No, no. [inaudible 00:20:12]. It's Barcelona." It is the example. Has anything changed in terms of your structure internally, research or how you're doing things that's meaningful, do you believe, or to that type of view?

Phil King:

No. We're very fortunate that I think we've had no changes to our starting 11 in the last 12 months, no changes to our Sydney front office. We're very fortunate that everyone is fit and playing well. We still very much aspire to be the Barcelona of investment management. Even though we might not win every match, we certainly want to be there at the end of the season. And we certainly aspire to kind of chase the title as it were. So we're very, very focused on the longer term, staying fit, playing well.

I also I think I try to draw the analogy. We want to have the best buyers in each position. So that's why I think it's very important to have industry specialists. There are certain sectors like mining, healthcare, technology that I think it really lends itself to being specialists. And then it's good to have generalists like myself who can kind of question things and look across everything.

David Clark:

Phil, it's been very, very helpful and I'll wrap up now. In doing so, would you have any overarching thoughts or comments that you think would be helpful for wealth management clients who are sitting there with their portfolio of assets often and the output of their life savings and building businesses, et cetera, over times who have just gone through this very tumultuous time? Are there any thoughts you would like to leave them with or think that are particularly pertinent for them?

Phil King:

No. Look, I remain strongly of view that longterm investors need to be exposed to equity markets. I think equity markets do give the best returns in the long run. And I would encourage people who are looking for longterm returns to stay exposed. I think the best returns in the Australian market will be at the smaller mid cap end of the market. So I'd just encourage investors not to lose their nerve and just stay the course. I think over the next five to 10 years, there should be very, very strong returns coming out of the Australian market. Yeah. I just encourage people to not give up and stay involved.

David Clark:

Well, Phil, once again, thank you very much for taking the time. I understand it's a very busy time in market, so it's very kind of you to carve this time out for us. I hope you and your team, your families all stay well during this time. Keep washing your hands.

Phil King:

Thanks, David. We certainly do. And all the best to you and all the team at Koda as well.

David Clark:

Terrific. Thanks, Phil.

Thank you for listening to Inside the Rope with David Clark. Be sure to subscribe to this podcast on iTunes. You can connect with David by visiting kodacapital.com.

Any views expressed in this recording represent the personal opinions of the speaker and do not represent the view of any other party. If this recording contains reference to any financial products, that reference does not constitute advice or recommendation and may not be relied upon. Listeners in Australia are encouraged to visit (VIEW LINK) to obtain information regarding financial advice and investments.

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