The Greg Matthews interview

Transcript of Michael Pascoe's interview with Greg Matthews of Independent Asset Management
Michael Pascoe: Independent Asset Management: What is it, and what does it do?

Greg Matthews: We’re an Australian equities fund manager. We’ve got two main funds; an All Ordinaries Fund, which has about $800 million in it; and a specialist resources fund with about $100 million in it.

And why do people give you that money to play with?

We’ve got five big clients and they’re all either industry superannuation funds, corporate super funds or government funds. They give us the money because we’ve had good returns basically and we’re a small boutique, so we can be flexible in the way we manage the money and we can continue to give these people the returns they’re looking for.

You’ve gone from the big end of town to running your own boutique house. What’s the main difference?

Oh, there’s a lot of differences between being in a big organisation and running your own boutique. One of the main ones is the way that you structure decisions within a big team of people. That can get quite political, and difficult when you’ve got a lot of different personalities to manage. When you’re in a small team you can get to the nub of the matter much quicker, you can make decisions much quicker and you can outperform the market more easily. You’ve also got the advantage that because you’re not moving so many funds when you’re buying and selling, you can get a set in the stocks a lot quicker.

And that translates into definite measurable outperformance?

Well our performance has been going really well. We’ve become number one of the 60 or so managers in the Intech survey in the last 12 months, and we’ve been number two over three years, so it’s very hard to know what exactly of those factors is actually helping but I think the boutique size has been shown by a number of people to be a definite value adder.

How do you do it? How do you outperform all those other managers?

Well, the first thing is that you don’t know you’re going to keep doing it. You don’t want to get too cocky about it and you don’t want to think that you’ve got the market licked because I don’t think anybody ever has done that. So you try and stay flexible. You try and stay well diversified and I tried to look at a number of inputs that drive the market, so basically we look for growth at a reasonable price. There’s very few managers that do that. Most managers actually divide themselves into value managers or growth managers. They tend to go on roller coaster cycles. You get the growth stocks all out-performing at once and then they all collapse at once. Then the value stocks will outperform and then they’ll all collapse.

We try to ride through that cycle and always be selecting the stocks that have got the best value attributes for the growth that they’re delivering. But outside of that, we’re even looking at a number of other factors that drive markets, such as what’s happening in the macro economy: what’s happening with interest rates, currencies '¦ even what hedge funds are doing '” where the buyers and sellers are in particular stocks. All those things move stocks around and I think you’re crazy to ignore any of them. Our underlying focus, though, is this growth at a reasonable price.

Which sounds like a degree of buy-and-hold, but a fair bit of trading around the edges.

Well it changes over time. We can hold the same set of stocks for six or 12 months. There’s stocks in the portfolio that have been there for four years '” since we started. We can get very active at times, too. At the moment there’s been a huge run in the resource stocks. We were very overweight the resource stocks and we’ve pulled that weighting down quite dramatically just in the past few weeks waiting for a potential pull-back that we may see occurring in those stocks. But also because they’ve become so big in the portfolio '” because they’ve out-performed so strongly '” that we’ve had to pull them back down to more sensible sort of levels. So on those stocks we wouldn’t have traded, or wouldn’t have sold any for six months, suddenly there was a lot of activity there.

Can you give me an example of the process? Pick a stock that you’ve bought; why you bought it, how you did it?

Well one of our key stocks would have been BHP Billiton or Rio Tinto, particularly over the past two or three years. They’re easy stocks to understand. They’re leveraged to the resources cycle. We had a very strong overriding view that resources were cheap, that there hadn’t been any new major resource projects built really in the five years prior to three years ago and that there was huge demand coming out of China and later on India, and that there weren’t the mines to supply that. Now having said all that, even on the resource forecasts that people had in, BHP and Rio were only trading at 9–10 times price/earnings (P/E) multiples '” very cheap and not at all reflecting the huge growth that we saw coming through.

The stocks have now had very good rises, but on those P/Es, on the current metal prices and oil prices and so on '¦ bulk commodity prices '¦ they still look reasonably well priced. They’d still only be on about 12–13 times earnings one year out. The difference is that people have, of course, dramatically jumped up their earnings forecasts as commodity prices have stayed higher than expected: the stronger-for-longer scenario that the stockbrokers are now talking about.

So you’re still fairly comfortable with it?

We’re reasonably comfortable, although we are expecting a pull-back in the short term, and we would be seeing any significant pull-back as another good buying opportunity.

That’s an example of a major economic trend: fundamental demand driving the stocks. You must also play with individual stocks that aren’t part of a big economic trend as well.

Yeah. Well one of our big successes there was Worley, now WorleyParsons. It’s basically like a shovel maker that the mining companies '¦ you know '¦ Worley does the services for the oil industry and it’s done some major takeovers that have worked very well. When the stock first floated it was relatively unloved and we got an allocation in the float. We bought more in the market after that and basically all it’s done is go up. Now it’s not like a BHP or a Rio because it [provides] services to those industries and it’s now looking relatively expensive on a P/E in the mid-20s, although there are earnings upgrades from people all the time as they realise the number of big projects that some of the companies, the mining companies in particular, have got going forward over the next few years.

In fact if you look at a list of the projects coming up from BHP, you’d think that WorleyParsons is going to be doing very well for the next few years to come. Now having said that, its price has risen dramatically. As I said, the P/E in the mid-20s is now starting to look a little rich. It will need a lot more work coming through and more upgrades to justify the price at current levels.

As a funds manager you had a very successful run by getting into the resources stocks early and riding it. Does it worry you what the next trick will be?

You’re always looking for the next trick. Basically over the past three or four years it hasn’t just been the resources; we had a major move on the general insurance companies when we thought that they were priced far too cheaply, particularly after the September 11 attacks. Companies like QBE were absolutely slammed and the managing director of QBE came out several times, almost thumping the table at one of the analysts' presentations when he said that the earnings were going to be up 50% and that because they were able to raise premiums, the whole sector was very cheap on a P/E basis and that it was a great sector to be in. We wrote that up and we exited those stocks probably 12 months ago now, but that was a strong pick for us.

We’ve also had moves up and down in the banks over that time. Telstra was a very strong one for us for quite some time, and we’ve actually gone back in and bought a few Telstra just recently down near the lows, not because we think it’s particularly cheap but just because it’s a nice place to park some money while we wait for some of the resource stocks perhaps to come off. We’ve also got a good position in the wealth management companies at the moment: we’ve owned AMP, AXA and Australian Wealth Management. Australian Wealth Management’s nearly doubled for us over the past six months or so. There are big positions we’re taking all the time in different sectors. We’re always looking at the benefits of those sectors and whether the stocks are underpriced relative to the growth that we’re expecting to come through.

How big do you want to be?

We don’t want to be really too much bigger than we are now. We’re currently about $900 million in funds under management. If we went to $1.5–2 billion, that would really be as big as we’d want or need to be.

You never see yourself being an offer to retail level investors?

We’ve had a look at that and we prefer the big wholesale investors. All our money’s managed under individual mandates with big wholesale investors. We aren’t really set up to handle all the flows and phone calls and so on that you get from retail, so it’s an option for the future but it’s not something we’re really looking at seriously at this stage.

Is there a touch of revenge is sweet doing so well in the past few years?

Not really. We’re just happy to be doing well and living a nice life really. There’s no real aspect of revenge in it.

The last time we recorded an interview you were underweight News Corporation. You were right but the timing was wrong. It was a dot-com bubble under way. Do you still keep an eye on it?

Well, I’ve got to say, yeah, I have done over the past few years but now that it’s left the Australian index there’s not much point in looking at in any more. It becomes a very big risk if you’re buying an overseas stock that, frankly, more people are looking at in the US than are looking at in Australia. The coverage by Australian analysts has dropped off dramatically, so I don’t feel that we have quite the upside in being able to track News Corp or I feel that there’s people with more knowledge on it than we have now, so I’d tend to stay away from it.

Well just been talking about your successes in the past couple of years. When you were underweight News Corp, what did you learn from that experience as a funds manager?

One of the big things I think is that tracking error can be important for clients, particularly if you take a big position away from a stock. Now that’s led us to have tracking error limits for our funds. We’ve got a 6% tracking error limit on our funds. A lot of clients now are saying that they want unlimited tracking error or they want those huge positions. I think, though, at the end of the day, if you take those big positions and they go against you, then it just causes a lot of grief so we don’t take those sorts of positions any more.

Is that part of an evolution in what clients want, or is it a symptom of a big bull market where everyone thinks everyone can make a ton of money all the time?

Yeah, I think in a big bull market clients think hedge funds in particular are a pretty easy bet. That they can make a lot of money and that you can take huge positions and get away with it. The problem is, of course, if things do turn down those positions that tended to be the biggest, most volatile ones will be the biggest most volatile ones on the downside as well. So that’s one of the reasons we limit the size of the positions that we take so that we’re not too exposed. We limit ourselves to the less than 5% of the equity in a company. We limit ourselves to a 5% overweight versus the index in a company and then we’ve got limits on the sector weights within the index that we take so that we don’t run any more than 6% tracking error. Now there’s other people that take much bigger bets than that. That will have concentrated portfolios of 20 or 30 stocks and take huge positions on a stock or a sector, and that’s fine for them. That’s the way they manage money. It’s just not something that I feel comfortable with. I think when things go wrong, those sorts of investment strategies can crash and burn.

At this stage of the market running around record highs, are you nervous or you remain confident?

No, I’m nervous of the rise in the market here just at the moment. I think there’s aspects to a bubble in some of the resource stocks, particularly some of the small uranium-type stocks that frankly haven’t got anything until legislation has changed to allow them to mine. There’s also a number of small mining stocks that have land next to somebody else and their prices are booming. It’s the same sort of thing that you saw at the top in the 1969-70 boom. It’s the same sort of thing you saw in the entrepreneurs’ boom. Every boom’s the same. The same as the internet boom. You often get a bubble phase at the end of a boom and I would call it the bubble phase when the rubbishy sort of stocks with absolutely nothing are running and you’re getting that now.

That doesn’t mean that the big stocks are going to crash. The rubbishy stocks probably will have a crash and there will a slow sort of deflating in the big stocks. It’s a deflating in their P/Es I’m talking about. Their earnings may go up while their prices don’t do too much. Or we may get a pull-back. Now this run in resources has been going really for four or five years now. The low was really back in 2000 if you look at the resource stocks relative to the market, and there have been numerous pull-backs over those five years. There was a nasty one in April last year, and January to April the year before. So pull-backs by these stocks is nothing new. Although the way that it’s going at the moment, with a lot of the share prices going vertical and some doubling in the past month, it seems to me you’re getting pretty close to the end and that risks have arisen in the market that aren’t now being priced in.

So any company with uranium in its name and a geologist employed somewhere can do very nicely?

Well it has done very nicely. A little bit like the coal stocks up until six months ago. We had coal stocks in the portfolio that had run from $1 to $7 and they’re back now about $5 or $4.50. Things can get over-priced. The company is still there. It’s a good quality company and there’s a number of good quality companies, but when any tiny little thing goes wrong after a share price run like that, you tend to get a big reaction back down in the share price. It may well be that legislation’s changed and that these uranium companies have a much stronger run. I’m just saying that the risks that are there, I don’t think are being priced at the moment.

How do you see the health of the funds management industry itself? It’s got money pouring into it almost quicker than it can get it out again. Does that make sense to you?

Well funds management’s incredibly healthy. That’s why we’ve got overweight positions in some of the big funds managers like AMP, AXA and so on. There’s pressure on margins for the big commodity-type producers of funds management products but the inflows are so strong that that’s swamped by cost-cutting scale inflows and so on. So I haven’t got any problems there. The Australian stockmarket '” it’s very hard to find value and I think that’s partly because there’s been so much new money coming into our market from super and we’re now seeing people starting to move their Australian equity weightings down and push that money offshore.

Does that make sense to you?

Well yes it probably does at the moment. It’s hard to argue with. I don’t want to hold myself out as an expert in picking world markets, but taking some money off the table probably does make some sense. However, the net amount of money going into the Australian stockmarket is still rising so while the weighting to Australian equities is coming down within portfolios, the net amount of new money coming in is still very strong, and a lot of the stockbrokers are very excited about the Future Fund coming on and another big new amount of money hitting the Australian stockmarket from that.

Is this incarnation the most fun you’ve had in terms of employment?

Well this is great fun. Most of my jobs have been fun, I must say. Even when I was a young kid starting out in my career, I found it good fun but having the flexibility to make the decisions yourself without a big structure around you and the ability to actually say, 'Maybe I’m wrong on a stock', is very important and that’s to the extent that I think a very good fund manager will get about 60% of his calls right and 40% wrong. It’s very hard within a big political organisation to admit that you’re getting 40% of what you’re doing wrong. But if you don’t ever admit that you can’t fix it. You can’t get rid of those stocks that are the mistakes. The flexibility in a smaller group is that everyone’s working towards the same aim and we’re constantly looking for where the mistakes might be and getting rid of them.

So the big managers can only ever hope to slightly beat the index?

Yeah, well the big managers '¦ there may be some survivorship bias in the surveys, but in Australia the big managers generally do beat the index and by enough to more than cover their fees, so you’d have to say the big managers are doing a reasonable job for what they’re trying to do. And what they’re trying to do, I think, is to offer people a balanced diversified portfolio of Australian shares or other asset classes and to add more value than the fees they’re taking out. I think in general they have been doing that. Where I said there may be a survivorship bias is that sometimes if a fund is particularly performing badly in the surveys it gets pulled and a new fund gets put in, so maybe there’s some poor statistics in there but generally when you look at the bulk of the big funds in Australia they’re doing a reasonable job.

How crowded a space are you operating in? How many boutiques are out there jostling for the attention of the big super funds?

Well there’s not that many. There’s probably a handful in the space that we’re in, which is All Ordinaries, big-cap stocks; ASX200, long only funds. We look like a standard big fund manager in terms of our style but we don’t have much by way of funds under management. That’s our niche. There are a number of other boutique managers out there, but they tend to be hedge funds or small company experts. There’s even the odd property expert and so on. We wouldn’t see them as in our space. They generally get different mandates from the major clients and so on. The hedge funds are proliferating, there’s no doubt about that, but they tend to be absolute value type funds '” long/short funds. I mean, there’s as many different hedge fund strategies as there are hedge funds almost, and they go from the very small '” there’s $10 million hedge funds out there '” to billion-dollar hedge funds. But, again, I wouldn’t see them in the space that we’re operating.

Are those hedge funds having much of an impact on the market itself? On the way stocks are traded?

Definitely. The market’s become a lot more volatile because there are hedge funds out there shorting stocks. There are so many hedge fund strategies and overseas hedge funds operating in Australia, and they’re getting information and processing it very quickly. So where 10 years ago you’d get a stock putting out a profit warning perhaps and it would fall gradually maybe over the next six months, now it tends to happen all in the one day because there’s a number of event-driven hedge funds, as they call themselves. When they get a profit downgrade or a piece of bad news they will sell immediately, no questions asked. So the market’s pricing in information probably much quicker than it was before because of the hedge funds.

Is it doing it efficiently or just quickly?

I would say probably just quickly. We’re actually finding some opportunities when stocks get dumped down if you do a bit more in-depth research you can actually buy the stock that day or maybe within a few days later, because it tends to get oversold as everybody jumps on top trying to play the momentum as the thing collapses. Now in some cases it’s well justified, but in other cases we can find some little good value nuggets out there and actually take advantage of the big sell-down in prices. We saw that with some of the medical stocks. ResMed got absolutely slammed a couple of years ago and we did very well out of buying stocks like that.

Some hedge funds pitch as a safety net not being long only when the market slows down. To what extent has the growth '¦ again a symptom of a roaring bull market '” so much money chasing anything?

I think that’s probably right. There is a very big push because people have got very good returns in their funds and there’s a very big push to put more money into hedge funds to an extent I think they feel that with performance strong across the board they can take a few more risks than they otherwise might take in down markets, and members of funds are happy to take that risk on again because returns are so strong. I think that in a falling market people are less willing to take on riskier looking strategies and that, possibly, if we did have a big fall in the market rather than money flooding into absolute return type hedge funds, it may just sit in cash.

Can we have too many hedge funds at some stage or will the market take care of that for us?

I think it’s the capitalist system. I don’t think you can have too many hedge funds. If you do have too many, their costs will be too high. They won’t get the scale, they’ll merge and you’re seeing a little bit of that happening already. The less successful ones drop off quite quickly. The clients pull their funds out very quickly, so there’s a sort of a natural selection process to the whole thing and we’re seeing some little hedge fund incubators out there building hedge funds up. We’re seeing other ones conglomerating under little umbrellas, so it’s like the economy writ small and writ very quick. It’s very fast, capitalist sort of development going on in that sector.