Philip Richards is one of the world's most successful fund managers. His RAB Special Situations Fund has shown a staggering 2,200% increase since January 2003. In a rare interview, he talks to Merryn Somerset Webb
Merryn Somerset Webb: At MoneyWeek we've written a great deal about the bull market in commodities, but not everyone agrees with us that this is a secular bull market rather than a cyclical upturn.
Philip Richards: I think you're right. I believe we are on a globalsupercycle in terms of demand. If you look at the long-term chart of the CRB Index in the US, adjusted for inflation, you can see that. There was a supercycle during the British Industrial Revolution and then a correction in the 1880s. There was another during America's huge period of growth on the chart you can see that there was a long upward cycle that spanned the war, the industrialisation of America, the rise of the consumer society, the spread of motor cars everywhere, etc. Then there was a long sell-off and then another supercycle that coincided with Japanese industrialisation and various other factors. The point is not that they happened, but the fact that they did with such regularity. Since then we've had another nasty supercycle down.
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This has been a particularly long and vicious bear market in commodities, so much so that I get mining analysts and heads of mining companies saying to me that, in the long run, the real price of commodities must always go down. And maybe in the very long run, they will be right technology will go on getting more and more efficient but on a shorter-term view and for investment purposes, it seems clear that we have started another upwards supercycle.
MSW: Thanks to China?
PR: Yes, basically, but it's about more than China. You've got India, Indonesia and Vietnam, and you've got Russia too. All of those places now have growth rates of around 8%. That sounds high, but one thing to note is that it is actually slower than the rate of Japanese growth during the industrialisation of Japan. This suggests that this kind of growth is sustainable, as does the scale of the populations involved. In Japan, we were talking about 150 million people. This time it's more like three billion. To me, this gives the inescapable conclusion that what's happening now in the world is bigger than anything that has happened before on the demand side. It's huge.
MSW: Huge just in terms of the materials needed for basic infrastructure projects?
PR: Yes. The Chinese are building 50,000 miles of motorway three-lane highways for example. That's about the same amount as the entire American Interstate network. They're planning to do this in five years; the Americans did it in 40. Then look at the power problems that China has had. They have to upgrade the national power grid, so you just can't avoid the conclusion that huge amounts of steel and copper are going to continue to be required by the Chinese and that's before you start thinking about the materials needed to build their cars, etc. I also think that it is worth pointingout that the Chinese government is committed to this infrastructure spend. It is all well funded and it will be finished.
MSW: So you don't worry about Chinese growth falling and demand for commodities falling as a result?
PR: I don't really. Last summer there was a period of correction, but we remained convinced that commodities were going to come back. If you look at the copper chart, you can see it was beginning to spike last year. The Chinese definitely helped to push the price down from that level and, arguably, some of the bigger mining companies did as well.
I think it is now the consensus among big mining companies that if they can do anything to stop the smaller mining companies building competing mining projects to take advantage of high prices they will do so, which is another reason why the supply side is likely to remain dangerously tight over the next few years. In the correction this time round, copper came down it just penetrated 3,000 US$/tonne and is now picking up again. I think that when you see these successions of rising lows as the market rides higher, it's normally quite a healthy sign. I don't know of any big new mines coming on stream any time soon, so I'd say there could be an increasing supply deficit. Nickel's not a dissimilar picture. It did actually break through to a new high, has settled back and recently broke to a new high at 16,800 US$/tonne. I guess it will go higher again.
MSW: What about steel? Isn't there now a chance that China could upset the market by becoming a steel exporter?
PR: That's possible. Steel, I'm slightly less sanguine about and we have almost no investments in steel. Copper, zinc and nickel are all much bigger metals for me.
MSW: What about coal?
PR: The portfolio is 10.3% invested in coal. If people are building a lot of new steel capacity (which is why the Chinese can move towards exporting), then demand for iron ore and coal will hold up.
MSW: So your basic point is that commodities are in a supercycle and any slowdown in global growth is not a big concern given the high levels of growth in China, India and Asia, etc?
PR: Yes, but I think the slowdown in growth is useful. Global growth probably hit 5% last year. If it was to slow to 3.5% or 4%, that's still above the long-term trend rate of 3%. Under those circumstances I think commodities would trundle upwards, and trundling upwards is probably more sustainable than having a spike that eventually causes everybody to put the brakes on. As for the recent corrections in the commodities markets, I'd say this is symptomatic of the early stages of a bull market confidence is always fragile at the beginning.
MSW: Does the same go for oil?
PR: Yes. Oil, medium term, could become in very short supply. Demand at the moment is about 85 million barrels a day, and most people forecast that it will hit 125 million barrels a day in the next 15-20 years. I see no way in which that will be met even with this major new oil province in the Falklands. It means oil prices will stay high and alternative fuel will benefit. People will have to switch into alternate fuels such as coal.
MSW: What about nuclear power? You hold some uranium shares, don't you?
PR: Well, we've bought quite a few uranium companies. Nuclear power is a fact and it is growing. You can't get away from it. There are new nuclear power stations being commissioned around the world. The received wisdom until two years ago was that nuclear power stations were steadily going to be closed and that the Russians had enough of a nuclear stockpile to last for the next 100 years. But neither of those things are true any more. There is no Russian nuclear stockpile left and every time a nuclear power station gets old, its owners revamp it and double the capacity while they're at it. It pays not to listen to received wisdom. That's why I started looking at uranium. We have six private uranium companies in our private equity portfolio. That to me is one of the main attractions of the Special Situations fund. We can go into things very early at the private equity stage and buy things at discount prices.
MSW: What percentage of the portfolio is in private-equity-style investments?
PR: It varies, but right now it's 21%. This means that anyone who does invest in our new Special Situations Company (now listed on Aim) gets access to a raft of private equity investments. We have spent two and a bit years building up our private equity portfolio and financing small companies, and we want all investors to have access to that, whether they're a big name, rich client in our Cayman hedge fund or a smaller individual. Note that we tend to get an uplift of four to eight times when we bring our private equity investments to market. All our investors can now hold the same portfolio of stocks and pay the same fees via us. Trying to treat people of whatever size the same is actually quite important to me.
MSW: What are the risk levels in the fund like?
PR: In this fund we do try to reduce risk a bit. In particular, we try and top-slice investments quite regularly if they're going up. Irrespective of how much we like them, we just take some cash off the table. I've been trying to keep the portfolio well diversified, too. Years ago, somebody said to me that it is possible to make a living out of short selling, but you'll only ever make a fortune out of being long in a bull market. That was worth remembering, and it has been true for us. In 2000 and 2001 we made a living out of being short during difficult times, but by definition you can never make a fortune out of it because you can't get the multiplication that you get from the long side. But if you invest in the long position, you can multiply your money many times over.
MSW: You always refer to yourself as a generalist and the fund has no parameters whatsoever, no geographical, no sectorial, no asset-class restrictions. How does this work?
PR: The mandate of the fund is to maximise returns with minimal investment restrictions. But it doesn't mean that I necessarily will look anywhere. My own background is in equities. So I've got a fairly good understanding of not only what makes a company tick, but how to talk to management, how to understand what their dreams and aspirations are, and how to figure out whether they're capable of actually carrying those through. There is often a gap between management dreams and reality. So while the fund is very free ranging and while I am supported by a pretty good team, it is still a fund that plays to my skill sets.
MSW: What financial parameters do you use to judge an investment?
PR: Cash flow is the most important to me. A financial asset has to generate cash flow. One of the problems with the dotcom bubble was that the dotcom companies did not. A lot of the outperformance of the fund also comes from negotiating good entry prices. There's a City saying that states there are two prices in any transaction: the price at which you buy and the price at which you sell, but the only price which you control is the price at which you buy. So we concentrate a lot on how deeply discounted our buying price can be.
Look at Asia Energy, for example. We came across this when it was an ex-BHP exploration project, but BHP had put a line through its exploration portfolio and so this was picked up for free. We bought in at 15p a share, but when it came to market it was 75p, so we had a five times mark-up there. Then we put more money in and it has just gone up and up. We've made 60 times our money from the beginning, but we have sold slices of our holding along the way. I would have thought it still represents reasonably good value, particularly as there is a lot of good news to come from the company. Nice little things are falling into place. Its cost of production should end up at about $12 a ton, and it looks as if it has about a billion tons of coal. A billion tons of coal is a big global resource, and at $12 a ton it is way down the global cost curve. There are producers in the US producing at $40 a ton.
MSW: Any other financial measures you pay particular attention to?
PR: Well, I look at asset value on the ground. I like to think that most of the stocks I'm in, if they're not cash flowing now, will cash flow within a two- to three-year view, but there are parts of the portfolio where I have invested just because the firm has a global resource of a sufficient size, that it's worth being there just for the asset value of that resource. Take Celtic Resources. When I invested in Celtic, I was buying gold in the ground at $3 an ounce. When I sold it was for about $10 or $11 an ounce. So I will buy some companies very cheaply on contained metal value. That's the reason I'm keen on Galahad Gold. It's not going to be cash flowing for some time, but there are very large assets within a politically safe environment.
MSW: You hold quite a lot of gold. Are you very bullish on the gold price?
PR: I like to hold companies that I think are still cheap as companies, so I won't hold gold companies just for a kind of optionality on the rising gold price. That said, if you look at the chart of the gold price, it looks like it is in a steady up drift, rising about $50 a year, and I think that will be maintained thanks to the rise in the printing of paper money around the world and increasing wealth in India, as well as other factors. I'm not looking for gold to hit $1,000, though of course I'd be happy if it did.
MSW: Any other favourite gold companies?
PR: Oxus Gold is interesting. If you really want to be in a company with a very low multiple of cash flow, as well as one that has a globally important resource and a low cost of production, then you're probably going to have to give on something else. For me, it means being prepared to be in a country that is not everybody else's first choice for investment.
Hence, being in Asia Energy (whose operations are in Bangladesh) andOxus, which has its mines in Uzbekistan. Oxus reputedly has about 60 million ounces of gold in Uzbekistan. That's never been properly documented, but it does have a very rich area there. It is also producing it at $140 an ounce, so with the gold price well over $400 it means its cash flow is great. Yes, it isin Uzbekistan and in Kyrgistan, but how much risk is there really? Nationalisation is no longer really in vogue anywhere, and most governments understand the value of having well-managed companies in their countries that pay their taxes and state royalties. (Most gold mines pay royalties regularly.) The odds are stacked against misappropriation. Also Oxus's management tells me that it has $100m worth of political risk insurance which would pay out if it was expropriated. The fact that it can afford that sort of insurance probably means the insurers aren't that worried. Otherwise, the premium would be too high MSW: You're a big holder of Falkland Oil and Gas. Can you tell us something about that?
PR: I think this is the only stock I have in the portfolio that I think in the longer term could still make people a return along the lines of 60, 70, 80 times their money. I think you might make three times your money if you bought Asia Energy now, but that's not the same. The latest reports from Falkland suggest that there might be recoverable reserves of 8-24 billion barrels. With oil at about $40, the net present value of a barrel of oil is about $8. At $25 it's about $2 and at $50 it's about $10. This means that the oil is worth $80bn to $240bn. Yet right now the company has a market value of about $120m. So the upside is huge, more than enough to justify the downside risk.
MSW: How much of the company do you hold PR: We had about 45% in the beginning and now hold 30%. It's rare for us not to top-slice more, but we just think the upside from here is still about as good as Asia Energy was right at the beginning, so why sell any? It's not that often you get chances for multiple returns like this. Even Oxus Gold is never going to be 20 times where it is now. Two or three times maybe.
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