Doug Barnett, President, has 14 years' of experience in the investment banking and fund management business, specialising in the Thai stock market. The Thai Focused Equity Fund is a long/short Asian equities fund, with a strong long bias and a bottom-up value approach.
Interview with Doug Barnett
- What are your risk management measures?
The biggest risk for us is illiquidity in the market. To control this risk, we look at the lowest liquidity month in the last 12 months for each investment. We then take one third of that volume as the maximum amount of liquidity that we can count on. Anything that we own above that liquidity limit, we put into our illiquid bucket and make sure that the illiquid bucket is no more than 40% to 50% of our portfolio so that we can always meet our promised one-month liquidity; we assume that no more than 50% of our investors will redeem at the same time.
We also control drawdown risk on 2 different levels. First, if an individual stock in our portfolio drops 20% below its high water mark (the highest price since we bought the stock), we would examine the situation (buy more or cut our losses). Second, we control drawdowns on the portfolio level by looking at the current gross NAV compared with the high water mark on gross NAV. For instance, if the current NAV drops 10% below its high water mark, we would raise cash in our portfolio to 15%; if it drops 15% below its high water mark, we would raise 30% cash and short our available short stocks. If gross NAV dropped 20% below its high water mark, we would raise 40% to 60% cash. We would then be quite defensive and would wait for another good entry price.
We also hedge currency to counter currency risk.
As a result of these measures, we have downside risk of only 16.7% versus SET index downside risk of 27.2%. To put this in perspective, the S&P downside risk is 12.5% and the NASDAQ is 23.2%.
While we have risk similar to developed markets, our return has been much higher. Since April 1990, we are up 1499% vs 359% for the Nasdaq, 216% for the S&P500, and -51% for the SET Index.
- Where do you see the greatest risk to your performance?
Having a concentrated portfolio. If we chose our stocks poorly, that would have a big impact on our portfolio. However, we minimise this risk of taking concentrated positions by doing in-depth research on the few stocks that we have, and developing very close working relationships with those company's management teams. We are also on the Board of Directors for a couple of our large positions, so we generally have better information on those companies than the rest of the market.
- What themes for both the long and short books do you find interesting right now?
First, the short book is only about 2% of the portfolio and right now we do not have any shorts on because we think the market is going up.
We have not had large short positions because previously, it was illegal to short in Thailand. Now it can be done, but the terms on which you can borrow are 1-day call. Lenders do not offer term borrowing in Thailand. Even international brokers lending Thai stocks want 1-day call on the short stocks. This is a problem because the size that you can reasonably short is based on volume traded on the most illiquid day in that stock over the previous year. If you short more than that, you are taking the risk of not be able to cover your short positions in time to meet your call. There are 30 Thai stocks that are shortable and the liquidity in those 30 names is not that great. Therefore, shorting has never been a major part of our activity in Thailand. When we short, we do it as a directional short; when we think that the market is overbought, sentiment is deteriorating or volume is going down. We are never market neutral, and we seldom run hedged positions.
On the long side, the biggest theme over the last couple of years has been the emergent domestic consumer economy. This began in late 2000 when the world economy was slowing down and rolling over. Thailand is an export-driven country and at that time, the Prime Minister's idea was to stimulate the economy and to pick up the slack where the exports had been driving in the past.
There was plenty of idle liquidity available because for the last 40 years, Thais have been over-saving. The economy was also stimulated by cutting interest rates from 10% to 1% and by the removal of taxes for buying real estate. The reason that the government decided to stimulate the real estate sector was that there is a big multiplier effect in the economy as people spend more money to decorate, furnish and maintain their new houses. The real estate sector was the first sector to recover, and property stocks initially led the market higher. Not only could investors benefit from high earnings growth, but p/e multiples also expanded as interest rates dropped.
The initial surge in real estate was followed by improved earnings for the mass market retailers, steady increases in the purchasing of cars and motorcycles and a big surge in personal finance, including mortgages, credit cards and personal loans. We initially invested in the property developers, but the big gains in this sector have made it more speculative. Now the only way to make big gains is to invest in the marginal, recently restructured players where the quality of the companies is very substandard.
However, we see good opportunities in consumer finance, shipping, telecommunications, and a number of cyclical companies in the chemicals, cement, steel, paper and brokerage businesses. And we get that free embedded option of the export sector as the rest of the world comes back online.
Even with our portfolio up 115.8% and the SET Index up 94.1% for the year, we are not worried. The SET Index is currently valued at a PER of only 10x forward earnings, with projected earnings growth of nearly 20%. Meanwhile, our core portfolio is currently valued at a PER of 9.8x forward earnings, but with expected 2004 earnings growth of over 88%. The SET Index has historically traded between 12 and 20x PER, and speculative markets have driven it as high as 35x, so we still see significant upside.
- We note from your template that you are not averse to the use of derivatives and leverage. Can you explain in more detail?
Yes, we only borrow money to get over 1 or 2 day shortfalls; 1-2% maximum. The volatility of the underlying market is pretty high, therefore, we do not need to leverage our returns beyond that.
In terms of derivatives, we definitely like them as there are lots of different things that we do. For instance, we look at premium or discounts on warrants. Often, it is cheaper to buy the warrants as compared to stocks and that is what we are doing currently. Also, when a stock has had a big run and the warrant is deep in the money, we can take some of our invested capital off the table by switching out of the stock and into warrants. This increases leverage and reduces the total money at risk because that money goes into cash. It allows us to maintain exposure in the stock without tying up so much money. Warrants are always less than 5-10% of our portfolio; most of our returns come from selecting cheap stocks and riding them up over the long term. We also do index swaps, buy and write over-the-counter options as a way of protecting our positions.
- In the event of a general market rally, how much would you generally increase in the number of derivative products that you are using?
We would do so if we could find attractively priced options. Generally, if there is a big surge in the market, the volatility goes up, and the price of the option goes up as well. We would generally want to buy options when volatility and sentiments are low and sell them when people get excited.
- For a firm focusing on fundamental research-driven stock selection, is it necessary to run a small fund in order to remain flexible? How big will you allow yourselves to grow to?
We have just changed the liquidity terms in our funds. Up to $150 million, it has been reasonable to have a 1-month notice period for people to redeem. Now, however, as we are now at above $210 million, we must make liquidity terms more restrictive. For assets between $150 to $250 million, the notice period is now 3 months. If we grow to between $250 and $400 million, the reasonable notice period would be 6 months.
Longer notice periods allow us to take even deeper positions in our favourite stocks while controlling our liquidity risk.
- Where are you currently situating the fund to make profits over the winter months?
Since we have very few but big positions, we do not typically position over the short term; we are thinking more of the next 2 to 5 years. The current market environment for equities is very good because we have falling interest rates, good US GDP figures and Japan's recovery from economic depression. It is very likely in the next year that we will see Thailand's export sector getting its pricing power back. Over the last 3 years, manufacturers were running increasingly high capacity utilisation but at the same time, they had very little pricing power; most were running slightly better than breakeven. As the world economy gets going again, Thai exporters start getting their pricing power back, which will make them very profitable. They have tremendous operating leverage to small increases in prices.
The drop in interest rates will continue to influence domestic fixed income investors to take money out of the bank (1% deposit rates) and invest in the stock market where the yield is much higher (6% current yields).
- How would you characterise your investment style and what is your edge?
Our investment style is bottom-up driven. We are looking for cheap stocks which have low P/E, low enterprise values to cash flows and/or have big discounts to our estimate of their liquidation value. We also like stocks which have high earnings growth.
Since we are the largest or the second largest shareholders in the companies that we invest in, we have better access to management than the average investor. Even in companies where we are not on the board of directors, we have a very close working relationship with the management team; participating in the direction of growth.
- What have been the most difficult aspects in running your own hedge fund?
Previously, I was running a family office doing very much the same as what I am doing now. The most difficult aspect was finding investors who were really interested to invest in Thailand. I started off by doing personal direct selling, reading up to find people who might be interested. However, we found this to be very unproductive. Basically, we want to find people who were already interested to invest in Thailand and are looking for the best way to invest. Now, we use third party marketers who already have the relationship with clients. Through them, we can screen out the potential investors. We can also increase investor awareness of our service more efficiently through conferences and in publications.
- Do you have any opinions on or plans to diversify into China market?
We are aware of what is going on but are not experts in markets other than Thailand. Although China is growing and attracting a lot of the available investment dollars, there are certain factors which make Thailand competitive too.
For example, the tourism sector. Every year for the past 35 years, there has been an increase in the number of tourists to Thailand because tourists get excellent value for dollar, good quality and excellent service. This offers a great value of proposition for tourists, which produces a lot of repeat business. The largest tourist group in Thailand is now the Chinese as they now have enough money to travel. Since Thailand is close to them and is similar to Southern China, they get a great deal. The biggest increase in Thailand's exports has also been to China, which is buying not only raw materials but also value-added finished goods for consumption by the domestic Chinese.
After Tiananmen Square and SARS, people are reluctant to place all their eggs in the China basket even though the huge domestic market is very attractive. Direct investors find that, as an alternative source to China, Thailand is very attractive.
Quest Management Inc
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