A Very Special Situation

Laurence Davison talks to RAB Capital's Philip Richards

Laurence Davison
Originally published in the February/March 2006 issue

With the global hedge fund market following a trend towards more risk averse, volatility controlled strategies, the returns of RAB Capital's Special Situations Fund stick out like a sore thumb. Established in January 2003, the firm has returned over 200% compounded per year since launch. Even the fund's portfolio manager, RAB Capital founder Philip Richards, admits that it is not possible to fully manage the volatility, making possible such figures as a gain of nearly 1,500% in the fund's first year and 17.5% in January 2006. According to Richards, Special Situations continues to target annual returns of 50-60%.

With the fund set to close, as The Hedge Fund Journal can reveal, with an approximate $1bn of assets under management by the end of April, the manager was persuaded to give a rare interview about Special Situations.

One thing investors need not concern themselves with, however, is the possibility that Richards will get caught up in the side issues of being a star fund manager, including press interviews. A scant 20 minutes into a scheduled one hour discussion with The Hedge Fund Journal the manager cuts it short due to the weight of calls stacking up. After being persuaded to answer a couple more questions, Richards is gone, leaving one to piece together the story of his spectacular fund from the evidence available.

After an early focus on biopharma stocks, Special Situations refocused to specialise in commodity stocks during 2003, and has made most of its returns from them. Its particular speciality is in early stage mining and energy stocks, many of which it takes very large percentage holdings in, including a number of private equity type investments leading up to listing.

Richards insists that the process of finding and analysing potential investments in the commodity universe is fundamentally no different from any other sector. "I am a generalist by background, although we have a number of specialists within our team," he says. "We do a lot of due diligence and write pretty tight contracts: I've got five lawyers now working full time on the team which is fairly extraordinary. I would challenge you to find any fund management group where, on a single fund, you've got five lawyers working. I find it quite extraordinary myself to be honest."

Large team

He does add, though, that the fund's team also includes three senior natural resources analysts, and draws a comparison between the current focus and the previous investment approach. He says, "We made a lot of money for a while in biopharma, which is another area rather like natural resources where you have to put a lot of time and resources in up front but you can have huge returns coming out the back end. There is a similarity, funnily enough, between natural resources and biopharma."

Despite the size of the team involved, which Richards counts at 16 solely on legal, trading and analytics plus the support of many of RAB's 90 total headcount, the fund manager explains that he is the sole decision maker. For this reason a research report by ABN Amro – a market maker for Special Situations' London Stock Exchange Alternative Investment Market ETF listing – warns that the fund's continuing performance is "highly dependent on Philip Richards as investment manager".

Not that he shows any sign of leaving. His focus on managing the fund is absolute, as he explains: "I want to focus 100% on making high returns for shareholders and I'm not going to be spending a lot of time marketing." This suggests that after the fund closes the outside world should not expect to hear a lot of noise from Richards, although he concedes that the need potentially to replace redemptions does mean that he "wouldn't say we'll never talk to anyone again".

Increased holdings

Another area of caution, according to the ABN Amro report, is that the off-the-charts returns of the first year are unlikely to be seen again.

As it explains, "Until October 2003 the fund had less than $100m of assets, meaning that the winners had a disproportionate impact on the NAV. While the now enlarged size of the fund should mean that it can commit more capital to… deals, and thus negotiate more advantageous terms, the portfolio is far more diversified and so the outsized returns of 2003 should not be repeatable."

This is especially relevant because of the very large number of positions held in Special Situations: around 400 according to Richards. He points out that this means there is very little stock-specific risk at the portfolio level – "you can have something blow up if you like and it doesn't actually make a huge amount of difference" – but also acknowledges that this restricts capacity to the $level and means that there is a lot of work involved in monitoring positions. Once again, this adds to the labour intensiveness of the whole process and is no doubt part of the reason for the fund's relatively high 220% fee structure.

Richards points out, though, that the number and seniority of people in the team, combined with his investment approach, allows Special Situations to make gains above what would be possible in a simple buy high, sell low strategy. "I think that the way you structure things and negotiate your entry point is extremely important, on top of the analysis," he argues.

Trading edge

Asked to explain, he gives the following example: "If the market price [of a stock] is 10, and your analysis for whatever reason says it should go to 20, if you buy that in the market you'll probably end up paying 12 for it and making under 100%…. If on the other hand you can do a serious piece of corporate finance work and go in and finance that company, take a big stake, you might pay say seven for it and you get a raft of warrants alongside that seven as well. Then if the same thing goes to 20, the unit that you've created, including the warrant, is now worth 33. So you've enhanced your return from just under 100% to around 400%.

"The actual micro detail, in terms of the negotiation we get into, is very much driven by me. I would say that the returns are dictated more particularly by how cheaply you can buy. You'll notice that the analysis alone only made you 80% in that very simple example, but having renegotiated everything you make 400%. Most return comes from the way you negotiate."

Nonetheless, to maintain high returns in a fund that does not use, for example, derivatives to hedge currency or commodity risk, Richards' stock picking must be largely correct. He claims that extensive due diligence is the main aid to this, giving the example of an investment in Asia Energy where RAB's lawyers were on the ground in Bangladesh going over the details of contracts.

He also points out that the fund is actively traded, saying, "We've made people 33 times their money from original entry but we are not sitting on a bunch of stocks that are up 33 times. Most of the [original holdings] have been sold and we've got new things in – we do take profits. It's not just a puff in the market where things have gone up a lot." Quantifying this, he says that the average turnover within the fund is around 50% a year, which he somewhat disingenuously claims means that it is entirely renewed every two years.

Relatively heavy trading in smaller stocks must raise questions about the level of liquidity available in the numerous holdings, but Richards insists that this is "variable rather than really bad". He says that as a manager in this universe one has to be prepared to buy when there is bad news surrounding a stock and its owners are desperate to sell, and to be pragmatic about one's exit strategy – being ready to sell up if there is sufficient interest "at any point".

Buy and hold

For this reason Richards is keen to stress that Special Situations should only be viewed as a long term holding. He explains that his investment view on any given investment falls into the three to five year range, and although he says he has generally seen returns within two he counsels that investors should take the same stance as he does.

"I think one has to be frank about volatility because obviously it will be there. Having said that, I think the returns have far outweighed the volatility and I think that will continue to be the case. But I don't want to encourage people in who might have a problem if we go through a very bad period at a later date…. People should only invest on a 3-5 year view along with me: if someone just put money with me for six months I just cannot guarantee that it won't be a bad six months."

This is why he believes that the AIM listing – becoming the first UK single strategy, single manager hedge fund to take an ETF listing – is an excellent fit for Special Situations. "It's a closed ended fund, a pooled vehicle where people can't pull their money out, and that's a perfect vehicle. That's exactly what it should be – when people say this fund is not for the faint hearted I'd say it's more not for the short-term minded. Therefore people have got to buy into something that has permanent capital committed, and this has got permanent capital."

Bull run

Of course, to make that kind of long term, closed ended commitment potential, investors must be convinced that Special Situations will continue to be able to pick good stocks, invest in them at good prices, and take profits when possible. But, perhaps even more importantly, they must also believe that this massively long-biased fund will continue to benefit from a commodities bull market. While the past couple of years have seen increased interest and rising prices across commodity markets, this came on the back of a 20-year bear run. If the boom fizzles out, Special Situations would have to refocus or fall.

Richards, of course, is confident that the market has more growth to come – a belief in which he is not alone. "I would say commodities and natural resources in general have always gone in long waves in history," he argues. "There are 20 or 30 good years followed by 20 or 30 bad years. Periods of industrialisation and urbanisation are what drive commodities, and we are seeing the biggest industrialisation and urbanisation wave ever in history at a time when the supply side of commodities has been neglected for 20 or 30 years. There was a real bear market for the last 30 years and that means that no-one spent any money on exploration, particularly in metals. Everyone focuses on oil but metals in particular are running out. In general over the next 15-20 years you are going to see stronger prices in everything from metals through to energy."

On specifics, he says, "In the short term I think metals will probably do better than energy over the next couple of years, after that I think energy will probably move sharply ahead again. I would also caveat that by saying there will be sharp corrections along the way – in any bull market move you have sharp corrections. [But] we're investing in exceptionally cheap situations that have really been left behind by that 30 year bear market. At the bottom end of the market there is a lot of stuff that no-one has really looked at."

With investors increasingly looking for volatility management and diversification even in their single manager funds, there is less and less space for the high risk, high return strategy. Richards will need to keep being right about stock selection, trading strategy and growth in the underlying market for Special Situations to keep up its stellar performance.

Laurence Davison is the editor of FOW