You launched your fund – then called the Plato Global Net Zero Hedge Fund – in January of last year. How is it performing?

We launched the fund right before Russia invaded Ukraine, and energy prices went through the roof, and that’s provided a bit of a headwind for the fund. But because the climate aspect of the fund is not the principal driver, we’ve still performed very well. After fees, we’ve outperformed the MSCI World index by 8.5% and before fees, we’ve outperformed the index by well over 10%.

How does that compare to your peers?

In the Morningstar large cap universe, which we’re in, there are about 200 funds. Our performance is the sixth best out of those 200 funds. As you’d know, funds that are dedicated to the climate thematic have underperformed really significantly over the past 12 months because they have a huge growth bias. Relative to them, we’ve done even better.

A lot of investors also look at the up-market and down-market capture ratio. Our up-market capture is about 1.25, so when markets are up, we tend to be up more than the market. Our down-market capture is about 0.8, which means that when the market is down, we’re down less than the market again. So, we’re definitely off to a good start.

You recently changed the name of your fund to the Plato Global Alpha Fund. What was behind the name change?

We did it because the main thrust of what we’re trying to do is to generate Alpha [excess returns earned on an investment above the benchmark return] for our investors. The fund’s original name was giving people the impression that it was a grand thematic fund focused purely on the transition to net zero. This was misstep by us. The way the fund has performed, in an environment which has been outright hostile to low carbon names, supports the argument that this isn’t the primary driver of our returns.

That said, we are conscious of investing in a way that doesn’t screw the planet. We tend to short companies that are the most egregious polluters. Instead of taking the traditional approach of divesting or avoiding these companies, we’d prefer to take a short position. This is an active approach to agitating for change because it gives you a seat at the table.

It’s been a shaky start to the year on equity markets. What’s your outlook for the rest of the year?

We’re just over halfway through the US reporting season and it’s been surprisingly strong. Fifty-five per cent of US companies have reported. Of those, almost 80 per cent have beaten expectations on revenue, and about 75 per cent have beaten on earnings. Before that, the consensus was that US earnings for the year would shrink by 5.5%, but that’s now been revised to 2.5%.

I guess the key question is how long companies can remain resilient as interest rates go higher because, in my view, rates still have further to go. If you look at inflation, parts of the market, like energy and food, have come down, but the remaining sectors have been very rigid. It’s going to be a lot more difficult than people expected to get inflation back below the Fed’s stated target of 2%.

Unless the Fed abandons this target – which would be a huge step – we’re going to need interest rates to be well above where they are now. Core inflation is still running at 4-5%, which is a long way from 2%.  Will interest rates of 6% interest rates get us to the target? I don’t know, but I do think the Fed is going to keep raising rates until something breaks. This bodes poorly for growth companies that are reliant on interest rates out into the future.

In terms of how this relates to the Australian outlook, you’ve got to remember that we’ve just emerged from a period of incredibly low interest rates and incredible liquidity. That has created asset bubbles. The number of so-called “zombie companies” is near record levels in Australia and the US. These are companies that earn just enough money to service their debts, but can’t pay off their debt. Naturally, as interest rates get up to more difficult levels, these companies are coming unstuck. As a result, most of the Alpha we’ve generated recently has been on the short side. At Plato, we have a “red flag” system that helps us identify companies to short or just avoid. Looking at what this system is spotting, I think this is going to be a once-in-a-generation opportunity for active managers. If you take a passive, index-like approach and own everything, you could be in for trouble. There are a lot of companies out there that you definitely don’t want to be in!

Are there any particular concerns or themes emerging from the US reporting season?

Not really – apart from the obvious concerns around inflation and interest rates, where you’re seeing a bit of margin compression. But at this stage, both consumers and corporates are looking pretty healthy. We have people jumping up and down about interest rates of 4-5 per cent, but that’s in line with long term averages. We’ve become a generation of investors who are conditioned to free money, with 0 per cent interest rates. But really, companies should be able to cope with the current level of interest rates. If they can’t, you’ve got to question their business model.

You say you are generating most of your Alpha on the short side, how unusual is that?

I’ve been running long-short strategies since 2007. On average, we generate a similar amount on the long side to the short side, but in particular environments, it can be skewed one way or the other. This is definitely one of those environments; it’s been very favourable to the short side. I think that speaks to the fact that so many companies which have never made a profit and probably will never make a profit have had such a good run on the market in recent years. Now they are coming under pressure as investors run out of patience and realise that, in a world where money is not free, it’s going to be a lot more difficult for them.

Can you tell me about some of your short positions?

There’s a Queensland company, Brainchip (ASX: BRN), which has been a darling of the retail crowd. It has 22 red flags on Plato’s Red Flag system, which makes it the company with the second highest number of red flags out of the 10,000 companies we look at globally. Brainchip is supposedly using machine learning to make semiconductors more efficient, which sounds pretty impressive, and it has been massively pumped up by retail investors. A few months ago, it had a market cap of $2.5 billion, on less revenue than some cafes have! Before I invest, I want the company to prove to me that they can do it; I’m not one to dive in and take a leap of faith.

Another name domestically that has 10 red flags is Weebit Nano (ASX: WBT). There is so much hype and speculation around the company. It has a market cap of $1.2 billion with zero revenue.

I’m also short on Lendlease (ASX: LLC). There is a good argument that commercial real estate in general is the next big short. COVID has changed working patterns, perhaps forever, leading to many stranded assets. On top of that, Lendlease’s cumulative free cashflow is negative since 2009, which is remarkable in an incredibly supportive environment of record low interest rates and property appreciation. And the company also has low interest cover and high offshore debt.

What about your long positions?

I like BMW (ETR: BMW). It just seems crazy to me that an incredible, storied brand like that is trading at 6.5 times FY23 earnings. It has seen a 35% growth in electric vehicles, which is similar to Tesla, and yet Tesla is trading on a multiple of 50 times earnings, despite having a lot of red flags! Plus, BMW has a massive order backlog from pent up demand. Supply chains have healed and this revenue is now being unlocked.

I also really like Novo Nordisk (NYSE: NVO), which is one of the largest pharmaceutical companies in the world that no one has heard of. It’s at the forefront of anti-obesity drugs, which may be the blockbuster story of the next decade, just like immune oncology drugs were on the last. Obesity – which is associated with 200 comorbidities – has tripled since 1975 and has reached epidemic proportions. Novo Nordisk has 80-90% market share in this area, with several drugs in Phase III trials.

Finally, there’s ASML (NASDAQ: ASML), which is a Dutch semiconductor equipment company. We’re predicting it will be an eventual winner in the AI [artificial intelligence] race, which of course is fraught with uncertainty. ASML has 88% market share in the deep ultraviolet lithography machines that are used to make the advanced chips used in all AI. It has annual sales of 20 billion euros, with an order backlog of 40 billion euros. It has also doubled revenue and EBIT [earnings before interest and tax] over the past three years and has a 75% return on equity.

You clearly rely heavily on your “Red Flag” system, so can you tell me how it came about?

The idea came about back in 2014, when I was working at JP Morgan in London. I had invested in a Spanish public Wi-Fi company, Let’s Gowex, and it had been an incredible investment. The stock had gone up 40-fold and we were all patting ourselves on the back , thinking that we were geniuses. Then the Spanish Prime Minister came out and praised the company as the leading light in the European economy, and it was like the kiss of death. A couple of weeks later, they uncovered a huge accounting fraud, the CEO was indicted, and the stock price went to zero.

That was obviously a very painful experience, but we said, “Okay, well let’s make damn sure we don’t make the same mistake twice.” So, we did a post mortem and found we’d missed some pretty basic stuff. The first was that Let’s Gowex used an auditor that no one else was using and paying that auditor a very unusual amount. Being evidence-based investors, we decided to get 10 years of data across 10 countries and identify every instance where a company was using an obscure auditor. What we found is that, on average, you want to stay away from those names. It seems to be that, in almost every corporate scandal that comes out, this “red flag” is present. For example, with Adani (NSE: ADANIENT), they were using an auditor that was very junior and not used to dealing with complex companies. At FTX, they were using auditors that weren’t really of the scale that was required.

We then thought, “Ok, that’s one red flag we should be aware of every time we invest, but what are the other red flags that we are potentially missing?”  So, we got our hands on every corporate fraud, bankruptcy or downfall that we could and built up this system of red flags. These include related party transactions, special purpose vehicles, remuneration structures where shareholder value isn’t aligned with fundamentals and so on. We now have 126 red flags and we apply them to all 10,000 companies that we look at globally.

Had you shorted Volkswagen?

No, we hadn’t and I’ll explain why. Sometimes, you can initiate a short because a company has a high number of red flags, but sentiment is against you and the stock price can double or triple before things go wrong. It’s no good being right too early. We will almost always wait until the sentiment starts to turn and that stops us bleeding Alpha in the interim. So, we might miss out on the initial big pop, but that’s well compensated for by not suffering in the initial stages. That’s why, with Volkswagen, we didn’t take a short position early on.

Is there a hierarchy of red flags? Are some worse than others?

Yes, one of the questions clients ask all the time is which red flag is the most worrisome. While all our red flags are linked with poor future stock price performance, I’d say the most potent one is negative operating cashflow. And what’s particularly worrying is that Australia currently has a higher proportion of companies with negative operating cashflow than any other country in the MSCI World index. Some 28 per cent of our companies have had negative operating cashflow over the preceding 12 months.

Another red flag that is particularly worrying comes out of the forensic accounting literature. It’s called Benford’s law and it can be used to identify fraud. Benford’s law states that the leading digits in a collection of data sets are probably going to be small. For example, about 30 per cent of numbers in a set will have a leading digit of 1, when you’d expect the probability to be around 11 per cent (or one out of nine digits). If you think of a set of financial accounts, you’ve got the P&L statement, the balance sheet and the cash flow statement and, combined, they contain about 300 different line items. Ordinarily, you’d expect the accounts to contain a jumble of random numbers, but what you should find is that around 30 per cent of the numbers start with a 1, and only around 3.5 per cent start with a 9. It’s weird but this is an incredibly reliable test. If you look at a big, well-regulated company like Apple, its accounts look exactly like that. We have taken five years’ worth of P&L, cash flow and balance sheet statements from all 10,000 companies we look at and applied this test to them. If the numbers don’t follow this pattern, that’s a big red flag. Enron is a classic example where the numbers were all over the place.

What about ESG? How does that fit into your “red flag” screening process?

One of Plato’s great strengths is our ability to analyse different sets of information and to work out whether it contains any predictive power for stock returns. In recent years, there’s been an avalanche of ESG data sets and we’ve gone through every one we could get our hands on and tried to sort the signal from the noise. You know, what are the ESG factors that are associated with Alpha or outperformance?

While most factors aren’t that useful in terms of predicting whether a stock is going to outperform or underperform, there are certain subsets of the data that are actually pretty effective. One example is carbon intensity, or the amount of carbon dioxide that a company is producing relative to the amount of revenue it is generating.  So, if you have two electrical utilities and one is doing its best to minimise its carbon footprint, and the other one just doesn’t care, it’s likely that the one working harder to be more efficient and cleaner will outperform. There is definitely some Alpha to be found in some of the ESG factors.

With regard to your long-short positions, what’s your overall net exposure?

A lot of people think that because we short, we’re trying to do something that’s uncorrelated with the market. But because our investment strategy tends to be 150% long and 50% short, that gives us a net exposure of 100%. The advantage in that is that Australian investors want beta, which means they want exposure to equity markets. This strategy gives that to them, but it has this “satellite” gift of an additional 50% long and 50% short, which acts like a mini hedge fund to help drive Alpha. It’s a way of supercharging the returns that you can generate.

What are the two key lessons you’ve learned over your time in the market?

The first is to always make sure that you live to fight another day. I hate to quote sayings that have been said a million times, but the market can stay irrational longer than you can stay solvent. So, believing that you are always right, and everyone else is wrong, is very dangerous. You need to be humble and willing to constantly re-examine your investments. Ask yourself if there is anything you’ve missed or whether you need to take risk off the table in a particular environment.

The other key lesson is the one Buffett articulated when he said, “The first rule of an investment is don’t lose money. And the second rule of an investment is don’t forget the first rule.” The red flag system is all about that. If you can just remove the landmines from your portfolio, it’s amazing how well you can do.  We try to take things a step further by not only taking out the landmines, but also going short on them. That said, at Plato, we’re pretty conservative by nature. By just making sure that we’re not investing in companies that have a meaningful probability of blowing up, we sleep better at night.

We’re obviously very grateful that you manage money pro bono for Future Generation. Why do you do it?

I love ideas that bring the for-profit and not-for-profit sectors together. The for-profit sector is absolutely critical if we’re going to provide funding for the incredible programs run by not-for-profits. I was just down in Hobart for the Future Generation investor roadshow and I got to hear about what Big hART [one of Future Generation Global’s  new social impact partners] is doing – and it’s just so inspiring.

I’m president of a rugby club and I probably spend 15 hours a week involved in that. It’s about rugby, sure, but it’s more about the beating hub of the community. The club brings everyone together, from young to old, and that’s so important, especially after COVID where we lost a lot of connectedness. Programs like the ones Big hART runs are right up that alley, bringing people together, finding out the aptitudes of young people and then nurturing them. These types of community programs are important to me and it’s an honour to be involved in Future Generation, which promotes them.

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