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First State Stewart

First State Stewart – The Hardest Thing To Do, Is To Do Nothing

First State Stewart Asia Indian Equities semi annual report for August, 2015 titled, “The hardest thing to do, is to do nothing.”

This is the third semi-annual update on the First State Regional India Fund. Our aim is to provide a general update on some of our current thoughts and views, insights about existing holdings and changes to the portfolio over the period. We would appreciate your feedback.

First State Stewart

First State Stewart

First State Stewart Asia Indian Equities – The hardest thing to do, is to do nothing

As a team, our anchor investment principle is that of capital preservation. We therefore spend a lot of time thinking about what could go wrong with our portfolios. As in life, in investing, it is more important to know what not to do than what to do. We therefore do not spend our time pouring over excel spreadsheets, navigating complex models and trying to predict the smallest of incremental movements to the ‘numbers’. We are equally disinterested in the noise of the market; we don’t react to every piece of news and won’t be found staring at a Bloomberg screen all day (they are kept as far away from our desks as possible). We accept that we are not good at that. Instead, we spend a lot of time thinking about the history of the businesses we own, the moats they have, the people involved and the changes therein. All of which tend to provide far more useful insights about the risks that we face as long-term minority shareholders.

In the previous update, we discussed generational change and stewardship. To elaborate further on our investment philosophy, we thought it would be useful to provide a few examples of companies we have decided not to invest with – regardless of how attractive the growth prospects or the valuations might be. In our minds, the value of these businesses is zero. As a team, we realise that there are grey areas and that a rational judgement as opposed to relying on a simple checklist is needed. Debate and questioning around these decisions often form the core of our weekly team meetings. We outline in the rest of this note the traits of companies that we will confidently do nothing with.

Poor owners – Family, (some) MNCs or the Government

We once heard an anecdote about a finance executive from a large international spirits company who was performing a due diligence check on the largest Indian spirits company. Upon digging through seven levels of subsidiary companies registered in tax havens, he finally discovered that the mysterious asset on the books was the Chairman’s superyacht!

Some owners, such as the above in India, don’t seem to understand the difference between their personal wealth and that of a publicly-listed company. Whilst not unscrupulous, our meeting with the owners of a South India-based cement manufacturer about a year ago suggested they were pushing the limits of related party transactions – the promoter (also the Chairman and Managing Director) was then the 8th highest paid individual in the country, taking 5% of the EBIT (the legal maximum allowed) whilst the company was donating another sizeable portion of its profits to a charitable organization run by the family. Cash was also being transferred to the family-owned IT business that was under financial stress. Even though their cement franchise is fantastic, throws off a lot of cash and will probably have strong growth – we just cannot feel comfortable being minority shareholders with this family. The capital allocation in such organizations is prone to the whims of the owner (a private jet in lieu of dividends? Why not!).

Some MNCs (not all), which were forced to list in India (in 1978), are also not bereft of blame, taking every opportunity to transfer-price profits out of the hands of minorities. For example, Procter & Gamble (P&G), which does not have any listed subsidiaries except in India (these came about via global acquisitions), chose to demerge its personal care and detergent business out of the listed subsidiary into a wholly-owned subsidiary as soon as the Indian government allowed 100%-owned subsidiaries. They have since launched all new products via the wholly-owned entity whilst still allocating some shared expenses to the listed entities. Furthermore, the listed subsidiaries have ‘lent’ their cash reserves to the wholly-owned subsidiary – a move that is most unbecoming of an MNC of P&G’s stature. Another instance of an MNC acting against minority interest is the Holcim-ACC-Ambuja Cement deal where the parent company (Holcim) used cash belonging to its subsidiary unfairly and then tried to raise royalty rates to unreasonable levels, a move that was vetoed by the independent directors. Other examples include the Indian listed subsidiaries of Pharma companies, such as Novartis, which announced in 2006 that all new drugs would be routed via a wholly-owned subsidiary and used the subsequent fall in share prices to try and delist the business (they failed). It is pertinent to note, however, that India’s minority shareholder protection laws have been strengthened and offer decent protection now.

With state-owned companies, we often find ourselves misaligned as minority shareholders. A good example of this would be the much-publicised tussle between Coal India Limited (CIL) and a renowned foreign institutional investor in 2013, with the latter accusing CIL of supplying coal to ‘connected companies’ (state-owned and otherwise) at unviable rates and compromising minority shareholders.

Minority investors in companies owned by these types of poor owners can sometimes make a lot of money but we feel, they will usually find themselves short-changed, or worse, wake up to find that the law has caught up with the company in question. Steering clear of these sort of poor owners is very important.

However, this is easier said than done. We spend a lot of our time digging around the key people involved in a company (previous employers, track record, remuneration), meeting the independent directors (what other boards do they sit on and how have those boards acted in the past? A professional with a reputation to protect is unlikely to risk tarnishing it by associating with a company with poor governance standards) and getting reference checks from people we trust (the business community in India is quite close knit).We tend to err on the side of caution, perhaps unfairly, but better that than the alternative. The composition of the board sometimes gives away much that we need to know about the business – when Jet Airways (at one point of time, India’s leading airline) inducted Bollywood star Shah Rukh Khan and Bollywood director Yash Raj onto its board, we decided not to waste our time meeting the company.

First State Stewart Asia Indian Equities – Poor corporate cultures

A few years ago, there was a tense moment in our meeting with a company in Gurgaon (near Delhi) when the peon did not serve the CFO the ‘right’ coffee. After lambasting the server, it was the turn of the terrorised IR manager, who had fumbled at one of our questions (no doubt shaken by the outburst) and found the CFO staring daggers at him. We were not surprised when this company experienced one of the worst instances of violence amongst its factory labor force a few months later.

Another company executive boasted about how everyone in their company is treated equally, offering us an example of all employees eating together at work. We went around the office canteen after the meeting, only to find out that coffee mugs were colored according to the management hierarchy!

We are always looking for clues that help us understand the real culture in the business (not grand statements in the annual reports) – flashy cars in the car park, expensive paintings on the walls, separate floors for top management, exclusive elevators (avoid!) and the general vibe in the office. We have seen the way an open plan office can contribute to better culture e.g. Godrej Consumer Products’ old office was the embodiment of hierarchy whereas the new one is quite the opposite, a change that is reflected in its valuations too. Another example is Britannia Industries, which recently moved into a modern office after decades in its colonial, wood-paneled offices. Small details like these add up to a reasonable picture of the corporate culture.

We love managers who are willing to talk about the mistakes they made and what lessons were learnt in the process. This tells us that the culture encourages introspection and decisions are less likely to be influenced by ego. The interaction between the members of the senior management in a meeting sometimes yields good insights e.g. a meeting where the (older) professional CFO fiddles with his phone throughout whilst the young scion of the promoter family holds forth on strategy is a pretty good sign that there would not be much real debate in that office. Once when we asked the CFO of a Korean company if the CEO had made a mistake with one of the acquisitions, he almost fell off the chair spilling his glass of coke all over himself and looked around to check if anyone heard that. On the other hand, we recently met a consumer electronics company where the young MD (part of the promoter family) and the Chairman (his father) were openly at each other’s throats! What we are after is clearly a balance.

First State Stewart Asia Indian Equities – Aggressive management styles

We recently met a textile manufacturer that had managed to limp back to normalcy after over-extending itself around eight years ago (they spent US$100m on capex and acquisitions when their revenues were less than US$50m and lost another US$100m by punting on forex derivatives in 2008). The CEO (part of the promoter family) had just finished telling us about everything that had gone wrong over the past few years and sounded like he had gone through a catharsis. We were beginning to get interested as it seemed like finally the company would be able to deleverage its balance sheet with cash flows and the valuations three years out would have looked very attractive. We wanted to know if he intended to expand again now that they are out of the woods. To our disbelief, he began talking about a fresh US$200m investment plan! We have seen many such examples of CEOs/promoters who do not seem to learn – they bet the farm on every business cycle and tend to lose it all eventually.

Another common fault with aggressive managements is their unwillingness to acknowledge risk e.g. we were amazed that the management of India’s largest telecom company insisted that their Euro/Dollar-denominated debt raised for their Nigerian operation was absolutely risk-free because ‘the Naira is pegged’ (that peg broke down pretty spectacularly towards the end of last year, resulting in ~20% currency depreciation versus the USD).

Finally, aggressive styles are not terribly sustainable over the long term. We once asked a leading beverage company about concerns that water tables were falling around their main factories. “What do you mean by water tables exactly?” was the reply (and no, it was not a case of lost in translation). A risk-aware culture is what we are looking for.

First State Stewart Asia Indian Equities – Bad industries and an invalid license to operate

Every stock market has its share of companies that are extremely successful, but, are run by unscrupulous people whose only license to operate is based on cronyism or bribery. There are a few industries where this is common – mining and infrastructure for instance. One of India’s largest companies is quite (in) famous for having much of the government on its payroll and manipulating government policies to its advantage. We tend to stay away from such industries. Another way we gauge whether a business has earned its license is  to look at the taxes they pay the government – in this respect, Sun Pharma, India’s biggest pharmaceutical company by market cap, fails to make the grade as it employs a range of highly unusual structures to pay far lower taxes than its peers (used to be as low as 3%!). Indeed, Sun Pharma’s ex-CFO and director prides himself on this aspect, even holding a patent in ‘financial structuring’.

Recently, we met a company that (we thought) was operating in an ancillary industry to coal mining. After explaining that 30% of the business was selling explosives to India’s state-owned coal miner (Coal India), the CEO announced that he viewed warheads as the next big growth area. We rushed out the door as quickly as we could.

Tobacco, Gaming and Armaments are some of the other industries we actively stay away from. It is not because these are bad industries from an investment standpoint (indeed, Tobacco companies have proven to be amongst the best long-term investments in history), but rather because we view ourselves as part owners of the businesses we invest in, concomitant with all the rights and responsibilities that it brings, we are prevented from backing a company that has a harmful effect on society. So, it is with some trepidation that we view India’s large planned investments in the defense sector. The government is understandably keen to get the best business houses from the private industry involved, given their track records, but we hope that there will be clear demarcation between the existing listed businesses and any new defense-related ones.

In conclusion, in our experience, there is no such thing as a perfect company, but we believe there are better companies to invest in. We also cannot claim that all the companies we own are perfect businesses, far from it. In the next edition of our semi-annual update, we will highlight some of the concerns we have with the companies that we currently own, and how we will look to balance these risks over time.

First State Stewart Asia Indian Equities – Portfolio moves

At the end of June 2014, we held 35 companies in the fund. Of these, the top 20 holdings accounted for 81% of the assets and we held 1.6% in cash. One year on, we have more than 40 holdings. But, the top 20 now account for only 70% of the assets whilst we hold 9% in cash.

On the one hand, this tells us that we are continuing to find management teams and franchises that are worth backing for the long term, but, also that we are wary of the recent exuberance (and resultant high valuations for some of our favourite companies). Our previous note in March also spoke of this dilemma, and sadly, we find ourselves in much the same situation even now.

Over the past six months or so, we completely exited our investments in Britannia and Eicher Motors on valuation grounds (we touched upon this in our previous update). We have been shareholders in Britannia (India’s largest biscuit company) for a long time and had always believed that its franchise was dominant. However, a combination of external pressures (irrational competition, raw material price inflation) and uninspiring leadership resulted in a business that had low margins. Despite its shortcoming, it did generate strong cash flows and was cheaply valued (below 1x price-to-sales) as recently as 2013. The management changes in the last couple of years (new CEO and CFO appointments and markedly higher involvement from the promoters) and the commodity tailwind have lifted the EBITDA margins from below 5% a few years ago to 14% in the recently declared quarterly results. Now, the stock trades on 4.5 times the price-to-sales and above 50 times its next year’s earnings estimate (28 sell-side analysts cover the stock now, whereas there was hardly any coverage when we first invested in this company). We find the valuations and the expectations on which they are based, unsustainable.

Similar is the case with Eicher Motors. Although we believe its dominant motorcycles and trucks franchises have a lot of growth potential, this is more than adequately reflected in current valuations. With earnings per share estimated to increase from Rs.200 in 2014 to Rs.700 by the end of 2017, and the stock valued at 30 times that 2017 prospective EPS, there is no margin of safety. The recent launch of its four wheeler has underscored our thesis, when we first invested, that it is amongst the most differentiated franchises in the auto industry. We would buy it back at lower valuations.

We also exited our investment in Great Eastern Shipping. A legacy holding in the portfolio, we held on as it appeared cheap, trading on 0.7 times its book value. However, the book value is perhaps inflated to a certain extent, as some of the shipping assets were purchased at the peak of the last cycle. More importantly, we have no clarity about what stage of the current shipping cycle we are in. Therefore, given the backdrop of a slowdown in China, questions over the viability of shale gas production in the US and cuts in offshore exploration budgets globally, we are being cautious. Indeed, when the family sold some of their shares recently – we decided to join them.

We initiated a position in Godrej Industries, the holding company for Godrej Consumer (24% stake), Godrej Properties (58% stake) and Godrej Agrovet (61% stake – unlisted Agri-business). It also has a chemicals, palm oil, poultry and animal feed business. At the time of investing, it was trading at a discount to the value of its stakes in the listed consumer and properties business even after applying a holding company discount (we are happy holders of both in the portfolio directly), implying that the other businesses were available for free (these businesses are growing fast and have high quality backers, such as Temasek who own ~20% in Godrej Agrovet). As per the agreement with Temasek, Godrej Agrovet may be listed within the next two years, which would result in significant value being created for the holding company.

We also initiated a position in Suprajit Engineering – a niche auto-component maker (market cap of US$250m). We have met the promoter and his team (and even visited their factories) a few times over the past year and grown to appreciate the culture. The company predominantly makes automotive cables. Despite being an insignificant proportion of the overall manufacturing cost of a motorcycle or a car (the average cost a cable is US$0.70), it is a vital component of the automobile’s operation. So, automakers tend to rely on a handful of vendors, who in turn build their manufacturing facilities suited to their needs. As a result of scale benefits (and a relatively simple production process), Suprajit has been able to achieve good performance metrics e.g. the five year average ROE as of 2015 was 31% whilst sales have compounded at 18% in the same period. The founder is well aware of the risks (client and product concentration, obsolescence) and has been making moves to mitigate them via strategic acquisitions (e.g. they recently bought an auto lamp company) and adding new clients (BMW has signed up recently). Overall, we expect earnings growth over the long term to gradually burn off what are admittedly rich valuations (it currently trades at around 18x the prospective EPS).

Blue Star, a leading maker of commercial and residential air conditioners in India (market cap US$510m), is another business where we recently bought a small position. Again, we have met the key people many times over the years and are convinced that it is a high quality team. They have made mistakes in the past, notably when they grew the commercial HVAC business too aggressively on unprofitable terms, which has come back to bite them in the past couple of years. However, they are making amends and the construction cycle has likely bottomed out for them, resulting in strong earnings growth. However, since we began building our position, the share price has appreciated significantly and is already pricing in a lot of the upside. We chose not to chase the share price. We have had similar experiences with some of the other new ideas and have been left holding smaller positions than we would have liked (which explains the higher number of holdings). However, we would like to own more of each of these businesses and prefer to wait patiently for our chance. We expect that in the next period, the portfolio will get consolidated back towards 30-35 names with increased concentration in the top 20 holdings.


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