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 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