Dalton Investments Talks Activist Investing
Dalton Investments' Jim Rosenwald talked with NYU about activist investing, among other things. Here's the highlights:
In what geographies/sectors are you currently finding the most compelling opportunities on the long side? What about the short side?
In terms of geographies, we can first talk about Japan. The implementation of the corporate governance code by the Japanese Government in June 2015 now forces management to focus on return on equity and alignment of interest between shareholders and management. Noncontrolling shareholders should benefit over time from this. This is particularly valuable when combined with the fact that Japan has one of the lowest costs of capital in the world. From an enterprise value multiple perspective you should be able to find some interesting companies in Japan. Number two is China – it is commonly known that industrial production is declining dramatically (and unemployment at industrial companies is increasing) – China’s wages are not as globally competitive as they used to be. In spite of that, China’s consumer economy continues to grow in the very high single digits and therefore focusing on companies which benefit from China’s consumption should do very well. The Chinese stock market (including Hong Kong and Taiwan) has been hammered and there are some good opportunities that emerge from this type of situation. One should be particularly focused on the entrepreneurs in Hong Kong and the technology companies in Taiwan that benefit from consumption in mainland China. This is another long theme. The third country we have a long bias on is India. We continue to believe that the current prime minister of India is the most pro-business leader in the country’s history. In spite of the recent election in the Bihar region (the ruling coalition suffered a heavy defeat), we continue to believe that there are material improvements within the bureaucracy. The problem is that they are starting from such a low base with high expectations - and the stock market is starting to come back from its highs post-election. Three years out or longer, there are phenomenal opportunities in India both on the manufacturing side and on the consumer side.
On the short side, we continue to hold our South East Asian shorts. Due largely to high valuations in those areas and low commodity prices that are a terrible headwind for many of these countries. The potential devaluation of the Renminbi and the Yen also puts pressure on these countries to devalue their currencies.
On November 2, 2015, Dalton filed a 13D disclosing a 6.2% stake in Eros International Plc – a company that has recently come under attack by a short seller. What is your longterm outlook for this name?
We met with the CEO and founder of Eros while he was raising money in the U.S. and Europe to buy film libraries in India. He had been doing it for the last few years and it was still very early in the purchase of film libraries. He was able to buy the libraries at a small multiple of their annual revenues – far smaller and cheaper than in the U.S., for instance. My research team explained the valuation and how deeply discounted Eros was versus what private equity would pay for such a film library. That got us focused on Eros’ valuation when the stock was at $14 per share. More recently, the last purchases were made when we started to see the royalty and membership of ‘Eros Now’ – their online platform. The short sellers then started coming out about issues that were highlighted in the initial prospectus that the company filed with the SEC when it went public. There was nothing new about what they were talking about. They focused on these issues when the stock price was an all-time high ($30+). This created fear among people who were short-term momentum focused. Eros had a disproportionately large number of short term focused shareholders and the fears exploded. Dalton saw this air pocket as an opportunity to increase its stake in the company and subsequently we more than tripled our existing position over the last 2 months and increased our focus on what we see as a superb opportunity. And I am pleased to say that there are other like-minded, longer term shareholders that are invested in the name. While short-term investor ownership in the company has fallen, there continues to be a large short position in the market.
Could you give our readers an example of an investment where Dalton worked hand in hand with incumbent management? What were some of the challenges you faced?
As related to working with management to enhance shareholder value, I actually have highlights from different decades:
1980s - We suggested to management of closed end mutual funds that they would do better for shareholders if they became open ended funds rather than the closed end structure wherein they traded at big discounts to NAV.
1990s - We suggested to savings and loan institutions (what later became commercial banks) that savings banks did not make much sense as small, stand alone, individually listed enterprises. There were sizable economies of scale to be had – in particular because of the high cost of filing and regulatory requirements. This led to investments whereby these banks merged with other banks.
2000s - In Japan, we tried to convince management in the early to mid-2000s to buy back shares to increase return on equity. In many instances, they responded positively and shareholder value increased across the board for everyone. The final culmination was the first privatization of a Japanese company by private equity and other investors including Dalton. We took a company called “Sun Telephone” private. Share buybacks and privatizations were activities we pursued in the 2000s in Japan.
2010s - We have focused on trying to convince management of the benefit of having a major shareholder (in the form of a non-controlling minority) as a director on the board. We’ve seen the benefit of this in the U.S. and Europe. This is similar to the practice of private equity firms that usually have multiple board members from different private equity firms with different experiences, but also represent minority ownership in a private company. The concept is to run the company more like a partnership instead of a public enterprise. Partnerships tend to focus on all the partners that enter. The public enterprise sometimes moves away from this type of behavior. This is our corporate governance focus.
Dalton’s four investing pillars are: 1) Is it a good business? 2) How good is management at allocating capital? 3) Is management aligned with shareholders & 4) Is there sufficient (50%+) margin of safety? Do you have an example of an investment that satisfied all four criteria but did not turn out as expected? What went wrong?
The one thing that comes to mind is value traps. These were most common in Japan where management teams (usually 2nd/3rd/4th generation owner/operators) did not regard public shareholders as important when considering corporate actions. While the companies were good businesses, traded with a large margin of safety, theoretically had a strong alignment of interest between the family owner operators and the shareholders, and had a long history of being able to allocate investor capital well, the management’s view of long term shareholder interest was different from what you or I would normally consider long term. For example, we could consider long term to be 3, 5 or even 10 years. However, management here viewed the long term as spanning different generations. Therefore, returning cash to shareholders was a low priority and of no interest to management. I am potentially invested in a bunch of these companies even today. You have to take a tremendously long-term view of the company and be patient. You don’t know when the family will decide to focus on their share value and the market cap, rather than their day-to-day business. The other mistakes or problems with the four criteria are when you get the alignment of interest wrong and the family’s goals and objectives are not really in the best interest of shareholders. The assessment of the character of the family is usually incorrect. While initially we may believe that the alignment of interest is strong and you have a benevolent family managing the operations, you can fall in the trap of being incorrect. So value traps and misalignment of interests are the two areas where we have fallen the most.
In today’s highly volatile global environment, how do you bridge the lure of quick shortterm returns v/s your long (5+ years) time horizon? Are your clients comfortable with your holding period?
The only thing I control is my philosophy of value investing and the process that we use to choose our investments (the four criteria and the detailed criteria within the four main criteria). Beyond that, the most important thing we can and need to control in order to maintain our strong conviction is managing the client. Matching client objectives with our portfolios. If you do not have investors who have a similar philosophy and who understand your philosophy and your process, and understand that the ownership of the long positions is 5+ years, then you will end up with clients who are short term focused which will make it nearly impossible to manage your portfolio. We try our best to manage our clients in a way that matches client objectives with our own objectives. If we can’t find investors who are comfortable taking a private equity approach to public markets in Asia, then we will have to avoid those types of clients. We have had situations in the past where we had a sizable amount of money from fund of funds – this turned out to be very hot money that follows short term performance. We avoid funds of funds money at all costs. In 2015, we are seeing plenty of hedge funds blowing up or closing down, due in large part due to the mismatch between the investment horizon of the investors and the fund managers/founders.
Is Dalton’s future goal to increase AUM or will you be focusing specifically on performance? Have you considered branching out to frontier markets?
The objective of Dalton is performance and has nothing to do with AUM. 90% of the money we manage is based on referrals. All we focus on for our client base is performance. We really are very focused on performance. Dalton has a broad reach – we consistently look for opportunities in places like Vietnam (we bought Vietnam bonds at 22 cents on the dollar during the Asian crisis). We’ve been invested in Russia since the 1990s. So we are always looking at frontier markets. But if frontier markets are more expensive than the developed markets of Japan or Hong Kong or India – why invest in frontier markets? A lot of money has chased frontier or emerging markets. However the valuation analysis has not used a high enough discount rate. We are constantly looking at frontier markets of Asia – Myanmar, Vietnam, Cambodia, Laos etc. However, if the valuations don’t justify the high capitalization rate, then what is the point of investing in them? When they’re desperate for capital and the valuations are screamingly cheap, you’ll find us there.
Having worked with the likes of George Soros and the Grace family, what have been your main takeaways?
My mentor, Oliver Grace, who I believe was one of the greatest value investors of all time, although very low profile, helped me to learn tremendous amounts on the value of being able to take advantage of short term swings in the market and going where others were fearful. Be greedy when others are fearful and be fearful when others are greedy. These are two consistent ways of making money in the market. George Soros was also a proponent of this type of behavior. George was unbelievably contrarian in his general investment style. He invested in Korea with me when the market was just opening to foreign investors and was at an all-time low. He went against the banks with the British pound these types of trades would make any other investor balk.
Your partner, Gifford Combs, has spoken about investors experiencing FOMO (fear of missing out, specifically in a rising market). Do you believe this is especially true in Asian markets where sentiment is a highly influential factor and where investors tend to buy in a rising market?
FOMO is a fun topic. FOMO is fueled to a large extent by momentum investing. The criteria we use essentially eliminates the concept of FOMO. Dalton is the opposite of this type of concept. Gifford points this out as one of the great risks of the market. In China, we saw the unbelievable momentum – going up 100% and then the bottom falling out over a two to three week period in June/July. Markets – whether it’s China, U.S., or Europe – markets climb a wall of fear – and then fall off a cliff when things hit the fan.
Do you expect your net exposure to remain low in the upcoming months given the global uncertainty and somewhat excessive valuations in your target universe?
Our net exposure is low in our long short fund and we will continue to maintain that exposure. On a beta-adjusted basis, we are close to flat. In 2015 we have made more money on the short side than we did on the long side.
How do you think about risk when it comes to global investing? Is there an added level of diligence that is required? Are there any frameworks that can be applied in an international setting?
As a portfolio manager, you have a number of key areas to manage risk. One is sizing each of your position. Second is sizing net exposure. Third is your currency management and exposure. Fourth is your overall cash position. I look at risk in all of those different ways.
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