Morningstar - Q3 2024 - 53

Now, US assets are more productive. There should
be a premium. I would just argue that it's too high.
Too much money has gone into US assets.
When you slice and dice it, it's the top-quartile PEs
in particular that have attracted these massive
amounts of money from around the world. So, I do
believe that at some point, mean reversion will
bring this back into sync.
Managing Geopolitical Risk
Benz: I'd like to ask each of you about China, which
has gone from hot to not hot. How are you
approaching China, and how comfortable are you with
state-owned enterprises?
Herro: We treat a company listed in China like
any other company-does it meet our
criteria? Does it possess management teams that
I say have the two C's: the capability and
the commitment to build shareholder value? As
long as there's transparency to the financial
statements, as long as we believe that the
managements are working towards that objective
of creating shareholder value, and as long
as they sell at discounts to what we measure to
be their intrinsic value, we are happy to invest
there-with a caveat.
Because of some of the big macro concerns,
we're not going to use the same cost of equity in
China. In Switzerland or the US, we use a 9%
or 10% cost of equity. For China, it's 14% or 15%.
So, a company has to go through a much higher
valuation hurdle in order to make it into
our portfolio. Then it also has to have the other
standard factors we look for. For this reason,
we shy away from companies that have big state
ownership, because our view is the state has
a different objective. A state bank might want to
keep an SOE, a state-owned enterprise, open and
float them a loan. It's doing things for the
good of the locality, but not for the good of the
shareholders. We want to be number one.
Jain: We have a slightly different view. If you look
at the long history of companies that have come
under the gun, it includes SOEs and private, China
Mobile 00941:HK, toll roads, utilities, gaming,
education companies. For state-owned enterprises,
as they stand today, there's a direct reform that
benefits them. There's a much better alignment
with shareholders, with better ROEs and
higher equity ownership being mandated by the
government. The government wants these
stocks to do well. In fact, 80% of our exposure
is SOEs, because the government policy is
promoting them.
Everything's subject to change. Everything
is temporary. This could last two years, five years.
I don't know. But we're very nervous owning
any private sector in China because the
government policy is specifically targeting private
sectors, which is opposite of some of the
other countries.
Lefkovitz: How is geopolitical risk affecting your
investment decision-making these days?
Herro: We try to understand how what's
happening in the geopolitical scene filters down
to a specific company's ability to generate
cash for its owners. Many, many, many times,
an election result, a central bank pronouncement,
a regulatory change-many times, these
things impact price far more than it actually
impacts the underlying intrinsic value of the
business as defined by its ability to generate cash.
We can't be oblivious to what's happening
in the world around us, but what we have to do
is actually see, does this really impact the
fundamental economic value of this business?
Most times, the answer is no, especially if
you consider that when discounting the present
value of a future cash flow stream, one little
period just has a small impact.
Lefkovitz: Rajiv, you've had investments in Russia
before. Did it change you at all as an investor?
Jain: Well, yes and no. Our view on Russia was
that there was a big change in corporate
governance code in the 2015-16 era. Before that,
I never really invested big time in Russia.
We thought they were trying to do the right things
from a shareholder perspective. There are some
very powerful companies which are some
of the lowest-cost producers of commodities in
the world, and they were paying a high dividend,
so the interests were aligned.
As the war clouds started gathering, we started
cutting back our exposure. We do a macro overlay,
and where we feel that we can't handicap the
risk, we need to cut back. The companies that we
owned, basic commodity companies, are doing
fine on their own. But obviously, we lost money.
I'll give you one interesting data point. From
1993-approximately when Russia and China
opened up-until the war started in February 2022,
which market did better for shareholders?
It was not China. It was Russia, in dollar terms.
Any market can blow up. France nationalized
a vast majority of the banks in 1980-81. France and
Germany just nationalized some of their utilities.
Malaysia put on capital controls in '98. Our
view is that we need to manage risk; everything
is risky in the world.
People can draw different lessons. Somebody
will say, well, why invest in Russia at all?
That's one lesson. Our view is that there are other
big markets which have gone under, so the
lesson is we need to manage risk more tightly. We
did cut back, but obviously too slowly; we
started cutting back after the geopolitical risk
[emerged]. But on the other side, understanding
Russian commodity companies gave us a
much better perspective on what's happening
in OPEC and so on and so forth, which allowed us
to have greater oil exposure, which sort of
offset some of those losses.
Where's the Value?
Benz: David, you've avoided energy stocks, whereas
Rajiv had a massive bet on the energy sector
that he's since scaled back. How do you think about
the sector today?
Herro: I do believe that all energy companies are
investable. However, these are tougher businesses
than one would think. Any extractive business
is relatively difficult, so you have to price it as such.
We own shares in Glencore GLEN:JE, and two
thirds of their business is mining. First, you have to
keep in mind that they're price-takers. Even
when [the commodity] price goes up, their cost
inputs go up. And they face regulatory scrutiny
perhaps more than other business, depending on
where they're located. It's not that we wouldn't
own them. It's just that there's a higher valuation
hurdle that they have to overcome.
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Morningstar - Q3 2024

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