Speaker 1: Welcome to Inside Active, a podcast about active managers that
Speaker 1: goes beyond sound bites and headlines and looks deeper into
Speaker 1: their processes, challenges and philosophies and security selection. I'm David cone, I,
Speaker 1: lead mutual fund and active research at Bloomberg Intelligence. Today
Speaker 1: my co host is Laurent Dulier, senior equity strategist at
Speaker 1: Bloomberg Intelligence. Laurent, thank you for joining me today.
Speaker 2: Thank you for inviting me.
Speaker 1: So you published last week your stock six hundred earnings outlook.
Speaker 1: What can we expect for the rest of twenty twenty
Speaker 1: five based on what you're seeing?
Speaker 2: I mean, I would say overall it's not that great
Speaker 2: because the earning groups of the index has now for
Speaker 2: them to lose single digit for twenty twenty five. At
Speaker 2: the beginning of the year it was around seven percent.
Speaker 2: And two main reason for this downgrade in growth expectations
Speaker 2: are further than certainty on US tariffs given that the
Speaker 2: initial rate and on the by tramp at twenty percent
Speaker 2: was much higher than initially expected. And also we have
Speaker 2: seen significant cuts to the forecast of some of the
Speaker 2: commodity related sectors in Europe, black energy and also the
Speaker 2: mining industry, despite the announcement of the five hundred billion
Speaker 2: euros fiscal stimulus in Germany and also all the rumors
Speaker 2: about the ramp up in defense spending. I think it
Speaker 2: will take some time for all the shovels to be
Speaker 2: put into place and to really have an impact on
Speaker 2: the earnings level. So I think that is more twenty
Speaker 2: twenty six rather than twenty twenty five stories what the
Speaker 2: impact of US stariff are likely to play in the
Speaker 2: second half of the year. So one of the main
Speaker 2: reasons why we have much lower growth expectations. Whoever investors
Speaker 2: are looking through I would say is a short term
Speaker 2: earnings weakness and now are really focusing on the recovery
Speaker 2: potentially in twenty twenty six, and that's the main reason
Speaker 2: why the shop I saw now back to where they
Speaker 2: were before the announcement of Liberation Day.
Speaker 1: Okay, we'll be interesting to watch. I think we should
Speaker 1: hear from our guest on the topic. I'd like to
Speaker 1: welcome David Sama, founding partner of the Artists and Partner's
Speaker 1: International Value Team. Thank you for joining us, David Well.
Speaker 3: Thank you for having me. David and Laurent so.
Speaker 1: I'm sure you're looking at European companies. What are you
Speaker 1: seeing in terms of earnings for the year.
Speaker 4: Well, there are only two large liquidity pools outside the
Speaker 4: United States, both Europe and Japan, and so of course
Speaker 4: our portfolio is heavily invested in Europe. And I think
Speaker 4: what Laurent referred to in terms of earnings growth the
Speaker 4: year backstopped by the stimulus spending by the German government.
Speaker 4: So the headline number was about five hundred billion dollars,
Speaker 4: which is about ten percent of Germany's GDP. But I
Speaker 4: think you've got to think about that in slightly broader
Speaker 4: terms because you're also seeing other European countries stepping up
Speaker 4: with a little bit of stimulus spending. You saw Canada
Speaker 4: come out with some numbers also that will support some
Speaker 4: GDP growth, albeit a lot of that spending in less
Speaker 4: productive parts of the economy, but it is supportive. But
Speaker 4: I think a lot of the growth, you know, interestingly enough,
Speaker 4: is coming from widening spreads at European banks, which has
Speaker 4: little to do with what's going on with deficit spending
Speaker 4: and a lot to do with what's driving the underlying
Speaker 4: equity markets in Europe so far this year. With respect
Speaker 4: to the tariffs. It's it's really sort of interesting as
Speaker 4: you go through the earnings results announced during the first quarter,
Speaker 4: which is sorry post the first quarter, which was in
Speaker 4: the middle of the Liberation Day announcements, what you saw
Speaker 4: from most companies was an itemization of the impact that
Speaker 4: tariffs would have on their twenty twenty five earnings. So
Speaker 4: it's already embedded in whatever estimates the broker dealers or
Speaker 4: the cell side are putting out there as consensus. What
Speaker 4: is not fully baked into the earnings are whatever teriff
Speaker 4: rates are eventually settled between the European Union and other
Speaker 4: parts of the world. The other thing that's not baked
Speaker 4: in there are what are the economic consequences of those tariffs,
Speaker 4: because that's much less of a linear outcome, so it's
Speaker 4: harder to get analysts to bake that into the earnings estimates.
Speaker 4: And I also say that there is a fair amount
Speaker 4: of speculation on the parts of corporates and temporary tactics
Speaker 4: that have been deployed on the part of corporates to
Speaker 4: diminish the impact of the tariffs in twenty twenty five,
Speaker 4: the most common one being the acceleration of purchases of
Speaker 4: certain raw materials or inventories or shipping inventory into the
Speaker 4: United States ahead of the tariffs, and of course you
Speaker 4: know in twenty twenty six, you know that will anniversary
Speaker 4: and will have an impact that none of the companies
Speaker 4: have yet to quantify.
Speaker 3: And is less likely to be embedded in earning.
Speaker 4: So I think just in terms of, you know, what
Speaker 4: is built into consensus From what we can see, it's
Speaker 4: still unfinished business.
Speaker 1: Okay. Is there a process that you go in terms of,
Speaker 1: you know, when you find ideas or you know, for instance,
Speaker 1: can you tell us how an analyst's idea could make
Speaker 1: its way into the portfolio?
Speaker 4: Well, we have so it's very important I think for
Speaker 4: any successful long term active investor to have a certain discipline,
Speaker 4: as implied by the name of our strategy, the Artists
Speaker 4: and International Value Strategy. We are value investors and as
Speaker 4: a result, the price that we pay is a very
Speaker 4: large determinant of our investment outcomes.
Speaker 3: So we look to.
Speaker 4: To find businesses out in the marketplace that are trading
Speaker 4: at a significant discount to what our research is telling
Speaker 4: us that a business is worth. Those are the fundamental
Speaker 4: concepts behind value investing. You know, it's I love two
Speaker 4: for one deals. Value investing is sort of a two
Speaker 4: for one deal because, on one hand, if you're able
Speaker 4: to find an asset worth a dollar and you're paying
Speaker 4: sixty cents for that asset, you get excess return, especially
Speaker 4: if it's a decent business that grows that dollar slowly
Speaker 4: but surely over time. You capture that underlying growth, and
Speaker 4: you capture the unwind of the discount from sixty cents
Speaker 4: all the way up to a dollar. Now, the second
Speaker 4: part of the two for one deal is, let's say
Speaker 4: you make a mistake, or the rules change, the government
Speaker 4: does something like put a stimulus package, or does the opposite,
Speaker 4: and the value of the business ends up being eighty
Speaker 4: cents instead of a dollar. Because you've paid sixty cents,
Speaker 4: you've built an emergin of safety, and you've avoided a
Speaker 4: permanent loss of capital. So value investing, the fundamentals of
Speaker 4: value investing allow you to effectively have that too for
Speaker 4: one deal. Now we take it a step further. We
Speaker 4: take a more thoughtful approach in terms of the types
Speaker 4: of businesses that we want to be involved in. So
Speaker 4: not only do we want to find a business where
Speaker 4: there's a big spread between where it's trading and what
Speaker 4: our research is telling us it's worth.
Speaker 3: But we also want.
Speaker 4: To have good businesses, that business where that dollar is
Speaker 4: growing over time. That's because usually in order to get
Speaker 4: a good deal out in the stock market during let's
Speaker 4: say normal time periods like today, something has to be
Speaker 4: wrong with the business. People don't give away a share
Speaker 4: price at a cheap price when there's nothing wrong with
Speaker 4: the business. When there's something wrong, the stock market generally.
Speaker 3: Doesn't like it.
Speaker 4: People don't like bad news, people shy away from it,
Speaker 4: would prefer to be involved with companies that have good
Speaker 4: news and maybe with share price momentum. As a result,
Speaker 4: it takes time usually before the market is able to
Speaker 4: recognize the fact that the security is significantly undervalued, and
Speaker 4: during that time period, you want the underlying value of
Speaker 4: the business to be growing that way. When you finally
Speaker 4: get that revaluation, inflation which as we all know is
Speaker 4: ever present, doesn't erode your purchasing power. So we not
Speaker 4: only focus on securities that are undervalued, but we focus
Speaker 4: on securities that are undervalued that are attached to very
Speaker 4: good businesses. Now stopped there. We are very particular and
Speaker 4: that we're also looking for companies with strong balance sheets.
Speaker 3: So why do we do that.
Speaker 4: You know, most of the market is focused on companies
Speaker 4: that have an appropriate amount of leverage. We don't think
Speaker 4: there is an appropriate amount of leverage. We actually prefer
Speaker 4: no leverage and companies with very very strong balance sheets.
Speaker 4: That way, if something goes wrong or we have some
Speaker 4: bad luck, or if the company needs to repair a problem,
Speaker 4: that they have the resources available to them to be
Speaker 4: able to fix that problem, invest back in the business,
Speaker 4: create competitive advantages, and grow over the long term. And
Speaker 4: the fourth thing that we look for is a management
Speaker 4: team that has a track record and history of building
Speaker 4: per share per share shareholder value over time. And if
Speaker 4: you think about the combination of an intelligent manager with
Speaker 4: a strong balance sheet that knows how to effectively allocate capital,
Speaker 4: what that can do, if executed well, is actually accelerate value.
Speaker 4: You know, instead of you know, buying company at a
Speaker 4: dollar and it's growing at five percent per year. So
Speaker 4: in normal time periods you go from a dollar to
Speaker 4: a dollar five of underlying value. If you take excess
Speaker 4: capital and you invested, you could accelerate that value creation
Speaker 4: to a dollar ten or a dollar fifteen. And that
Speaker 4: is a very powerful driver of return. So if you
Speaker 4: think about what we're trying to do is we're trying
Speaker 4: to stack the odds in our favor. Right, we want
Speaker 4: an undervalued security, a very good business in the hands
Speaker 4: of a great management team with a strong balance sheet
Speaker 4: to try to maximize the potential for us to.
Speaker 3: Have a very successful investment. And our process is one
Speaker 3: where we focus on.
Speaker 4: Companies that have that characteristic, those characteristics in combination, and
Speaker 4: then take our time to do intensive first hand research.
Speaker 4: So we don't use any sell side research. We don't
Speaker 4: use any databases we build. You know, we're sort of
Speaker 4: like pre ai dinosaurs. We build all of our own
Speaker 4: financial models. We use firsthand data because we need to
Speaker 4: exercise judgment on the underlying economics of this business. We
Speaker 4: can't outsource our judgment to an algorithm or of course
Speaker 4: we use these tools for data gathering. But once we
Speaker 4: get that data, we analyze it firsthand. We talk to
Speaker 4: management teams, we talk to competitors, we talk to customers,
Speaker 4: we talk to former employees, we talk to anybody who
Speaker 4: will help us understand the long term underlying economics of
Speaker 4: that business. And we use all of that information along
Speaker 4: with the data that we gather to create an estimate
Speaker 4: of intrinsic value, and then we look to purchase shares
Speaker 4: only in the case where there is a meaningful discount
Speaker 4: to intrinsic value, and that's our process. We have a
Speaker 4: group of seven very experienced securities analysts on our team.
Speaker 4: We are all generalists with regional responsibilities, and we're all investors.
Speaker 4: We don't really have analysts here. We have investors who
Speaker 4: can allocate capital across multiple industries, across different geographic locations,
Speaker 4: in both develop markets and in emerging markets. So I
Speaker 4: think David and Laurent that gives you a pretty good
Speaker 4: sense for the way that we think about the world
Speaker 4: and how we approach finding securities.
Speaker 1: We talk a little bit about the intrinsic value. You know,
Speaker 1: you mentioned you have a bunch of different information that's
Speaker 1: kind of going into that. Are there metrics that you
Speaker 1: use as well or is it kind of you've got
Speaker 1: like a proprietary system to determine its intrinsic value.
Speaker 4: Well, you know, I don't think there's any magic to
Speaker 4: you know, the value of a business is the present
Speaker 4: value of its future cash flows, and you learn that
Speaker 4: in your first finance class. And we haven't really varied
Speaker 4: from using a very simplified diskind of cash flow model
Speaker 4: to perform our let's say, formal valuation of the business.
Speaker 3: Most of the stuff you could.
Speaker 4: Do on the back of a napkin, you know, and
Speaker 4: when you know, when we think about metrics, there's shorthand
Speaker 4: that comes from the analytical process.
Speaker 3: You know, pe ratio is ev to e bit pre.
Speaker 4: Cash flow multiples, all of those are sort of shorthand
Speaker 4: methods to evaluate the attractiveness of a company. And of
Speaker 4: course everything is relative, right, So if you think about
Speaker 4: the quality of let's say LVMH, which is a large
Speaker 4: luxury goods company, the quality of that business relative to
Speaker 4: let's say BASF, which is a large German chemical conglomerate.
Speaker 4: Of course, those are two different businesses, one with significant
Speaker 4: brand value that results in very high levels of profitability,
Speaker 4: and the other one that operates and commoditize, you know,
Speaker 4: businesses that are tough competitively and they operate with unionized labor,
Speaker 4: which is a much more difficult, capital intensive, lower return business.
Speaker 3: They're not worth the same thing.
Speaker 4: If they were both at eight times earnings, of course
Speaker 4: you'd far prefer to own LVMH. Then you would prefer
Speaker 4: to own BASF. And you know, I don't use those
Speaker 4: two companies to pick on them, but I use them
Speaker 4: to point out that, uh, you know, we we can
Speaker 4: look at shorthand metrics, David, to help us put shorthand
Speaker 4: valuations on companies. But everything has to be taken into
Speaker 4: context based on the type of business that you're looking.
Speaker 2: At, David. I mean in terms of marketing efficiencies, I mean,
Speaker 2: based on your long experience. Where do you think the
Speaker 2: market or the saleside get it wrong. Is it more
Speaker 2: in understanding the underlying value or the interesting value of
Speaker 2: the business, or is it more in how it should
Speaker 2: be valued? How your experience I mean, is making you
Speaker 2: look for more opportunities in one way or the other.
Speaker 4: Well, I would say, broadly speaking, the non US market
Speaker 4: or less efficient than the US market. So first, there's
Speaker 4: a lot less liquidity outside the United States than there
Speaker 4: is in the United States. So that's one. Two, you
Speaker 4: have the complexity associated with you know, various currencies that
Speaker 4: you're dealing with. Three, you have complexity with respect to cultures.
Speaker 4: You know, what does it mean to be invested in
Speaker 4: a French company versus an Indonesian company versus a Japanese company.
Speaker 4: And then you have different corporate governance structures, right, different.
Speaker 3: Rules of the game.
Speaker 4: What does it mean to be a shareholder of a
Speaker 4: South Korean company versus a shareholder of a Swiss company?
Speaker 4: You know, what is the construct of a board of
Speaker 4: directors in Japan versus the construct of a board of
Speaker 4: directors in the United Kingdom. So then you have different
Speaker 4: time zones, you have different languages, you don't really have
Speaker 4: different There's a little bit of accounting differences that exists today,
Speaker 4: but they're not.
Speaker 3: Nearly as as big.
Speaker 4: But they're they're out there, right, and and that level
Speaker 4: of complexity makes it much more difficult for the average
Speaker 4: investor to truly understand what they're getting themselves involved in.
Speaker 3: So that's that's step one.
Speaker 2: Uh.
Speaker 4: Step two UH is with respect to the cell side.
Speaker 4: The cell side, you know, they make their money on
Speaker 4: the corporate clients, right, So their clients are the LVMH's
Speaker 4: of this world, not the David Sammers of this world.
Speaker 4: And uh, and they have over the years realized that
Speaker 4: in terms of brokerage commissions, their their their bread is
Speaker 4: buttered by fast moving hedge funds, and so they love
Speaker 4: to have you know, short term movements based on earnings
Speaker 4: estimates and things like that, and has nothing to do
Speaker 4: with the long term in during intrinsic value of a business.
Speaker 4: And so the cell side tends to be very short
Speaker 4: term oriented, which is an advantage for somebody who's actually investing. Right,
Speaker 4: So let's let's talk about investing to build wealth over time,
Speaker 4: which is a very different concept than just owning a
Speaker 4: security to take advantage of a trend. Now, what else
Speaker 4: is also driving in efficiency is the advent of ETFs.
Speaker 4: ETFs have become you know, have played into the gamification
Speaker 4: of investing. It has sort of dumbed down investing and
Speaker 4: provides things like exposure to financial advisors and broker dealers.
Speaker 4: I think if you, you know, go over to your
Speaker 4: friend's house and ask to see their statement from their advisor,
Speaker 4: you know it's likely to have ten or fifteen ETFs
Speaker 4: in there. And so what do they own, Well, they own,
Speaker 4: they own products, they don't own businesses or investment investments.
Speaker 4: And all of these inputs into the way that the
Speaker 4: equity markets operate today, plus the added inefficiencies of investing
Speaker 4: out the outside the United States, that's what creates opportunities
Speaker 4: for long term investors, and David and Laurent let's use
Speaker 4: you know today is a really good example, because it's
Speaker 4: really interesting to see, you know, the European markets rallying
Speaker 4: so significantly in the first part of this year. And
Speaker 4: it is fantastic that you know, some of the banks
Speaker 4: and the defense contractors and the utilities are likely to
Speaker 4: have growing earnings on the back of what's happening. But
Speaker 4: if you think about the relative quality of those businesses
Speaker 4: compared to you know, other potential long term compounders, those
Speaker 4: aren't fantastic businesses. You know, that's not like Google or Facebook.
Speaker 3: You know, you know, these.
Speaker 4: Long term fantastic compounders rising very rapidly because their earnings
Speaker 4: are growing and they have a very bright future.
Speaker 3: These are pretty.
Speaker 4: Ugly businesses that went from horribly undervalued to now still undervalued.
Speaker 3: But they're not, you know, they're not long term compounders.
Speaker 4: I mean, the banking industry and in Europe is is
Speaker 4: fragmented and it needs to consolidate. And you know, the
Speaker 4: regulatory environment, though less hostile than it has been over.
Speaker 3: The last decade, is still reasonably unhelpful.
Speaker 4: So you know, you're not and and what's being left
Speaker 4: behind during this rally, are uh, you know, some of
Speaker 4: the better businesses that are out there, which creates opportunity
Speaker 4: for long term investors. So that gives you a sense,
Speaker 4: Laurent in real time, you know how stock markets can be,
Speaker 4: you know, incredibly short term oriented and as a result,
Speaker 4: inefficient in our view.
Speaker 1: I just wanted to ask you about you know, you
Speaker 1: were talking about, you know, the fundamental aspects and balance sheets,
Speaker 1: and I guess, in your opinion, what is the best
Speaker 1: indicator of a business's you know, what is their their quality?
Speaker 3: I should say, yeah, well so that's a good question.
Speaker 4: In fact, I along dialogue with somebody yesterday about this.
Speaker 4: You can see in the financial metrics, the historical financial
Speaker 4: metrics of a business whether or not it has historically
Speaker 4: been a high quality business, so it shows up in
Speaker 4: return on capital employe. There are other things to look at,
Speaker 4: you know, if it's a financial would be an ROE
Speaker 4: you have to You can look at operating profitability, you
Speaker 4: can look at in the rate of growth, and so
Speaker 4: you can see it generally speaking in the historical financials.
Speaker 4: But that is just the beginning of the analysis rather
Speaker 4: than the end of the analysis. Of course, you have
Speaker 4: to make because the value of the business is the
Speaker 4: present value of the future cash flows, not the past
Speaker 4: cash flows. It is imperative that you are able to
Speaker 4: make some level of determination as to whether or not
Speaker 4: the conditions that allowed for that fantastic level of profitability
Speaker 4: and returns in the past will continue to exist in
Speaker 4: the future.
Speaker 3: And that's that's what we're here to do.
Speaker 4: You know, that's what separates, at least today, the difference
Speaker 4: between an algorithm and a human being is that, you know,
Speaker 4: we have to take the information that's available to us
Speaker 4: and make some judgments around that information. And that's what
Speaker 4: fundamental research is for. We're looking at the competitive position
Speaker 4: of the company, the quality of the management, the quality
Speaker 4: of their products, who their customers are, whether or not
Speaker 4: their customers will still have the capability and the desire
Speaker 4: to buy their products. What are the raw material inputs,
Speaker 4: what are the substitute products, what is the status of
Speaker 4: their competitors' products and their competitors' strategy. And when you
Speaker 4: bundle in all this analysis, you make some assessment as
Speaker 4: to whether or not this business will still be able
Speaker 4: to grow and create strong levels of profitability without having
Speaker 4: to put so much capital in the business. Where the
Speaker 4: returns of the business might decline over time, in which
Speaker 4: case it's worth far less than you know it was
Speaker 4: worth in the past when it did not have to
Speaker 4: do that. And so it really is that that last step,
Speaker 4: that fundamental analysis step, which we'd call last but certainly
Speaker 4: not least, part of the process that helps us determine
Speaker 4: whether or not this business is actually a quality business.
Speaker 2: One question. I mean, sometimes some of your investment in
Speaker 2: the initial stage may turn out badly, I would say,
Speaker 2: I mean, how do you review I mean for them,
Speaker 2: I mean positions which are not going the way you
Speaker 2: fought it could go. I mean, because of antc in
Speaker 2: as cutting glasses early is one way to avoid disasters.
Speaker 2: So how do you process the review of investment which
Speaker 2: unfort can it be observed stage I'm not going in
Speaker 2: the right direction.
Speaker 4: Yeah, it's a very good question, and it's something that
Speaker 4: we call reinvestment risk, and it's sort of the bane
Speaker 4: of the value investor generally speaking. Is a value investor,
Speaker 4: you're selling securities where the news is very good and
Speaker 4: the share price is going up and everybody's happy and
Speaker 4: people are jumping on the bandwagon, and you're getting involved
Speaker 4: in securities where the news is very bad and people
Speaker 4: are selling. Now, there are a couple components to your question, Laurent,
Speaker 4: and so that you use the word disaster, and we
Speaker 4: try to avoid disasters by some of those fundamental characteristics
Speaker 4: that we spoke about. I mean, generally speaking, if you're
Speaker 4: buying a pretty high quality business with a strong balance sheet,
Speaker 4: very hard, not impossible, but very hard to have a
Speaker 4: disaster associated with the business that looks statistically cheap, that
Speaker 4: has a strong balance sheet and is fundamentally a pretty
Speaker 4: good business. The other thing that to sort of internalize
Speaker 4: about what value investors do is that we're very aware
Speaker 4: of this reinvestment risk. So you make a certain level
Speaker 4: of assumptions around what the trajectory of the business should
Speaker 4: look like, and as long as the business is moving
Speaker 4: in that direction, and we are able to separate the
Speaker 4: facts and circumstances that are dictating how the underlying value
Speaker 4: of this business is moving over time from the noise
Speaker 4: in the marketplace. Because you know, there's there's you work
Speaker 4: at Bloomberg, there's a lot of reporters, and reporters like
Speaker 4: to put out headlines and say lots of things, which
Speaker 4: is fun, and but you have to be able to
Speaker 4: separate yourself and look at what's on a sober realistic basis,
Speaker 4: what's happening to the underlying value of the business, and
Speaker 4: as long as that moving in the direction that's pretty
Speaker 4: consistent with your underlying assumptions, there's no reason for.
Speaker 3: You to change.
Speaker 4: You know, your expectations and value investors as a result,
Speaker 4: are very good at averaging down. You know, it's it's
Speaker 4: part of the process.
Speaker 3: You're you're there early. The news is likely to continue.
Speaker 4: To be bad if you've if you've baselined your expectations properly,
Speaker 4: you understand the business deeply, You understand what the trajectory
Speaker 4: of the business is likely to be, and the business
Speaker 4: is following in that trajectory, and the share price continues
Speaker 4: to go down. That creates an enormous opportunity and is
Speaker 4: also an you know, part of that process. You know
Speaker 4: that we talked about earlier in terms of the market
Speaker 4: being inefficient. You know, if the underlying business is improving
Speaker 4: and the share price is going down, that makes no sense, right,
Speaker 4: But it is very very common when you're getting involved
Speaker 4: with a company that's having some sort of issue, where
Speaker 4: there are headlines being created where the share price is
Speaker 4: going down, yet you know the changes that the management
Speaker 4: team are making are all very positive in the companies
Speaker 4: headed in a much better direction.
Speaker 2: In one of your earlier questions answer, you mentioned about
Speaker 2: understanding the culture of the country you invest in, the
Speaker 2: different style of corporate governance. So I think for me,
Speaker 2: Japan or Japanese equities is a good business case of
Speaker 2: there is so much open the market that changes, structural
Speaker 2: changes happening in this market with a return of inflation,
Speaker 2: apparently corporate changes in corporate governance making the market much
Speaker 2: more shareholder friendly. I mean, what is your view? I mean,
Speaker 2: do you think this is for real and it offers
Speaker 2: really good investment opportunities for value investors, or do you
Speaker 2: think that given the readies that we saw in Japanese
Speaker 2: equities over the past two and three years, in fact
Speaker 2: most of it is already priced in. So what is
Speaker 2: your view on this market?
Speaker 3: Japan's an interesting place.
Speaker 4: I've been investing there for thirty years, and for most
Speaker 4: of that time period.
Speaker 3: The country offered extraordinary valuations.
Speaker 4: You know, net nets companies trading blow cash value, and
Speaker 4: some of that still exists, although as you said, there
Speaker 4: have been at least in yen terms, right, and I
Speaker 4: have to think of dollars. My shareholders are American and
Speaker 4: I have to make money in dollars and so and
Speaker 4: yen terms. There has been a significant rally in Japanese equities,
Speaker 4: but in US dollars it hasn't been nearly as as
Speaker 4: positive as market commentators make it make it seem to be.
Speaker 4: You know, I can't, I can't offer my clients returns
Speaker 4: in Turkish lera. You know, it just doesn't, It doesn't work.
Speaker 4: But Japan has been a fascinating place to invest in
Speaker 4: over the years. There was a Prime Minister came into
Speaker 4: office five or six years ago named Shinzo Abe who
Speaker 4: made a number of positive changes to Japan. There was
Speaker 4: some legislation pass that started to improve corporate governance. He
Speaker 4: changed the dialogue around where shareholders sit in the pecking
Speaker 4: order of priorities for companies. So traditionally the shareholder was last,
Speaker 4: it was, it was society, it was customers, it was employees,
Speaker 4: and then shareholders in the pecking order, and and the
Speaker 4: way that that displayed itself practically speaking, David and Laurent
Speaker 4: was in the boardroom and with respect to the shareholding structure,
Speaker 4: of the companies. So the board of directors was traditionally
Speaker 4: all employees, and the chairmen and the CEO were the
Speaker 4: same person, and all the rest of the board members,
Speaker 4: as I indicated, were employees will all owed their job
Speaker 4: to the chairman and the CEO. So if the company
Speaker 4: wasn't operating as effectively as it could be, it was
Speaker 4: basically a waiting game for the chairman or the CEO
Speaker 4: to retire, and then you had to hope that the
Speaker 4: next person in line, you know, was better. Now why
Speaker 4: would the outside shareholders, who presumably have a vote.
Speaker 3: Put up with this?
Speaker 4: Well, first of all, there was a culture for domestic shareholders,
Speaker 4: domestic Japanese shareholders of cohesion and if this is the
Speaker 4: way the company wanted to operate, then we as shareholders
Speaker 4: are aligned with what they want to do. And in
Speaker 4: addition to that, you had cross shareholding. So there was
Speaker 4: a structure, a historical structure that was put in place
Speaker 4: after World War two called a CORRETSU structure where there
Speaker 4: were groups of businesses that are all held together by
Speaker 4: a parent treating company and a parent bank, and they
Speaker 4: all had cross shareholdings with one another, and so a
Speaker 4: large part of the voting block was within the group
Speaker 4: that also protected the board and foreign shareholders. The result
Speaker 4: had you know who who were the most likely cohort
Speaker 4: to complain about poor returns or a very small force
Speaker 4: in this equation and sully but surely and accelerated based
Speaker 4: on the reforms that shinzo Abe had put in place,
Speaker 4: these structures are starting to unwind, so you see some
Speaker 4: of the very large companies now will have a majority
Speaker 4: of their board will be independent directors. Even many of
Speaker 4: the smaller companies will have a couple of independent directors
Speaker 4: on the board. The vast majority of the board still
Speaker 4: are employees. You've also seen reforms at the stock exchange,
Speaker 4: which is not normally the part of the market where
Speaker 4: you're expecting reforms, where you know the exchange has put
Speaker 4: out certain return hurdles and valuation hurdles, where you know
Speaker 4: you can be on the first section of the Tokyo
Speaker 4: Stock Exchange if you meet certain price of book and
Speaker 4: return on equity hurdles, and if you don't, you're off.
Speaker 4: And you know that of course has liquidity and valuation implications.
Speaker 4: And then that you know the third thing is you
Speaker 4: know the willingness on the part of companies to create
Speaker 4: incentive compensation that's equity based, and typically there have been bonuses,
Speaker 4: but people have been paid seventy or eighty percent on
Speaker 4: fixed in fixed salaries and very small bonuses that were
Speaker 4: largely paid every year, you know, because there's nobody on
Speaker 4: the board that's not going to pay the president and CEO. Right,
Speaker 4: So you know, all of these changes are happening. It's
Speaker 4: created excitement, some justified, some not. And it's also one
Speaker 4: of the other changes that Abe has allowed for is consolidation,
Speaker 4: is so there's more private equity, there's more consolidation. I
Speaker 4: think that there's one final step that he was unable
Speaker 4: to finally execute on, which is labor reform. The ability
Speaker 4: and the cultural willingness to actually reduce employees.
Speaker 3: You know they have.
Speaker 4: The Japanese system was one around loyalty.
Speaker 3: Where you you know you and there's a lot to
Speaker 3: be said for this.
Speaker 4: It's it's nice you take a job somewhere and you
Speaker 4: work there for the rest of your life and you're
Speaker 4: devoted to that company. It creates a very loyal family
Speaker 4: like environment at working at a company, and.
Speaker 3: You know, the longer you were there, the more.
Speaker 4: Responsibility that you got no matter if you were good
Speaker 4: or bad at it. So it definitely had its downside.
Speaker 3: And the downsides are worse than the upside.
Speaker 4: I mean, companies were horribly inefficient, overmanned and it's still
Speaker 4: to this day that's the case. And in order to
Speaker 4: generate very good returns and the way that we as
Speaker 4: Americans think about, you know, we want companies that have twelve, thirteen, fourteen,
Speaker 4: fifteen percent return on equity. You know that's rare in
Speaker 4: Japan to get those sort of returns. And if you
Speaker 4: sort of internalize, and I'm going to sort of bring
Speaker 4: it back to our strategy, if you internalize, you know
Speaker 4: what our strategy is, which is to own very good businesses.
Speaker 4: You can imagine that over the course of many years,
Speaker 4: it's been a difficult market for us, even as value investors,
Speaker 4: to find a preponderance of businesses that we find to
Speaker 4: be very attractive. Over the last few years, it's been
Speaker 4: virtually impossible.
Speaker 3: We've only owned a.
Speaker 4: Couple of companies because of the end based appreciation of
Speaker 4: securities in that market. But this year it's actually been
Speaker 4: much better with that market again in yen terms coming
Speaker 4: off and we're starting to see some larger better businesses
Speaker 4: starting to trade at valuations that we're finding more attractive,
Speaker 4: so we can be a little bit more productive there.
Speaker 4: But I think that sort of embeds you know, what's
Speaker 4: happened in Japan, and now that's spilling over into Korea.
Speaker 4: You've seen that we've had a new election recently and
Speaker 4: the interestingly, the the you know what we would call
Speaker 4: in the United States a democratic party or the more
Speaker 4: liberal leaning party is coming into power and as part
Speaker 4: of what they're doing is they're implementing reforms that in
Speaker 4: the end will create better returns for investors over time
Speaker 4: in a similar manner to Korea has different issues than
Speaker 4: Japan had, but it's sort of a very similar path
Speaker 4: to what Japan did to try and get companies to
Speaker 4: improve their returns.
Speaker 2: Okay, I mean another market which I think is also
Speaker 2: quite interesting as an international investor is China because there
Speaker 2: was about a year ago the question is China equities
Speaker 2: in uninvestable or not? I mean, the market is still cheap.
Speaker 2: I mean what is your view on that? I mean,
Speaker 2: do you think it is a market that you are
Speaker 2: avoiding at all costs because of lack of transparency or
Speaker 2: the geopolitical risk or do you think, in fact, it
Speaker 2: may offer some good value investments.
Speaker 4: I think that market is unquestionably the cheapest market in
Speaker 4: the world. I think the Chinese economy under different leadership
Speaker 4: definitely has the ability to be the dominant economy in
Speaker 4: the world. Unfortunately, this leadership has imposed a government control
Speaker 4: structure that will impede their ability.
Speaker 3: To get there.
Speaker 4: However, you have the cheapest valuations and some of the
Speaker 4: best businesses in the world in China. Now, if laurent
Speaker 4: I was sitting where you're sitting, as a European, I
Speaker 4: would have no problem having fifteen or twenty percent of
Speaker 4: my portfolio invested in Chinese securities. But given that my
Speaker 4: clients are American, we have a geopolitical rivalry that could
Speaker 4: at any moment be subject to an executive order barring
Speaker 4: us from owning Chinese securities.
Speaker 3: And you know, that's.
Speaker 4: That's a risk that is hard to handicap and one
Speaker 4: that puts us in a position of severely limiting our
Speaker 4: exposure to Chinese securities. And I you know, because America
Speaker 4: is the largest source of capital invested in almost every
Speaker 4: stock market outside the United States, I think that's part
Speaker 4: of the reason why valuations there are far lower than
Speaker 4: they than they are in other parts of the world.
Speaker 4: It's it's an opportunity for people who live and who
Speaker 4: live and are domiciled and invest from outside the United States.
Speaker 2: Okay, interesting, My last question will be on European iniquities.
Speaker 2: I mean, you did mention about many of those businesses
Speaker 2: not being high quality, but they are a nice run
Speaker 2: over the past two to three years. So what is
Speaker 2: your latest view, I mean, what are the sectors or
Speaker 2: industries that potentially you think are still good to invest
Speaker 2: in Europe?
Speaker 4: Yeah, you know, we we as value investors, we generally find,
Speaker 4: you know, markets to be very attractive to us when
Speaker 4: there's some sort of pain that's going on.
Speaker 3: And today it seems like.
Speaker 4: Equity markets have chosen to focus on two things. One
Speaker 4: is the dramatic potential of AI, which is fantastic. And
Speaker 4: you know, we we spend a lot of time trying
Speaker 4: to understand what's happening and what the impact could be
Speaker 4: to the many businesses we own about forty businesses, the
Speaker 4: many businesses that we own, in addition to other companies
Speaker 4: that we don't own. The market has has preferred to
Speaker 4: focus there, and the market has preferred to focus on,
Speaker 4: especially in Europe, the short term implications of lower interest rates,
Speaker 4: higher spreads, and the stimulus that's mainly coming.
Speaker 3: Out of Germany, and so markets are pretty buoyant.
Speaker 4: And as a result, you know, we don't find any
Speaker 4: particular country, we don't think by country anyway, but any
Speaker 4: particular industry to offer seriously attractive outcomes. The opportunity set
Speaker 4: in markets that aren't in distress generally comes from, you know,
Speaker 4: companies that are having their.
Speaker 3: Own particular issues. Right.
Speaker 4: So in our last shareholder letter we outlined the purchase
Speaker 4: of two securities. So one is an Irish company called Icon,
Speaker 4: which is in the contract research business, and you know,
Speaker 4: it's having its own particular issues based on problems with
Speaker 4: its customers and customers spending less, and that's creating an
Speaker 4: opportunity to buy what is a fantastic business at a
Speaker 4: very attractive multiple company with a strong balance sheet and
Speaker 4: a experienced and value creating management team, and they're actively
Speaker 4: buying back their own shares. And it really the opportunity
Speaker 4: set for value investors like us in an environment like
Speaker 4: this comes from particular companies rather than any broad swath
Speaker 4: of the market, geography, or industry that is offering a
Speaker 4: big opportunity set aside from the China, you know, opportunity
Speaker 4: set that I mentioned earlier, which we effectively can't take
Speaker 4: advantage of.
Speaker 1: Well, this is great. I really appreciate you coming on, David.
Speaker 3: It was nice to be here. David and Laurent. It
Speaker 3: was a fun conversation.
Speaker 1: Thank you very much, and Laurent, thank you for being
Speaker 1: my co host.
Speaker 2: Oh welcome.
Speaker 1: If you enjoyed this episode, don't forget to subscribe if
Speaker 1: you want to, if you're interested in our research, don't
Speaker 1: forget to go on the terminal either b I Fund
Speaker 1: or b I Stocks until our next episode. And this
Speaker 1: is David Cone with Inside Out.
Speaker 2: Mm hmm