Why India – not China – is the most exciting market in Asia

Sam Benstead, deputy collectives editor at interactive investor: Hello and welcome to the latest Insider Interview. Our guest today is Doug Ledingham, manager of the ACE 40 sustainable recommended fund Pacific Assets (LSE:PAC) Investment Trust. Doug, thank you very much for coming into the studio.

Doug Ledingham, manager of Pacific Assets Investment Trust: Thank you for having me.

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Sam Benstead: About half the portfolio is invested in India and only about 10% in China, so it's very different to the benchmark. Can you talk me through that investment decision?

Doug Ledingham: So, it's entirely driven by bottom up by, where we see the best opportunities for long-term capital growth. In India, we are spoilt for choice when it comes to world-class family owners running interesting franchises and are well positioned for structural growth. One example of our favourite companies in India is a company called Mahindra & Mahindra Ltd ADR (LSE:MHID). It's been around since the 1940s, it’s family owned and has a professional CEO. So, it's got that combination of a long-term steward with highly competent professional management that we seek in our companies.

It's been a great performer for the company to date on account of growing evidence of both its restructuring and knockout sales from its tractor franchise, as well as the release of its new line of electric vehicles. Mahindra & Mahindra is also a great example of where we've engaged with the company. We've held the company for close to 10 years, but in the last few years we struggled slightly with some of the capital allocation decisions that have been going on at the company, so we had multiple conversations with the board and the family member about how Mahindra & Mahindra could improve its capital allocation. And in 2020, we saw a new CEO appointed and since that appointment, the CEO has come in, he's closed loss-making businesses, he's sold a terrible Korean auto investment that they had, and has since set the company on a better trajectory towards profitability, while, as I mentioned, releasing a new line of electric vehicles and continuing to invest in their dominant tractor franchise.

When it comes to China, we've long struggled to build an extensive list of investable companies because of their inability to meet our quality threshold. We've never owned the Chinese internet companies because we struggled with the quality of people. We've struggled with the corporate structures that meant that minority shareholders didn't own the underlying business. We struggled with the financials, and we struggled to understand how these companies were aligned with the Chinese Communist Party longer term, as it became increasingly dominant in all parts of the economy.

In China, where we can find opportunities are in companies that operate as far away from the state as possible. So, we don't own any state-owned enterprises (SOEs). We don't own companies that operate in politically sensitive sectors. Instead, we own companies that are run by private entrepreneurs, who have built quality franchises on the back of R&D and who are well positioned to benefit from the tailwinds that the Chinese Communist Party is looking to deliver.

So, whether that be the creation of a low-cost, high quality healthcare system, so we own a diagnostics company, for example, or the supply of industrial automation that will increase productivity, or a company such as Vitasoy International Holdings Ltd (SEHK:345), which is a Hong Kong-listed manufacturer of plant-based beverages and holds a leading market share in China and in our view, should be well positioned to benefit again as the Chinese middle-class looks to consume a healthier diet. But again, as bottom-up active investors, we really have the freedom and flexibility to allocate the trust capital where we believe the best opportunities are, no matter what the benchmark looks like.

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Sam Benstead: China has a huge population, this emerging middle class, everyone's very well educated, so aren't you missing out on an amazing opportunity to profit from that trend? Or do you have companies listed in other markets which operate in China, so you get the best of both worlds?

Doug Ledingham: Yes, so certainly that's one way we've looked to approach investing in China over the past 10 years, is finding companies listed outside China where we have the ability to gain comfort in the quality of the people and the quality of the franchise and whether that be companies in Japan, such as Hoya, which is a leading manufacturer of semiconductor equipment, as well as the second-largest manufacturer for lenses and eyeglasses.

China has an epidemic when it comes to myopia and short-sightedness, so we believe that Hoya is perfectly well positioned to enjoy not only structural growth in its profits, but also solve a major societal issue in China.

Similarly, a number of our Taiwanese companies have exposure to China. Companies such as Voltronic, which is a leading manufacturer of uninterruptible power supplies. Now, these are the devices that kick in when mains electricity fails and can provide back-up power to vital equipment in hospitals, data centres or in industrial settings. It's also a leading manufacturer of solar inverters. Now Voltronic is a global company and has exposure to great structural growth opportunities, while also being able to gain growth within the Chinese market, so it's the kind of company that we're looking for. There's a great, passionate long-term founder at the helm. It has world-class technology, a highly respected reputation and exposure to very attractive structural growth markets with some exposure to China. So, I think with Voltronic we have the ability to own the company for the next 10 years without too much concern about what happens at the macroeconomic level.

Sam Benstead: So, you own Taiwanese stocks and Chinese stocks, this is obviously an area of tension globally at the moment. So, what's your understanding about what may happen and how do you go about picking companies which might be OK if there is a conflict? Or do you just avoid the idea of the conflict ever happening at all?

Doug Ledingham: Well, it's going to be a very boring answer. Again, we appreciate the growing tension that's going on between the two countries, but we don't believe that we have the ability to guess what will happen and when it will happen, and especially not the ability to build a portfolio around how stock prices will react to that kind of news.

So, we try to keep our head down and focus bottom-up on owning those companies like Voltronic, or companies like Vitasoy or Hoya, that have resilient franchises that are delighting their customers every day, where there's a large unmet need for the products they're supplying and which have balance sheets that should survive macroeconomic turmoil, and people at the helm who can take a long-term view and again invest today for building a better company tomorrow, which gets us excited.

And it's, in our eyes, far better to get excited about those resilient long-term companies, rather than spending too much time reading the news or trying to speculate on what could happen to the portfolio on a top-down basis.

Sam Benstead: India is the biggest position in the portfolio. It's also been one of the best-performing markets globally this year. So, are there signs of exuberance in India and how expensive are shares there? Are you now paying a premium to own Indian stocks?

Doug Ledingham: So, I'd say that India certainly hasn't been immune to the euphoria that's engulfed global markets over the last few years. It had its fair share of blockbuster technology IPOs, greater retail participation in markets and headlines again, similar to here, full of high-flying technology companies with unproven business models.

More recently, we've seen a slowdown in IPOs. Those major IPOs are now trading below their initial trading dates, and we've seen significant foreign selling of Indian equities. From a valuation perspective, if we take HDFC Bank Ltd ADR (NYSE:HDB), which is one of the trust’s largest positions, it's the leading mortgage provider in India and it's trading at valuations close to all-time lows, and its mortgage book is valued at a level similar to its European or US contemporaries, despite quality that's far superior and the ability to benefit from growing mortgage penetration.

So, mortgage penetration as a percentage of GDP in India is less than 10% versus the 65% or 70% that we see in much of the developed European markets. And again, similarly, Mahindra & Mahindra, the company we've touched on, a leading franchise in India with exposure to a number of growing structural tailwinds, is viewed on less than 20x price-to-earnings ratio (P/E). So, these aren't valuations that we believe reflect a euphoric market. What I would say is that more recently there's been a greater appreciation of the opportunities for some of the country's high-quality industrial companies to generate attractive growth should we see a revival of the Indian infrastructure and manufacturing cycle.

Sam Benstead: So, you're looking for quality companies. Often that comes with a high price tag. Other examples where you've perhaps sold out of companies that you really like because they've become too expensive, or invested in perhaps lower-quality companies that are now very cheap. So, what have been the most recent, you know, trades that you've been up to?

Doug Ledingham: So, the average long-term turnover of the trust is between 10-15%, so we don't tend to do very much and move quite slowly. Some of the recent activity in the portfolio has been to take some money out of our very strong performing Indian companies and, despite our belief that they continue to offer a long-term growth, the position sizes have reached very dominant positions in the portfolio, so we've chosen to take some money out of those, which we never like doing, but we believe in having a relatively diversified portfolio and we don't want too much exposure to a particular trend.

Where we have been adding recently is to some of our favourite smaller Southeast Asian names. One example would be a company called Humanica, which is the leading provider of HR software in Southeast Asia. Now HR software in Southeast Asia is a long way behind what we see in the US or Europe, but we're very excited about Humanica given its fantastic stewardship, its world-class technology, its very attractive cash-flow generation, that over the next 10, 20 years, Humanica should be a key beneficiary of that gap in HR penetration closing between Southeast Asia and the US.

And with a market cap of only $200 million, a large opportunity ahead of its minimal local competition, we're very excited about the opportunity it has to deliver long-term returns to the investment trust.

Sam Benstead: You don't own any resource stocks in the portfolio. Has that cost you this year with the rising oil price and other commodity prices, and why don't you invest in that part of the market?

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Doug Ledingham: We don't really think about relative returns or things that we don't own. So, we don't own resource companies because they tend to fail our want to own quality companies well positioned for sustainable development. Resource companies tend to be highly cyclical. They lack pricing power. And the vast majority tend to have portfolios that aren't well positioned for sustainable development.

Now, there are a couple of companies in Asia that have portfolios with interesting commodities like nickel or copper, but the corporate governance of these companies makes it very easy for us to say, no thank you, and move on very quickly.

Sam Benstead: Have you been doing much travelling to Asia recently? Obviously there's been a lot happening and travel has been quite restricted. So, have you been getting out there to meet companies face to face?

Doug Ledingham: The last few years have been a very frustrating time for us as it's involved lots of early mornings talking to Asian management teams in front of a computer screen, and travel and spending time with people is an important part of our process. We attribute a lot to the quality of people behind a business and especially the culture in which they're looking to build. So being able to travel and spend time with people and spend time with employees is an important part of our process. And being able to sit across from an executive who's passionately looking to solve some of Asia's leading problems is one of the most exciting parts of the job. Thankfully, over the last couple of months, we have been able to get back on the road, so some of my colleagues have been able to spend a week in India, and I'm just back from a week in Japan. So, it's great fun being back on the road and we've got lots of trips lined up in the pipeline.

Sam Benstead: Pacific Assets Investment Trust has a sustainability mandate. Can you tell me a little bit about what that means and how it impacts how you pick stocks?

Doug Ledingham: So, yes, at Stewart Investors, we are long-term investors and in our view, being a long-term investor naturally means you have to think about how a company is positioned relative to the multiple sustainable development headwinds and tailwinds. So, we're looking to own companies that are high-quality and well-positioned for sustainable development, as we believe that they have the ability to deliver above-average returns for our clients.

And as part of that sustainability focus, engagement is a core part of what we do every day. Every member of the team is an analyst and every member of the team is engaging to improve the quality of our companies. We believe that none of our companies are perfect, so engagement is a core part of what we're doing to help both improve returns and reduce risk.

So, we'll be talking to management teams from a variety of perspectives, whether it be their supply chain, the quality of their product portfolio from a sugar or fat perspective, the recyclability of their products, their exposure to oil and gas. And this for us is not only an important part of what we do in terms of improving companies, but it's also an important part of the job in terms of understanding the quality of the people behind businesses. The longer the time horizon of the management team, we believe the better they have an ability to understand the need for companies to improve, and thus we believe we have a far greater chance of engaging and successfully engaging with companies that have a long-term time horizon.

Sam Benstead: And finally, the question we ask all our guests, do you personally invest in the trust?

Doug Ledingham: Yes, I do. And just as importantly, so do much of my family and friends.

Sam Benstead: Doug, thanks for coming into the studio.

Doug Ledingham: Thank you very much for having me.

Sam Benstead: And that's all we've got time for today. You can check out more Insider Interviews on our YouTube channel, where you can like, comment and subscribe. See you next time.