FOR all the market’s focus on macro-economics, it can sometimes be forgotten that one of the key factors determining a company’s success is the actions of management.
That’s why understanding a company’s leadership, strategy and the industry dynamics in which it operates is critical to successful long-term investing, says Pendal’s Samir Mehta.
“It is important not just to know management mindset, but also understand industry dynamics, customer profile, competitive intensity — those externalities lead to substantial difference in business outcomes,” says Mehta, who manages Pendal Asian Share Fund.
Investors should seek to understand two main dynamics: industry-wide challenges like slowing growth, new competition and the rationality of competitors; and management’s response to these challenges.
“Companies and managers in different industries and different countries face somewhat similar challenges. But their approaches can be so different.”
Here are four examples:
Haidilao is a popular restaurant chain in China that specialises in hotpot, a communal meal where diners cook ingredients in a shared pot of simmering broth.
After nearly two decades of strong growth, the COVID pandemic forced a reckoning.
Haidilao’s management closed nearly a fifth of restaurants and let go more than a fifth of staff, something rare in China.
“Hotpot is not a cuisine that is amenable to home delivery because you have to be present in the restaurant, typically in a group, to enjoy it,” says Mehta.
“COVID forced them restructure. Staff compensation structures were changed from fixed to variable; they spun off their fast-growing, cash guzzling, international business.
They focused on generating cash flows, right-sizing costs, and bought back a part of their outstanding US dollar bonds.
Haidilao last week posted a 12% lift in revenue for its first half and profit of CNY2.26 billion — almost 30% higher than market expectations — compared to a loss in the same period a year earlier.
Sunny Optical makes components used in optical equipment like cameras and vehicle lens sets and is a major supplier to the mobile phone industry.
“The last 10 years were an era defined by mobile phones and Sunny was one of the poster boys of that trend.
“However, mobile phone growth has now plateaued.
“More importantly, one of their largest customers, Huawei, has been caught up in geopolitics. Combined, Sunny faces a very uncertain future.”
Yet management is investing heavily in R&D and new capabilities to find new avenues of growth.
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One area of focus is self-driving vehicles, which need lenses for the LIDAR components that help the vehicle understand its surroundings. Another is virtual reality headsets.
“Contrast this with Haidilao,” says Mehta. “Sunny has just kept on investing, spending money on R&D even as their gross margins have come off quite sharply and even as their growth has come off.
“I met their management team recently and my conclusion was that their DNA is to think about growth.
“They have increased their R&D budgets and moved employees across divisions but do not want to accept a future without growth.”
Asian Paints is India’s largest paint company. Paint is unique worldwide among consumer goods because it has largely resisted digital disruption, says Mehta.
“Almost every other consumer good has been disrupted by ecommerce, but paints are still primarily bought by going to the store,” he says.
But Asian Paints is facing a challenge. The industry so far is a benign oligopoly and highly profitable. One of India’s largest commodity based manufacturing companies, Grasim Industries, is making a play for the decorative paints market.
“Grasim is a commodity producer and for them capital expenditure is the solution to all problems. So, have spent tonnes of money getting a foothold in the industry,” says Mehta.
“But Asian Paints, recognising the nature of this competition, was well ahead of the curve. They too invested in the business aggressively, contrary to what they had done in the past, and have built on their brands and accelerated their growth quite dramatically in the past three years.
“They have generated so much cash flow that they have built up a fortress balance sheet which will allow them to survive years of intense and in my view potentially irrational competition.
“The unfortunate outcome of this is that the smaller players in the industry are going to get wiped out by the impact of Grasim — but the impact will be felt less on Asian Paints.”
US-listed SEA is an e-commerce leader in Southeast Asia. It’s flagship app Shoppee is the largest online shopping platform in the region.
“The stock skyrocketed during COVID as people went online, peaking above US$350,” says Mehta.
“As was the wont of those times, they were subsidising customers and losing money on every trade.
“When inflation became an issue and investors started focusing on profits not growth at any cost, the shares collapsed.”
Management’s response was to dramatically change strategy to control costs.
“They mandated everyone to fly economy. They went to single ply toilet paper in the bathrooms. These were extreme changes,” says Mehta.
And for a while, it worked.
SEA shares doubled from their lows of $30 to almost $60 as management prioritised cash flows and profitability.
“Despite best efforts, they never achieved it,” says Mehta. “And they changed direction again last quarter because even though they wanted to do the right thing, their competitors have refused to follow.
“Shoppee was starting to lose business to competitors who were willing lose money to gain customers.”
“These four companies faced similar kinds of challenges, yet took completely different approaches,” says Mehta.
“This is the contrast I want to present. My focus on owning stocks in our portfolio is on profitability, cash flows, and high returns on capital employed.
“Asian Paints is a very good quality business run by management who understands the long-term dynamics, take into account competitive changes and addresses that to the benefit of shareholders.
“Contrast that with SEA which unfortunately is in an environment in Southeast Asia where growth is not as robust and consumers aren’t as rich — while the competitive intensity accelerates.
“Sunny Optical continues to invest despite a fall in growth, margins and profits.
“But Haidilao recognised that times have changed. They resized their business, cut expenses, cut capital expenditure, focused on cash flow, bought back their debt, and prepared themselves to be in a situation where things might remain tough.
“For investors, it is important not just to have the management mindset, but you also need to understand your industry, your customers and those externalities that make a big difference to the business.”
“It’s not difficult to guess which two of the four names I own in our fund,” says Mehta.
Samir manages Pendal Asian Share Fund, an actively managed portfolio of Asian shares excluding Japan and Australia. Samir is a senior fund manager at UK-based J O Hambro, which is part of Pendal Group.
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