How this pro weighs up risks and rewards

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The Asia-Pacific region is an adventurous area that can potentially add spice to a portfolio. Joining Kyle to share his outlook on the region and talk through how he aims to strike a balance between risks and opportunities, is Doug Ledingham, manager of Pacific Assets Ord (LSE:PAC) Trust. Doug explains why the investment trust has been increasing exposure to China, offers his view on India, and discusses other countries he favours.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to On The Money, a weekly look how to get the best out of your savings and investments.

In this episode, we're going to be looking at the outlook for investing in the Asia-Pacific region, and in particular, we're going to be focusing on the prospects for China.

Joining me to discuss this topic is Doug Ledingham, manager of Pacific Assets investment trust. So, Pacific Assets has had a longstanding underweight position to China. The trust is still underweight versus the index, but it has been increasing exposure to China over the past year or so.

Doug, could you explain why you've turned a bit more positive and where you're finding the opportunities?

Doug Ledingham, manager of Pacific Assets investment trust: So for us, Pacific Assets should always be a reflection of where we're seeing the best opportunities to predict and grow our clients’ trust over the long term. Now, if you look back to the trust in 2010, 2011, when Stewart Investors took over, so China and Hong Kong was roughly 20% of the portfolio vs India, which I think was 10%. So, over the past 10, 15 years, there’s been material evolution in the portfolio and, hopefully, that’s a reflection of us evolving the trust to where we see the opportunities.

Now, in 2015, we were given the opportunity to invest in mainland companies for the first time through the Hong Kong Stock Connect. But those of us who know Stewart Investors, know that we take our time.

We're really looking to hand the Pacific Assets Trust capital to reputable privately owned enterprises with great stewards, very attractive business models, and long-term opportunity for growth.

When we first started looking at China, a lot of the companies that we were interested in just hadn't been listed for very long. We really are looking at financial history to get an insight into the behaviour of a franchise, and the behaviour of the people that we're handing the trust’s precious capital to.

So, for us, yeah, time was important in the market in terms of understanding the opportunity set, and also valuations. You could probably spend a whole podcast talking about valuations in China and what that really tells you.

But for us, the types of companies that we are interested in, you remove the big state-owned banks, the state-owned insurance companies, and the types of companies that we were interested in handing our clients' capital to were not that cheap, and were actually probably more expensive for the growth opportunity vs where we were being asked elsewhere in the region. Yeah, so for those two reasons from, say, 2015 through to 2020, we had limited exposure to China.

Now as you mentioned, there has been a growing exposure to China over the last 18 months, two years, and that's really a function of three things. The first one being a great understanding on our part of the investable universe, the types of companies that we get excited about, spending more time with them.

The second point being valuations. Since the end of 2020, you've probably seen private enterprises in China lose $4 trillion worth of market cap.

Finally, a shift in the positioning of privately held, or privately owned, businesses in China. I think in February this year, you saw Xi Jinping sit down and shake hands with the large Chinese entrepreneurs. I think that was probably a big turning point in how Xi and the CCP [Communist Party of China] see the role of private enterprise. That's an important indication for us in terms of how we think about risk and opportunity in China.

Kyle Caldwell: So, over the past two years, what's the exposure to China gone from, and what is it today?

Doug Ledingham: So, it's gone from less than 10% to 16% or 17% today. I don't know what that is in the index, but certainly for us as truly bottom-up investors, we're always looking for opportunities in the region where there’s clouds hanging over particular countries or sectors.

In China, the opportunity over the last couple of years where you saw companies get sold off, no matter whether they were state- owned or privately held, what the company did, the balance sheet, the valuations. All these companies were sold off together, and for bottom-up stock pickers like us, that was the perfect market, a perfect opportunity to really get on the road and see what's out there.

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Kyle Caldwell: You mentioned earlier, Stewart Investors, it has a capital preservation focus. Could you go into more detail about how as a house Stewart Investors invests and how it differs from other fund firms?

Doug Ledingham: I tried to move away from this idea that we are defensive or too risk averse. There’s many ways up the investing mountain. For us, we are really trying to position ourselves as the most attractive long-term stewards of capital in Asia. And we’re kind of working backwards from that and that really means looking for that combination of capital preservation and growth, and the knowledge that if we want to compound clients’ capital over the next 10, 20 years, we've got to be around to do it.

So, that capital preservation point is important to us. If you look back over the performance of the last 15 years of the trust, we have tended to underperform fast-rising markets, where you've probably got a little bit more speculation, a little bit more greed, probably a little bit more concentrated performance in regards to the index.

Then, on the other side of that, the last 15 years, we have tended to preserve capital better than the index in times of stress. Now that is a function of a few things.

So, coming back to how we think about risk. Risk for us is the risk of losing clients’ capital rather than deviation from a benchmark, and that has been a fundamental input to how Stewart Investors has invested capital over the last 30 years. Then that leads to a number of other inputs.

So, we try to take a long-term perspective to allocating clients’ capital. We’re not trying to beat our peers in in guessing what’s going to happen next quarter. We're looking for companies that we can allocate [to] for as long as possible and really benefiting from the growth of great companies.

When we’re constructing the portfolio, we’re trying to be as humble as possible. Looking back over the past 15 years, we’ve never forecast any macroeconomic events. We understand that we can’t do that. We’re looking to build a portfolio that’s robust and resilient to most macroeconomic events. I think this is probably something that doesn’t get enough attention in the investment industry, just who are the people you’re handing your money to?

I think we’re an industry where everybody wants a number with probably a couple of decimal places. But we spend a lot of time asking ourselves who we’re handing Pacific Assets’ capital to. I think that over 90% of the positions in the trust at the moment have a family, a foundation, or a founder behind them.

So, that’s been an important input to the preservation and growth aspect because when you go into that inevitable down cycle, you want businesses with robust balance sheets, resilient cash flows, the ability to think and act differently and [those that] look to maximize the value of a business over 10 years rather than 10 months, and owners think like that.

But, again, if you’re in an industry like ours where there’s lots of focus on quantification, there’s lots of focus on short-term time horizons, people don’t matter. We can read reports written by investment banks that could run to a 100 pages, and there’s maybe one paragraph in [there about] people.

So, I think one thing that certainly we are giving in terms of our long-term approach, our active approach, is that ability to think differently about who we’re handing money to. You can see that, hopefully, when you are investing in Pacific Assets, that you have your money alongside individuals and families that have billions of dollars invested alongside you, and also generations’ worth of reputation at risk. I think that's a very important thing to think about with Pacific Assets.

Kyle Caldwell: Your process, it involves seeking out predictable businesses that are also sustainable in terms of how they operate. With China, has the investable universe increased over the past couple of years? Are you now seeing more companies come on your investment radar?

Doug Ledingham: We are looking for companies, and I think this is important in most markets, but especially in China, where the management team are focused on quality of growth rather than quantity.

We speak to a lot of Chinese companies, and the ambition is to be the biggest, not the best. And that really leads to many sectors in China with very limited pricing power, limited margins, limited returns. So, when we're talking to management teams, we're looking for companies and management teams that are focused on value proposition.

This has been a very interesting time to be talking to Chinese companies because you can see what matters and the lessons that are being applied from the current economic downturn. We’ve had some really interesting conversations with our companies about lessons they've learned going into this down cycle, what they're doing with their balance sheets, and how, importantly, they're benchmarking themselves against global peers.

I think there's some really great opportunities in China in the software space, in industrials, especially those industrial companies that are providing a service where price is not number one on the customers’ priority list. An example would be an industrial company that’s saving time for customers.

So, we own a company that provides industrial automation inputs, and part of their value proposition is getting those products to clients as soon as possible, so they don't need to hold that on their balance sheet. That serves two benefits to the customer; they save money, but also, they have more time to spend on their core value proposition.

So, for us, there's a very long opportunity for these kind of industrial companies to evolve in China. We also really like companies that get stronger at the bottom of the cycle, and we're seeing that a lot in the industrial companies.

So, getting out there and talking to companies is [one] of the best ways that we can find opportunities. Screening companies, it'll tell you what's gone well in the past or what's not gone well, but, really, it's change, and also meeting the people, that will create those long-term opportunities.

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Kyle Caldwell: You're what’s known as a bottom-up stock picker. How does the wider macroeconomic backdrop influence your investment decision-making, particularly when it comes to deciding to increase exposure to a region such as China?

Doug Ledingham: That’s a good question. We appreciate that our companies don't operate in a vacuum, so it’d be naive to completely ignore what's going on in the macro picture. But I think probably China is a wonderful case in point in regards to the challenges and risks to your capital if you take a purely top-down view.

Over the last 30 years, the GDP has grown many, many multiple times. There's been wonderful educational and health outcomes over the last 30 years, but the Chinese market’s the same price as it was 30 years ago. Top down, you can sound very smart, but I don't think it's the right perspective to take when stewarding other people’s capital.

For us, we are really trying to understand the opportunity, especially in China, for high-quality companies to create value, not only for customers but for their shareholders. That throws up a number of questions in regards to China. So, we really struggle to find companies where there’s a large presence by state-owned players.

The playing field is not flat, and it really runs against the idea or our desire for great companies to inevitably dominate a market and lead through a better value proposition for their customers. If you’re competing against a state, it’s not a nice place to be.

The second point would really be that you’re coming back, again, to that: what is it? What are the dynamics that allow a company to win? There’s many sectors in China where prices is the dominant factor, and you have many companies operating in that space that have no consideration for profits. It’s not a nice place to be.

We were in Hong Kong recently talking to a number of consumer companies. But post-Covid, you’ve really seen a major shift in the psychology of Chinese consumers. Not only have you had a major economic downturn with the tightening of wallets, but you've had the emergence of Chinese companies that can produce quality comparable to multinational players at a comparable, at a similar price.

For a long time, there was a a perspective that multinationals could sell a trusted brand and they could just replicate models that have been successful elsewhere. I think that's changed materially, and [it's] certainly a dangerous place to be if you've got very high margins and consumers have changed their purchasing decisions.

Kyle Caldwell: How much of a factor is political risk in your investment thinking when you're deciding whether to invest in a company in a particular region such as China?

Doug Ledingham: The political risk is a major concern for us. And, again, coming back to that point on us being truly active, if we can't get comfortable with a particular company, sector, or country, we’ll have 0% of the portfolio invested there, which is a freedom you don't have if you are constrained by the benchmark. So, political risk is a major concern for us and especially that alignment question.

For a long time, we’ve really looked to find great opportunities in the healthcare space in China. They have some healthcare burdens, whether it be diabetes or cancer that's in line with what you see in the US from an absolute numbers’ perspective, but they spend a fraction of their GDP on healthcare.

So, they need to develop a low-cost, high-quality healthcare system. What we've really struggled is finding that alignment with the states because what we've seen is when penetration for a particular product [falls] in line with the global West, pricing changes overnight.

You saw that with orthopaedic products. You get an email one day saying the regulator’s decided to cut prices by 70% and share prices go with them. So, for us, it's very much understanding how our companies are aligned with where the CCP wants to take China, and then also questioning, and this is a heavily, I suppose, qualitative question, [what] is an allowable return?

Certainly, we get nervous looking at companies that are extremely profitable in China because, likely, they will fall under the lens of the state. I think that qualitative and holistic view of risk is important in China. If you were a quality manager purely focused on defining quality in quantitative terms, you probably have missed those risks in the past.

So, for us, keeping a close eye on that alignment with our companies. Again, if we were to see a shift in the CCP’s positioning in regard to the importance of privately owned companies in China and a shift back towards the dominance of the state, you shouldn't be surprised if you see Pacific Assets have a lot lower weight within China.

Kyle Caldwell: Would US tariffs also come into your investment thinking, particularly if it's a company that you're examining or own that is being hit by paying higher tariffs to the US?

Doug Ledingham: As I said, we’re trying to work backwards from all the ways that we can lose clients’ capital, and certainly tariffs and a changing of the competitive environment is something that we get increasingly nervous about.

I think what’s important is to come back and ask ourselves how much of the particular franchise and the investment cases is at risk here. A lot of the headlines probably overemphasise the dependence of many Chinese companies on the US. I think post-Trump 1.0, lots of companies realised that they needed to diversify revenue streams, and you’ve seen a lot of Chinese companies, especially in regards to overseas growth, emphasize Latin America, Africa, ASEAN, rather than just selling into the US.

I think the underlying risk to cash flows for many Chinese companies are probably not as high as people assume. We have material positions in the trust in India, and we have at least a number of industrial companies that are globally aspirational in their targets over the next 10, 20 years.

For us, when we are looking at industrial companies in India, we’re looking for companies that are offering high quality. They're looking to build trust with customer bases over time, and they increasingly understand, especially when we talk to these companies, that you can't build a world-class company in India if you're just leaning into labour arbitrage and competing on price.

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Kyle Caldwell: Let’s move on to India. As you mentioned earlier, 15 years ago, it was a relatively small weighting in the investment trust. It's now your top country weighting, although you've been taking some exposure off. Is that all down to valuations or are there other factors at play? For a couple of years now, India has had a premium valuation compared to other regions. Is that justified?

Doug Ledingham: For the last 10 years, India has been the material exposure of the trust. I think what's important to highlight about the investable universe in India is the breadth of the opportunity set.

We have the ability to own a number of world-class companies with wonderful long-term opportunities and exposure to a number of really exciting trends. It's not like some, perhaps, Asian or emerging market where you're forced to either own a bank or a telecom company.

If you were to look at the underlying exposure that we've had in India, it has evolved materially over the last 10 years, despite that weight being consistent. The material shift [has seen] a reduction in our exposure to consumer staples, which those of you who know Stewart Investors well will understand, have historically been a wonderful place to provide the outcomes that we're looking for in terms of resilience at the bottom of the cycle and nice, long-term growth opportunities.

But today, we’re being asked to pay very, very high multiples for growth that isn't as certain as it was in the past, and that's due to rising competition and evolving distribution channels. So, we've reduced consumer staples.

Coming back to that point on industrials in India, that's certainly something where you're seeing an emerging set of aspirational companies with very ambitious long-term owners at the helm.

I get really excited when you hear them talking about taking on global industrials in their backyard. When you look at some of the European industrial companies that are now very large, very bureaucratic, and do a bit of everything, these are the types of companies that our Indian owners are very excited about taking on. Yeah, that's certainly been one evolution that I’d highlight in regards to what’s been going on in India. In regards to valuations, we own companies, not countries.

I think coming back to comparing China and India, which is inevitable in Asia, [one thing] is the divergence in the largest companies in both indices, the divergence in the ownership structures. Then on that, just highlighting that the companies we own look and behave very differently to the index. Of the 100 largest companies in India, we throw 75% of them out for governance, franchise, or sustainability positioning question marks. So, we’re not owning the index.

What we would say is that when it comes to valuations, we try to take a step back from looking purely at short-term price-to-earnings ratios and lean into the advantage that we have of taking a 10-year time horizon and asking different questions. For example, asking, what is this company worth to us over the next 10 years? Rather than, ‘Oh, it's at a 10% price-to-earnings premium’. I think that's something that we try to utilise as much as possible and not get sucked into the short-term game of just comparing price-to-earnings ratios.

Kyle Caldwell: You mentioned that you invest in companies, not countries. However, when looking at the portfolio outside both India and China, which countries do you have the most exposure to and why?

Doug Ledingham:  We’ve got material weights in Taiwan, which, again, is the result of finding truly world-class industrial companies largely run by long-term competent stewards.

One country I think that's worth touching on is the Philippines. It's now, I think, 7% of the trust. You’ve seen the trust increase exposure to the Philippines for a couple of reasons. First, valuations are very enticing and coming back to that point on finding parts of the market [with] clouds hanging over them, the Philippines is kind of the land that foreign investors have forgotten. We were there a couple of months ago, and the brokers that took us around, it was like them seeing aliens. They were so surprised to see a foreign investor rock up. That's certainly something you don't see at the top of a market. From a company perspective, there are a number of very well governed companies in the Philippines.

Kyle Caldwell: As you've explained, you invest very differently from the index. You have a capital preservation focus, and a long-term investment approach. But if you look at shorter periods, say, over the past one year, the trust has made a small loss in both net asset value and share price total returns. Could you explain why that's been the case?

Doug Ledingham: Yes. The performance hasn’t been helped by the lack of exposure in the trust to Chinese mega-caps, Chinese banks, and the very strong performance of Taiwan Semiconductor Manufacturing Co Ltd ADR (NYSE:TSM). Then also, on the other side of the portfolio, the larger Indian holdings that we have, they’ve seen relatively muted performance over the last 12 months. So, certainly, that combination has not been pretty for relative performance over the last 12 months.

But, as you said, we’re focused on creating long-term value for underlying shareholders, and that really means focusing on 10 years, seven years. That’s where that focus on capital preservation and the focus on people really contributes to compounding. Over any 12-month period, it’s largely multiples and noise that drive share prices.

I think any philosophy has to have a trade-off and a cost. For us, the cost is not being drawn into attempting to outperform every 12-month period, and the cost is explaining why we have underperformed. I hope that when clients look at the relative performance of the last 12 months, they can understand that underperformance.

If we were to have outperformed over that period, I think it would have required material shift in the investment philosophy. So, it would require less of a focus on governance, less of a focus on leverage, and a shift to how we see position sizes.

TSMC is a wonderful company. We’ve owned it, I think, since 2010, 2011, when we took over the trust. It’s currently a 2% position in the trust, and I think it’s 10%, or at least very close to 10%, in the index. We wouldn’t have 10% in our highest-conviction name, partly coming back to that view of risk and humility and not wanting the portfolio to be overly exposed to a particular name or sector.

So, yeah, TSMC is a wonderful name and a wonderful company, but that position size for us is really a reflection of how we see risk and valuations.

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Kyle Caldwell: Looking ahead, what would you say is the main reason for optimism and also the biggest risk for investing in the Asia-Pacific region?

Doug Ledingham: I think the biggest risk with Asia given the diversity of the markets, the number of very large [emerging] democracies, the number of nuclear arms borders in the region, there’s always something to worry about. There’s always going to be a headline or two that’s picked up and has a risk of forcing you out of your Asian exposure.

Asia really does offer some wonderful long-term structural opportunities, whether that be financial inclusion, the rise of billions of middle class, or the rise of manufacturing powerhouses in, say, Vietnam or India.

Coming back to that point on what it is that Pacific Assets offers underlying clients, those long-term opportunities have always been there, but what does Pacific Assets offer? It offers you [the chance to] align your capital with owners who are willing and able to benefit from those trends. They've got their money invested alongside you. Like I said, I think they’re trying to build a better business in the next 10 years rather than the next 10 months.

Valuations are very attractive in our view for that growth opportunity. Some of the portfolio metrics for the trust, if you look at free cash flow yield, it’s near all-time highs, and if you combine that with the number of opportunities that we're coming across in the region, it tends to indicate a pretty attractive opportunity longer term.

Obviously, the US has done very well. When we talk to some of our clients, they’ve got the lowest exposure to Asia they’ve ever had. I think diversification is important and getting exposure to Asia over the next 10, 20 years through a trust that is allocating to outperform over those periods and not being dissuaded from that due to political headlines or the outperformance of the US…I think probably the greatest risk is not having exposure to the region over the next 10 years.

Kyle Caldwell: Well, thanks to Doug, and thank you for listening to this episode of On the Money.

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In the meantime, you can find more information and practical pointers on how to get the most out of your investments on the interactive investor website, ii.co.uk. I'll see you next week.

On The Money is an interactive investor (ii) podcast.