Hedge fund takes the long view of China

Hedge funds are no longer viewed as just short-termist troublemakers; many are long-term supporters of listed companies. But it’s still rare to find a hedge fund investing in Asia with an average holding period of five to seven years.

One such company is Dalton Investments, a US-based firm with $2.4 bn in assets and offices around the world. Tony Hsu, who manages Dalton’s Asia strategies and heads its Shanghai office, sees long-term potential in many of China’s entrepreneur-led companies, while also maintaining a short book full of state-owned enterprises.

‘We make it clear to companies that we are long-term investors and not short-term speculators’ – Tony Hsu

Prior to joining Dalton, Hsu held roles at Foxconn International Holdings and Goldman Sachs. He is an adjunct professor of finance at the China Europe International Business School in Shanghai and the National Taiwan University in Taipei, where he teaches an MBA course on global value investing.

Which screens do you use?

We maintain a monitor list of more than 3,000 companies. These are firms we’ve either met face to face or have become familiar with through our research process.

We ascribe a valuation to the company based on what we feel it is worth and, over time, the market may present an opportunity for us to buy quality companies at an attractive price.

Describe the investment strategies you are involved with. How many stocks do you hold? What is your average holding period?

Dalton Investments has $2.4 bn in assets under management, of which $1.3 bn is invested in Asia. For Dalton’s Asia strategy, we usually hold about 50 to 90 companies if we count both the long and short positions across Asia, including Japan. Our average holding period on the long side is five to seven years.

What are some of your largest positions, and why did you buy?

One of our largest holdings is a Hong Kong-based property developer with mainland assets called Century City International Holdings. The company develops residential and commercial real estate and also operates the popular Regal Hotels chain.

The chairman of the group, YS Lo, is the second of six brothers, all of whom have successful track records as entrepreneurs. Century City is certainly no exception and has been solidly profitable over the past decade, compounding book value per share by an average of nearly 20 percent a year over the same period.

In terms of valuation, Century City currently trades at a 75 percent discount to book value and offers a 4.5 percent dividend yield. Lo, who already holds 50 percent of Century City’s shares, has been buying stock both personally in the open market and at the company level via share buybacks. We like the firm’s long-term prospects and remain strategically invested alongside the owner-operator.

Can you describe any positions you have sold out of recently?

One example of where we took profits is a Singapore-based manufacturer of branded instant three-in-one coffee (packaged instant coffee with sugar and creamer included) and non-dairy ingredients. As a leading vendor in multiple markets in South East Asia, the family-run business has benefited from growing coffee consumption in the region.

The fundamentals for the company are still favorable, as Thailand and China have a per-capita coffee consumption of 100 cups and five cups respectively, compared with 500 cups on average for Americans. But investor expectations have been elevated and we took the opportunity to exit the position after the stock price had tripled from the time of our initial investment.

Can you describe any short positions you currently have? Why do you hold them?

We currently hold several shorts in South East Asia. One is in a state-owned oil and gas exploration company based in Thailand. As a country, Thailand is falling low on oil reserves and, in response, the government has put pressure on its state-owned enterprises (SOEs) to aggressively expand capacity overseas.

The SOEs generally comply and carry out expensive acquisitions, often with little regard for return on investment. We took advantage of an opportunity to short an SOE exploration and production firm that has made a string of overpriced acquisitions in recent years, most notably in Canada and Africa – as a result, goodwill and intangible assets have risen sharply.

We believe the goodwill will become written down at some point and will negatively affect the shares, which now trade at a lofty three times tangible price-to-book value.

How do you view the investment opportunities offered by SOEs compared with those offered by private enterprise in China?

As far as China goes, we generally prefer to invest in Hong Kong-listed companies that have mainland assets instead of China’s domestic A-share market. There are far more entrepreneur-led firms listed in Hong Kong than on the Shanghai Stock Exchange, which has a large percentage of state-owned enterprises.

We place a great deal of emphasis on alignment of interests and understanding the incentive structure of management. At present, there are many Hong Kong-listed family holding companies that are attractively priced. These holding companies own stakes in operating companies that are trading at large discounts to intrinsic value.

Thus, investors at the top of the pyramid receive a discount upon a discount on the underlying assets when owning shares of the parent holding company. Also, because the owner-operators themselves have a large percentage of their net worth tied to the holding company, alignment of interests is strong between the shareholders and the management of the companies we are invested in.

Our short book is mostly filled with SOEs where the senior executives tend to be either former politicians or have some political ties and have been put into these management roles by the state. These executives generally have no ownership in the companies they run. They typically have different motivations from those of entrepreneur-led companies and, in many cases, are just following orders from the government. The result is that they don’t put too much emphasis on increasing shareholder value.

Some SOEs have been told by the government to maintain employment in the state, some have been told to grow the size of the company at any cost, and some have even been asked to expand outside their core business into unrelated markets. Whatever the particular situation, the interests of SOEs are often more closely aligned with those of state officials than with shareholders.

How important is meeting company management to your investment approach?

Our investment process involves not only meeting management but also doing research on the executives themselves, including understanding their family background and whether they have enough skin in the game. The fewer outside interests, the better. We want to make sure the family’s wealth is tied to the specific entity where we are shareholders.

How many meetings with company management do you take part in each year?

The investment team spends a lot of time on the road – we meet hundreds of companies a year. In many cases, we are very familiar with management teams and contact them directly to set up face-to-face meetings.

Are companies ever wary of meeting you because of the hedge fund tag?

We’re aware there may be some companies that are reluctant to meet with hedge funds, but we haven’t experienced any such issues yet. We try to make it clear to companies that we are long-term investors rather than short-term speculators. Our holding period is five to seven years, so we are, in a sense, a provider of long-term capital.

What is the overall standard of IR like across Asia?

The quality of IR teams can vary greatly. What we do find, however, is that SOEs are generally less transparent and less willing to meet with investors.

Are there any companies you think have particularly good IR people or IR teams in Asia, and specifically in China? What sets these IROs apart?

We own a company called Fosun International, which is the largest non-state-owned conglomerate on the mainland. The company has interests in mining, property and pharmaceuticals, to name but a few areas.

The four founders own nearly 80 percent of Fosun and still serve as the firm’s executive management. Because most of the founders’ personal wealth is in shares of the listed company, their interests are well aligned with those of the shareholders.

I think what sets Fosun apart is that a number of its investments have been outside of China; recently, for example, it has been in Europe. Fosun knows that international investors require higher levels of disclosure, and it has put an IR team in place that understands this.

Can you discuss how you take part in ‘active collaboration’ with management, as mentioned on your website?

What we do across Asia is to promote management actions that increase shareholder value. A value investor in Asia often has to incite change through what we call ‘friendly activism’, which may involve writing letters to management or meeting regularly with the entrepreneurs who run the businesses.

Most of the time the management itself is the largest shareholder so, in theory, it should be naturally incentivized to increase shareholder value, whether that’s through higher dividends or more share buybacks.

Are there any particular sectors you don’t like?

The airline industry. Policy makers have to struggle between two competing interests: enabling profits and preventing monopolies from arising. In certain Asian markets, regulators have essentially granted monopolies to state-owned airlines.

In Singapore, for example, the state-owned airline has held a dominant position on various routes within South East Asia, enabling it to earn large profits but angering consumers in the process.

The politicians then have to step in and take corrective measures to allow greater competition. This leads to overcapacity, price wars and, ultimately, an unsustainable operating environment for the airlines.

It is something of a sticky dilemma for politicians who have to skillfully balance the interests of airlines and voters through policy – generally what happens is they overshoot and the cycle starts all over again. To date, we have never owned an airline company.

What impact, if any, is China’s economic slowdown having on your investment strategy?

I think we have to put everything into perspective. China has been growing at 9 percent a year, on average, for the last 20 years. While the pace of growth may change, China is a very large market and there will continue to be opportunities for well-managed companies.

There will be some ups and downs along the way but, for long-term investors, volatility is a friend. We strive to distinguish between the transient and the longer-lasting, and see these market fluctuations as opportunities to increase our ownership of good assets at cheap prices.

Please note, some figures have been updated from the print version of this article, which appeared in the October 2013 issue of IR Magazine.