The Capital Cycle Podcast - China vs. India

Episode Date: September 30, 2024

Investor sentiment towards these two Emerging Markets is now widely divergent. Where does the best value lie? Presented by Edward Chancellor With Alex Duffy, Portfolio Manager Emerging MarketsFor more information, or to access select articles from Marathon’s Global Investment Review publications which accompany this podcast series, please visit www.thecapitalcycle.co.uk Hosted on Acast. See acast.com/privacy for more information.

Welcome to the Global Investment Review podcast from Marathon Asset Management. My name is Edward Chancellor. With me today, I have Alex Duffy, who's an emerging market fund manager at Marathon. Good to see you again, Alex. Thanks for your time as well, Edward. So I think you've written a very interesting piece for the latest global investment review on the capital cycle. most people when they think about capital cycle investing think of it as a stock-specific idea, a micro method of investing. Whereas you're now looking at this picture from 60,000 feet high in the sky and say, no, actually, we can use the capital cycle to analyze entire markets. And in this case, you're trying to make the argument that the capital cycle can explain why China has done so poorly. from an investment perspective over last 15, 20, 30 years, depending on what your time frame is,

and why India has been doing remarkably well. So first of all, you start the piece by saying that a marathon, you reject the value and growth labels as capital cycle investors. Will you explain that to our listeners? Yeah, I mean, I think if you look at sort of investment narratives over the last decade in particular, but longer than that, 15 to 20 years or so, I would say, there's been a growing willingness to band investors into either growth investors or value investors. And as capital cycle investors, what we tend to focus much more closely on is the sustainability of return profiles and how intrinsic value creation is created through modest reinvestment

and a focus on sort of management skill in the capital allocation process that generates future cash flows. And often what we find with the growthier areas of the market is that they are the areas where reinvestment is the most excessive. And that actually soes the seeds of the downfall in markets. And equally, the value areas of the market disincentivize investment because companies are not being rewarded for reallocating capital into their core businesses. And it's that very dynamic which tightens the supply side, which is at the core of the capital cycle philosophy, and leads to an improvement in future returns. And so you have this somewhat perverse scenario, which is that over the very long term, what will once the value sectors become the future growth sectors as returns and then valuations improve, which encourages reinvestment in those areas. And equally what were once the growthier areas of the market as a consequence of the overinvestment

and the deteriorations of returns, they become the future value sectors. And that's very much the ebb and flow of the capital cycle. And we, you know, seek through our unique supply-side focus to kind of really identify the opportunities within it. So, Alex, as you remember, 15 years ago, everyone was touting China's GDP growth prospects and thinking that one should invest. on the back of those growth prospects. They ignored the fact that every serious investor knows that there's no correlation between GDP growth and stop market returns. We're going to get to China later in our conversation,

but let's start with the hottest of emerging markets, namely India. You're just back from India. Where you were to Jeffrey's conference there, listening to Chris Wood, the greed and fear writer, being ultra bullish on India. First of all, you talk about a speculative blowoff phase in India. Just tell us what's happening in India. So I think India is a fascinating market on multiple levels.

And as an equity investment market, it has created a number of very interesting opportunities, predominantly because of the fact that the companies are very returns focused as a consequence of their own shareholder base and insider ownership, which is, you know, returns optimising, being quite sort of dominant. What we've really noticed in analysing Indian equities, however, is the changing nature of participation in the equity market. So India has always been a country which for many years has had quite high valuations, P-E multiples in excess of 25 times, wouldn't be unusual.

Whilst that can be a warning sign, it's not necessarily a condition to exit the market in and of itself, What we've witnessed more recently is rising to participation of retail investors, more speculative activity further down the cap scale. So you mean, and you mean specifically mid-cap. Mid-caps and small-caps significantly outperforming larger-cap companies, despite not necessarily exhibiting higher return or growth opportunities. And now trading at a great premium to their historic average value. Absolutely.

Trading near double historic valuations and far in excess of. of comparable business elsewhere, whilst being somewhat commoditised. So no real sort of uniqueness to them that would justify such elevated valuations. And I think the final part about the market participation that is a warning sign to us is the rate of insider selling, which is dramatically picked up. And I remember going back to sort of the last boom in that pre-China period in 0607, where the stack of the red herring reports, the IPO prospectuses, would, build next to the desks. We don't get the physical reports anymore, but the emails that flood in

every day with a new place in India, I think, is a sign of euphoric market behavior. But that's where we are now. You say, and I think make a good point, the valuations, rising return investment, insider getting out. Those are all typical signs of a speculative blow off. However, India has achieved consistently high returns, those PEs of 25 that you mentioned, these companies have grown into their outsized valuation. Would you just explain to the listeners how the capital cycle can to some extent explain the extraordinarily good run of Indian equities? Absolutely. So I mean, I think the point we discussed earlier on around the high P.E. multiple in and of itself, not being a reason to exit, that was met.

by an Indian market which has a genuine cost of capital. Unlike China, interest rates in India, cost of capital has been higher than what we've seen elsewhere that reflects the nature of the economy. And partly because India had very low savings rate and has often run large current account deficits and therefore required foreign investors. And high interest rates to attract that. Absolutely. And so businesses have had to contend with the high cost of capital. And the way in which they've done that is to ensure that they generate higher returns on invested capital to offset the cost of so doing. And then against which you've had a market which has always been underpenetrated, the size of the population, the lack of investment and infrastructure historically, underpenetrated

consumer markets. And so what that's created is capital discipline at the company level and the reinvestment opportunity. At the aggregate level, as you mentioned, India's fixed capital formation as share of GDP has been relatively low? Absolutely. Fix capital formation fell from around 35 to 36 percent in 2007, 2008, came all the way down to 27 percent of GDP until about three, four years ago on a relatively low starting point for the invested capital stock. And you compare that to China, which for many years has run with fixed capital formation to GDP in excess of 45 percent. The highest levels of any country in history for longer and ever in history. On an ever-growing capital stock.

And that really sowed the seeds of the downfall, the excessive capacity, and then the explosion of exports, particularly of capital goods that we're now seeing enter the US and European markets and the reaction to that. So India's never had to contend with those excess capacity issues to start with. So it's had ownership focused on returns. It's had a relatively high cost of capital. And it's had relatively depressed investment at the macro level. And therefore, the country is, if you will, capital constrained.

And capital constraint means it earns a high return on capital, which is marvellous for investors. Now you think things are changing, beginning to change. Capital cycle moves. What we've been witnessing over the last few years is success on the part of the government in terms of forcing through CAPEX projects, restructuring tax structures, the GST structure was changed some years ago.

And so that has sort of unleashed some of this pent-up demand. More worryingly, the single equity level, or more cautionary, I should say, at the single equity level, whereas reinvestment had been relatively modest for most sectors, so CAP-X slightly above depreciation, maybe in line with depreciation, We're finding many instances in the industrial sector, in particular, cement companies, steel companies, copper wiring and harnesses businesses, where capex to depreciation has increased fivefold over the last two to three years.

I should mention that the capex to depreciation ratio is one of the prime capital cycle metrics that marathon uses. Absolutely. We get a sense of how much a business is redeploying back into its operations, to the sort of useful life and obsolescence of its existing infrastructure. And, you know, whilst India certainly has a need for capital investment, there are questions as to how far and how fast that should increase. And I think what is occurring at this juncture with the re-rating of valuation multiples is that the market's saying these companies can redeploy ever larger amounts of capital at the same, if not higher, rates of return.

And it's the intersection of both of those elements that I think create reasons for caution, because the base case scenario is that you get very high growth rates and constant, if not higher levels of profitability. And what history has taught us as capital cycle investors globally is that when you get ever greater levels of reinvestment at some point or other, particularly if it's a commoditized, industry, you will get competition and fall in returns. And that's not what we feel the market

in aggregate is priced for. Right. And with high valuations and speculative behavior, that these are all suggestive that, you know, that India is, let's say, in the last quarter of the capital cycle, but capital cycle investing, it's long-term investing rather than thinking about market timing. So as Chris Woods said, at Jeffrey says, you know, India is definitely a buy on momentum, but from a capital cycle perspective, you're now underweight. Yes, correct. So we're underweight India relative to its weight within the MSCI-EM benchmark. We own within India what we be believed to be very well-suited companies that are allocating capital efficiently and where we feel the valuation gives us a reasonable degree of sort of margin of safety.

And so we're not saying that India is a sort of busted flush by any stretch of the imagination, but the warning signs are there and are growing. And conversely, there are other areas of emerging markets where there's a different Let's get onto those at the end and turn our attention now to the emerging, if one can call it, the emerging market basket case, at least as far as the investment world is concerned, namely China. Briefly, explain why you think the capital cycle might help us understand why returns from Chinese equities have been so extraordinarily low. Well, I mean, I think that what we've observed in China over the last five to seven years has been the playing out of a classic capital cycle. So stocks across lots of sectors, not least the internet sector actually, generating decent returns, trading at multiples that implied the ability to reinvest and grow those companies at those levels of profitability.

So paying up for the growth rates. And that attracted competition from private players, from new listings, and ultimately, whilst the narrative on China is very much that it was all the government that drove the collapse in the equity market, one could argue that returns on invested capital came down because competition ramped up. So this is even outside the SOE, the state-owned enterprise sector. Absolutely. I think across the piece, whether it's consumer. businesses, whether it's internet businesses or technology companies, you saw a similar effect play out. You point out that the asset turnover, which is a key driver return on equity, has been on inexorable, almost Japan in the 1990s style decline. So what we find when you get these periods of overinvestment is you just have too much supply,

not enough demand. Or too many assets. Exactly, too many assets. And that results in a deflationary environment. where initially fall in pricing but also declining volumes results in sales to the asset-based decline. And so asset turnover comes down. And then profitability starts to weaken as a consequence of that. And in an ideal scenario, what we as investors would look for would be consolidation of those assets. And so capital exiting industries and markets.

You point out that these companies are not earning their cost of equity. Is that great? So I think that if you look at ROE's returns on invested capital for large parts of corporate China, it has fallen to the cost of capital, if not below in many instances. But positively, the management teams have recognized that. And so what were once the growth companies of Asia have suddenly stopped reinvesting in their businesses and are no longer trying to grow revenues, they're much more focused on their own share price. and rewarding shareholders through the return of cash flows.

And so share buybacks and dividend payments across all sectors in China have increased significantly in the last 12 to 18 months and reinvestment rates have declined. Now, we're not witnessing... By the way, as in Japan, the regulators are also trying to get Chinese companies to improve their returns. So I think this is an important point we shouldn't miss about China as well, is that really there are three sort of broad sources of household wealth creation or asset that they can invest in in a closed capital system. It's the property market. It's the bond market and it's the equity

market. And we all know what's happened to the housing market with excess supply and kind of collapse of property prices. Well, bond returns in China are very low because of the deflationary period in which they're in. And so, you know, in order to hold capital in, in China, the authorities recognize the need to reward shareholders. And I think there's a big part of that because China is typically a domestically owned market, there is a, you know, an increasing focus on shareholder returns. And you are seeing that through dividend policies and share buybacks and, as I said, a much greater focus on return on invested capital. So there's a positive, so as the Indian stock market moves into a negative phase, let's say, at the capital cycle, the Chinese market is moving into

positive phase, but you're still cautious. You're not convinced that management's are going to run the companies in the interests of shareholders and excise proper capital discipline. So in my mind, there are two aspects to it. One is the very quantitative capital allocation process, which is you've got X amount of cash flow. How do you sort of divvy that up between reinvestment and return to the shareholder. And then you've got the somewhat qualitative side, which is, well, how do you rationalize physical supply and consolidate an industry?

And so whereas the quantitative aspect, the management's taking corporate cash flow and returning more of that to the shareholders because the share price is not rewarding reinvestment is starting to work in our favor, it's the qualitative side around consolidation that isn't working properly. or where the capital cycle is less effective in China.

There are, I think, political reasons why that's the case. There's misalignment of interest or management ego, why that may be the case. And also, China remains a competitive marketplace. So if somebody sees an opportunity to generate a return, they will target it. And we've seen that with the electric vehicle sector in particular. And so I think that that side of the capital cycle in China is much more challenged, Whereas the quantitative element is more favourable. So we're conversant of that.

One way you can see that how is that China ranks second last in the Asian rankings of corporate governance, a good way just above Indonesia, but below India. And so the upshot of all this is that you are also underweight Chinese equities. You can't be underweight everything, so you must be overweight something. If China and India, which together are what, 40% of the MSCI index thereabouts, yes, there are there. Then there's another 60% where you see greater opportunities. So the way in which marathon emerging market portfolios have evolved over the last few years is really to benefit from what we perceive to be a broadening of the opportunity set.

So we are very focused on the cash flow return on invested capital of the company is able to generate and how that flows back to us as the shareholders and sort of the entry multiple that we pay for that. And what we have found is that we own companies in China, we own companies in India. But at the same time, we have well-managed businesses where management teams have skinning the game in terms of the ownership structure of the equity. And they have modest reinvestment opportunities sets and attractive valuations across. other parts of EM. And so that gets reflected in our exposure to South African equities, which has been absolutely in the doldrums for probably getting on for 20 years. And trading at a discount to its historic average value.

Trading a deep discount to historic average value with very well-managed companies. Not the reinvestment opportunity that you get in India. So you'll never drive the compound in potential yet. But neither are you being asked to pay for that? And we think that that risk reward is more favorable. Equally, and it hasn't been favorable for us in recent times, but Mexico has a number of well-managed family businesses, exposure across the Americas, consolidating the Coca-Cola bottling system in the Americas as a casing point. And that's been an area of focus for us, as has the consistent compounding of specific

Indonesian banks, where there's a genuine sort of deposit franchise that we've been long-time fans of. So we think that there's a very broad opportunity set within emerging markets. We, at the margin, like the direction of travel in terms of what we see in China, so we are working more there and we're trying to surface more ideas that we could potentially add to the portfolio in that part of the market. India, we think that capital cycle can take a long time to play out. And it might not be in the complete tail end of it just yet. But there are signs for sort of caution. And we just wanted to bring that to love. given equity markets have this obsession with everything's either fantastic. And so we're all in

on India and it's terrible so that we're not exposed to China whatsoever. And inevitably, the middle ground is sort of often where the truth lies. And that's where we try to position ourselves. So there you have it. So capital cycle investing is a tempered contrarianism. And thanks you, Alex. That's very interesting. And I look forward to further discussion with you sometime. Thank you. Thank you for listening. If you'd like to access the global investment reviews and or the podcast, you'll find them at the Marathon Pliant Portal. Do join us again next time.