Matt McLaughlin (0:13)
Hello, and thanks for joining us today. My name is Matt McLaughlin. I'm the international portfolio specialist at Diamond Hill and I'm joined today by Krishna Mohanraj, portfolio manager on Diamond Hill's International strategy. Krishna, thanks for joining me.
Krishna Mohanraj (0:29)
Great to be here.
Matt McLaughlin (0:31)
Maybe to start off, given that we are three-quarters of the way through the year, give us your overall comments on the markets and what's transpired so far this year outside of the US.
Krishna Mohanraj (0:44)
Matt, let me start with the most important message. The clear message in international is that it's a great time to be an active investor. This is not an environment for big macro calls. It's an environment for bottom-up stock picking. That's what we are finding.
It's the time you want to identify differentiated businesses. Look for what is misunderstood because there are just too many macro crosscurrents. So, if you go looking for themes, you can get lost in the noise. Just look back to what's happened year to date. Anybody looking for broad themes is facing the plush. We started the year with China: There was euphoria around reopening, which led to disappointment, and since then, the news from there has continued to disappoint. Japan: You have rising expectations that Japan might have turned a corner and has become investible. That's a theme we'll probably talk about more later.
Political turmoil and protests in many parts of the world, especially Latin America. Election campaigning or pseudo-campaigning already having started in Mexico and India. All highly volatile environments but also rich environments for stock picking.
Looking at Europe and the UK — generally struggling economies. You even saw the end of Credit Suisse this year — a Swiss icon bank with over 170 years of history…gone. You have an ongoing war, another major conflict now in the Middle East, and then the big theme of the time: the massive rise in interest rates, especially in the US but also across the world, which I think is changing the investing landscape in a big way and it's causing a lot of angst.
So definitely not boring. No shortage of headlines, and I can promise it's not going to be any less exciting next month or the following month or the rest of the year. But this is par for the course in international. In fact, it's the kind of environment you want to actively take advantage of. Bad headlines — we keep saying this — bad headlines are where we find the best investment ideas, and sure enough, we've been very active. We are excited. The team has been traveling extensively and engaging with management teams, and the portfolio is very well positioned.
If you're worried about macro, if you're looking at the macro picture right now, why would you ever own an international index product, which gives you a piece of so many mediocre businesses when you can be selective, own just the best and own a highly curated portfolio of companies? That's our mantra, and that's what the team has been focused on all year.
Matt McLaughlin (3:20)
Thanks for those comments. And I think you're right. The rise in interest rates this year has many people and investors scratching their heads. And given the importance of interest rates and discount rates to our intrinsic value philosophy and process, what are your thoughts on the continued rise in interest rates, the potential impacts, and maybe some opportunities or challenges that it creates for the team as investors in international stocks?
Krishna Mohanraj (3:55)
For way too long, we've had unusually low rates. And what does that do? When capital is plenty and cheap, fundamentals don't seem to matter much. Balance sheet strength doesn't seem to matter much. Discipline and skill and capital allocation don’t seem to matter much. The resilience of businesses doesn't matter much. Well, now we no longer have that. We no longer have low rates. We've seen a massive move up in rates, and that makes it super exciting for stock pickers like us because your ability to generate alpha by picking differentiated businesses finally comes through. And we are beginning to see that. We are beginning to see differentiation come through in fundamentals, in commentary from management teams, and slowly in stock performance as well. So, rates moving up for us, it's a positive.
And in terms of how does it play out in the portfolio? I would say, first and foremost, think about risk. We want to think about risk and protect ourselves from any unknown unknowns. When you operate in a low environment for so long like we have, there are blind spots the market has been building up, which is obvious to most people. We want no part of those. So first, business models that only work in low rates. The best recent example I can give you is companies in the renewable space, like wind/solar manufacturing companies, companies with lower returns on capital needing tons of capital investment on an ongoing basis and surviving only because capital was almost free for so long. You're already seeing the stress in that space. You can look at most of the listed companies there, and you see the stress. It's a space we avoid.
The second, I would say, is business models that can survive at higher rates but tend to build up hidden risks when rates change. Think about banks. Think about real estate companies. If you look at our portfolio, we don't own many banks, especially the European investment banks, Japanese and Chinese banks. In many markets, unlike what we have in the US, mortgage rates are floating rates, which means mortgage payments have gone up significantly, [causing] huge stress on customer balance sheets, and it's a fast-developing risk for the banks. Now, many of them screen cheaply. Typically, you look at the value international benchmarks, it's full of a lot of the banks, which we've avoided. They're complex balance sheets — hard to fully understand from the outside. Especially when you have these massive movement in rates, [they’re] prone to risk. So that's on the risk side, and I think we are very well set up in terms of exposure.
The other side is the opportunity, right? When there is any kind of big macro move, rates are one example. You can think about currencies; you can think about pretty much any macro factor. There are always businesses that benefit. We spend our time building a watch list of companies that are really good at what they do. And when there are big macro moves, and we think they can benefit, it's a time we get excited. We want to own some of them.
You will notice, if you've been following our portfolio over the years, for the first time in our history, we've built up positions in copper and energy stocks. Why? If the cost of capital is going to stay higher, that reduces the arrival of new capacity and new supply in resource-heavy, asset-heavy businesses. For energy and copper, we like the supply-demand picture in the coming years. Now, the fact that the cost of capital has gone up further increases the chances that new supply would be delayed. New supply would be harder to come by. Can you be sure of the price of the commodity in the future? No, but the odds have tilted more in our favor, which pushes us a little more into situations like that. So we'll see how things play out. But rates moving up is something we're excited about.
Matt McLaughlin (7:56)
You mentioned in your opening comments, Japan, and some excitement about Japan. I think that's due to some corporate governance reform that is going on or at least being talked about more and more in Japan. Is the team seeing signs that corporate governance reform is real? And what kind of activity has the team partaken in Japanese stocks so far this year?
Krishna Mohanraj (8:25)
Let me start with a little bit of context. When it comes to our style, we invest in companies, not countries. We keep saying that. We are always looking for unique companies to invest in and situations that are misunderstood. In terms of broad country themes, we keep an open mind. With many things in global markets, the short answer is that we don't know exactly what will happen. And even if we do, even when you predict something correctly, you can get tripped up on the second-order effects of what's going to happen. So, it’s very difficult to invest based on country and macro themes.
But with that caveat out of the way, let's talk about Japan because it is actually exciting. I would say we want to hunt not where everybody's fishing but where the fish are. And the most important thing to remember about Japan is there's a lot of fish — bargain stocks, unloved, with hardly anybody covering them, a complete lack of interest from the banks and their cadre of analysts.
So, the market itself might be in the headlines, but there's hardly anybody covering many of the stocks in Japan. That's what is interesting. I'll give you a comparison. Look at the S&P: 98% to 99% of the S&P [stocks] have at least 10 analysts covering them1, and many companies in the S&P will have over 40-50 analysts covering them. If you're on the buy side, every time one of these companies reports, there are 50 people out there telling you and the whole world what to think about it. Now, contrast that with Japan. Two-thirds of the market has zero coverage, maybe one or two token analysts — completely sleepy, an environment that nobody's analyzing, nobody's publishing yet another quarterly update. Nobody's on CNBC talking about individual stocks. That's the opportunity. But the trick is that you need to be super selective because Japan can really disappoint, and not every bargain in Japan is worth buying.
We patiently go through stocks one by one. I would say out of 4,000 publicly traded stocks in Japan, a huge percentage — I want to say three-fourths — are not very good businesses. We already know them, avoid them. It's the rest of the thousand stocks where the businesses are good, management intent is improving and the coverage is poor. That's the sweet spot. That's what is attractive to us, and that's where we are fishing.
Since you asked about corporate governance on management intent, it is definitely improving. Their stock exchange has been pushing companies to improve returns on equity, and this is leading to a bunch of them announcing large buybacks, dividends, and shareholder-friendly policies like that. And more importantly, there is a lot of low-hanging fruit, and that's what’s attractive. I think 70% or so of the listed companies haven't really done anything yet. And remember, Japan is a society that works on peer pressure. So, it's highly likely that more of these companies start moving in that direction.
So, we've spent a lot of time looking at Japan this year. We added one new idea in the third quarter, a company called Japanese Petroleum Exploration. Actually, it's a great example of what I'm talking about. It's Japan's second-largest oil and gas company. It's trading at a discount of just its net cash and investments, meaning the entire operating business you're getting for free. It's that cheap. They've been improving their corporate governance — began repurchasing shares, increasing dividends. Management seems focused on improving their price to book from roughly 0.5 to 0.6 right now to 1.0. So, the combination of cheap valuation, improving corporate governance, and of course, what we expect to be decent fundamentals for the energy industry as well, should bode well for the stock, we think.
Matt McLaughlin (12:22)
Another market people are talking about a lot is India. You've been there twice this year. You were there last quarter. Maybe go over some of the takeaways for the Indian market and anything that gets you excited at a company level about what's going on in India.
Krishna Mohanraj (12:42)
With India, it's been a journey for me. I grew up in India. I've been following the market for a very long time. So, my most recent trip was just the latest in many trips there. In fact, as you mentioned, I've been there twice this year, meeting with companies, and I would say with every year, especially over the last decade, I've been able to see a huge transformation in the market. And it's fascinating to see the change.
It's definitely the only emerging market (EM) that I would call secular growth. And there's a reason for that. It's really unique among EMs because you're getting a trifecta of things. If you go back to economic theory — you've got labor, you've got capital, and you've got total factor productivity. The elements that go into growth. In India, you're able to add labor because of your demographics. You're adding capital. Capital intensity has gone up over the last decade. And at the same time, the third variable in this, the total factor productivity, is also increasing because of structural reforms that have happened over the last decade. So, standardization of the tax code and reforms across monetary, land and labor. So, you have all three variables in the growth equation coming together, improving at the same time. That's a rarity. It rarely happens.
And I'll add a final piece to that, which is interesting is that China did this too, but China did this while increasing debt levels significantly. Whereas India is doing it with actually a slight reduction in debt levels because growth is making up for the level of investment. The level of investment is not as intense as it was in China, which we all know. So, you not only have growth, you have growth improving and then external vulnerability coming down. So, it's an amazing combination.
Now, this potential was always there with India, but I think what's changed over the last 10 years is that you've got to stretch. I mean, India's always reformed. The reform started in 1991, but in the last 10 years, you've got a stretch of reforms with no stoppage of momentum because you've got one government, a strong government with no coalitions, no reason to delay or backpedal reforms for political reasons. So that combination makes it very exciting.
While this is all exciting, we are still focused on companies, and what we are looking to find are businesses that can benefit from all this. So if you go down and you meet the businesses you find, the thing you find is the optimism is amazing. In every one of these trips, when I meet with management, the thing that's most striking is their optimism about what lies ahead.
Because when you look at industry by industry, penetration of the formal sector in India is so low that there's a huge opportunity for world-class companies, operators that can create value, that can compete. But you have to be very careful because this sort of setup with a lack of penetration invites competition. So, we want to be selective as to the kind of companies we think can win. Even though there is an opportunity ahead of them, you need to find the ones that win. Today, we own two financial services companies in the portfolio from India. Both are simply superbly run franchises. We are looking to own more businesses but at the right valuation. So I think we will keep looking and we will find more soon enough.
Matt McLaughlin (16:21)
Turning to an area of the world where maybe there's not as much optimism as India and Japan: Europe, it continues to be weak relative to India, Japan and maybe the US. What has the team been doing in Europe? Have we been adding on the weakness? Selling? What are your thoughts, and what are some activities that the team's been doing in Europe?
Krishna Mohanraj (17:56)
Europe, I would say, is a clear illustration of our approach. Invest in companies, not countries, because Europe is clearly in a slowdown. Take Germany, it is the biggest economy and it's the softest economy in Europe right now. They have this survey, which is the most widely followed survey. It's at an abysmal low. It is, I think, at the same levels it was during COVID. So clearly, the economy is not great. There are risks to the manufacturing sector. Energy costs are an issue, but at the same time, we are finding some interesting bargains in Europe.
Just this year, we invested in a German company called Vitesco. They're an auto supplier, primarily supply powertrains, both for combustion engines and electric EV cars. They were spun out of Continental, and when we saw the business, we realized that their electric business, their EV business alone, was worth more than the market cap, meaning you were getting the ICE, the internal combustion engine business, for free.
Those are the kinds of situations where we know we are going to be okay no matter what happens in Germany: energy crisis, manufacturing, slow down, China competition, consumer stress, what have you. If you're able to identify differentiated businesses with hidden values like that, you get rewarded. And sure enough, just recently, there's been an offer for Vitesco shares at a significant premium, providing us with a return completely uncorrelated with what's going on in Germany or Europe.
So that's how we are thinking when we look at these markets because look at the kind of businesses that are in Europe. They're just amazing, amazing companies. You just have to find them at the right price and look for…be a stock picker in those markets.
Matt McLaughlin (18:34)
Turning to a market that maybe some include in Europe, but some may not — the UK. It's the biggest overweight in the portfolio from a country perspective, but it's been a tough year for the local UK economy. Can you talk through some of the companies we own in the UK, why we like them, and what, if any, action we've taken with some of the weakness in the UK?
Krishna Mohanraj (19:00)
With the UK, I'll make this distinction. We own a lot of UK companies which are truly global. For example, we own the global spirits company Diageo. Less than 6% of Diageo’s sales are in the UK. So, what happens to the UK consumer is not that meaningful for Diageo. The other side, we own more UK-specific businesses. I would list two of them as significant for us. One is Tesco, and the other is Howden's. Tesco is the largest grocery retailer in the UK by a mile. So, it’s a consumer company, but very much essential staple grocery type business.
And then Howden's, which makes kitchen remodels. It's consumer, but it's a lot more discretionary as you can imagine. So I'll focus on that one, and that's something that we've owned for a long time. It is also a second-half business. So, it is somewhat interesting because a lot of the kitchen remodels happen towards the holidays, so it is prime season for them and the consumers are under stress. So, something that we want to think deeply about because we have a position there.
When we first came across this company, this was years ago, it sells kitchens. Not exactly the best business in the world, but if you look at their financials, it's a head scratcher. It doesn't look like a kitchen company at all. High gross margins. I'm talking over 60% gross margins, consistently high returns on capital, managed with a conservative balance sheet. It's a very unassuming company in a mediocre sector, but it's clear that it has a secret sauce. So what is that secret sauce? It's very simple but hard to replicate. They sell to intermediaries, not necessarily to you and me as the end customer. So they'll sell to contractors. That gives them a high degree of customer captivity. These contractors want to engage with somebody who's always there for them because they get paid on the contract, and they don't want to take any risks. They're a vertically integrated company, which means they own everything from starting with the wood to making the final designs, which means they rarely run out of stock. They have fine service, which again, increases, enhances the stickiness with the customer. And they have decentralized support. Managers at the depot level have a lot of equity in what they run, and hence they want to run it in the most sustainable, profitable way. Because of these unique advantages that none of the competition is able to replicate, every time there's a slowdown, Howden seems to do better.
What's happening right now in the UK. We expect the company will chug along fine, and in fact, at the end of a slowdown like this, we expect them to grab additional market share from the competition. So, while we are worried about the slowing economy in the UK, the kind of businesses that we own are businesses like Howden's where we actually think they come out better at the end. So that's our approach to looking at situations like this.
Matt McLaughlin (22:13)
Turning to the Americas or the Western Hemisphere, if you will, we added Walmex in the quarter, late in the quarter, Walmart based in Mexico. What was interesting about that company that you and the team liked, and what's interesting about Mexico from your perspective? I know you were also there this quarter.
Krishna Mohanraj (22:38)
Yes, I was in Mexico meeting with companies in June, I think, this summer. Mexico's an interesting spot. Getting ready for elections next year, and as you would expect, the political headlines, regulatory noise — they're all increasing in Mexico. We've seen several fairly drastic actions from the government and regulators going after some businesses.
Just as an example, the Mexican airport operators saw some very high-handed, almost unilateral, decisions from the regulators recently. The government overnight proposed changes to the tariff regulation for the airport operators. Remember, these are contracts from a very long time ago, so I think they've been in place since the 1990s, and overnight there was a circular from the government saying that they're proposing amendments to it. I think the next day all the operator stocks were down about 30%. So, definitely a shock and a surprise to all stakeholders, including the market.
Usually in places like Mexico, we have an on-deck list of companies that we like. It's a market that we've done a lot of work in over the years, and Walmex is one of those companies and looking at what is happening and how things are evolving, Walmex is the kind of thing we've had our eye on for a while, and it seemed like a good time for us to start a position. Given what will happen over the next year or so going into elections, I think I can tell you the path for Walmex might not be smooth, but over a few years, I think we should do okay, because inherently it’s such a good business. That even in bad times under some stress, you should do okay.
So, what is Walmex? Walmex is Walmart de Mexico. It is the largest retailer in Mexico and Central America — dominant position in the country. I think more than 60% of grocery spend goes to Walmex. The key attraction, I would say, is capital allocation. They've been so systematic about building stores, investing in online presence, investing in digital wallet functionality. Essentially, they've been relentless about investing in becoming embedded in customer lives. That's the key. They earn probably the highest return on capital of any grocery retailer globally. So that should tell you that all those investments are actually paying through.
The regulatory authorities are looking at it and saying there could be potential monopolistic practices in some markets for Walmex, which is the reason the stock is available for an attractive valuation. We really think the case won't amount to much. Walmex is dominant, not because they've bought out their competitors in an aggressive way. They're dominant because they've invested. So, they're earning the returns on the capital that they invested in places where their competitors were hesitant to invest in. So, that is the thesis for Walmex, is that high returns on capital, highly embedded in the customer life and available at a reasonable price. We'll see how things play out over the next year or so.
Matt McLaughlin (26:05)
Great. Thanks for those answers, Krishna. I believe the next time we'll hear from you will be the year-end webinar that Diamond Hill is putting on in December (register here to join the webinar). So we look forward to it and best of luck the rest of the year.
Krishna Mohanraj (26:19)
Thank you very much, Matt.