The universe we live in includes bubbles and busts. Mr. Market is rarely rational, meaning that no mathematical model can really explain what is going on, nor predict it consistently. However, as humans, we are uneasy when we cannot explain phenomena through theories, and so quickly revert to past patterns, rarely questioning the limitations, and thus ending up as part of the herd.
Real education tends to take place in the real world that is irrational and unpredictable. Universities provide students with applicable tools for many professions, such as engineering and medicine, but in finance and investments this is often not the case. Students are educated based on assumptions and complex formulas, most of which don’t hold true in the world of irrational exuberance and extreme pessimism. When theories do not align with reality, what is there to do other than follow the herd and revert to the mean? Keynes said it best when he said, “It is better for reputation to fail conventionally than to succeed unconventionally.” Like young kids who all chase after the same ball when playing soccer, the CEOs of many companies end up following a similar behavioral pattern. They are under such pressure from short-termism and the need to conform that doing something, even to their detriment, is seen as better than not doing anything. Our industry is no better, of course.1
Of course, we believe education is essential, but we also believe in continuous learning, and that includes knowing the pitfalls and shortcomings of previous theories and beliefs. Our continuous learning has led us to prefer equity funding to debt funding; we appreciate knowing that even in the worst of times, debt will not be the variable that will cause an undue issue. This way we spend more time on more relevant topics such as supply and demand, management ability and alignment, and long-term sustainability of the business. Specifically, we like to back managers who back their own convictions rather than follow the herd when it comes to managing balance sheet risks.
There are many ways that investments can go wrong, and we frequently see this with leverage in our part of the world, especially due to mismatches of dollar funding backed by volatile emerging currencies. We do not want to obsess over leverage or currency bets going wrong.
We understand that in emerging markets tides come and go regularly, and skinny-dipping is not our thing.
For these reasons, we require a margin of safety2 and a solid balance sheet when we look for investment ideas. In today’s world, when emerging markets have benefited substantially from a 30-year decline in interest rates, it makes sense, in theory, that companies should increase their leverage when the cost is so low, to be able to make their next big (debt loaded) acquisition or invest in a new factory. The Fed, ECB and various other large institutions’ policies have been targeting this. The potential issue arises because most participants gear up together; not because it makes sense, but because they fear losing out.
It is also notable that, generally, peak market valuations are the time for the highest buyback programs; it goes without saying that it should be the other way around. Across the emerging markets, higher debt levels can be seen from a top-down perspective.
Investor memories tend to be short, especially those of us who have not been in this industry long enough to have felt severe pain. Our investment team consists of a good range of experience, from 9 years to 31 years. Experience does not equal wisdom of course, but with backgrounds from three totally different emerging markets, boom and bust remains vivid in the team’s memory from a personal as well as professional perspective. We watched with great astonishment last year when Argentina successfully sold its first $2.75 billion 100-year bond.3 Events like this are also great indicators of when to be cautious. In a similar vein, we heard a young adult berating his mother on a London train about not buying bitcoin around this time last year – sometimes, the simple observations can be the best indications of market cycles.
An important trait we see in some of our companies is the ability to vividly recall the hard times, as these companies adopt a different approach as a result of these experiences – the Asian Financial Crisis, the ‘Tequila’ Crisis in Mexico, and so on.
In Asia, we regularly meet companies that still talk about the Asian Financial Crisis 20 years later, either how they survived or changed their attitude, or what they did to prepare for it. It is music to our ears because these companies have clearly learnt their lessons. The companies in our portfolios typically want to keep their cash for a rainy day and look for the moment when they can buy out their key competitors at reduced valuations or invest when no-one else is investing to strengthen their market position.
Like a house with no mortgage being worth more than one that is burdened with one, we are happy to pay up for companies we have determined to be quality companies with sensible balance sheets and strong franchises, backed by capable and honest stewards. We believe that the long-term stewards of businesses we invest in understand what they can and cannot control. In an article published by the FT in July 2007, Citigroup’s CEO said, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” We, on the other hand, try to invest in companies that don’t attend these parties to begin with.
As investors, we spend a lot of time trying to understand the debt conundrum and whether this relates to an attitude of a long-term owner instead of an empire builder. The motivation of the family behind the business or the manager running the company tells us a lot about risk appetite and whether they are someone who is willing to put stakeholders at risk. Equally, the debt structure may simply indicate a weak business model that requires borrowing in order to compete and remain relevant.
We actively search for sound businesses with co-owners who understand the importance of the journey rather than the destination, in order to build strong fundamentals upon which the businesses can prosper. Most importantly, we look for business owners who are responsible not only for their shareholders but also their employees, as a way to enhance and improve the communities they touch by being long-term partners, and not just shooting stars that hire and fire. We believe having capital for rainy days is one of the best indicators of such vision in practice.
Our continuing learning – the case of Yes Bank
The example we would like to discuss is our investment in Yes Bank. The initial Yes Bank investment case was based on investing into a growing private banking sector bank, with an ambitious co-owner who had successfully built the business from scratch. It was also the first Indian entity to issue green bonds. The bank was growing rapidly as it was taking advantage of the weak public bank sector as well as the growing appetite for corporate debt and a safe place for deposits for Indian households.
We have discussed Yes Bank on happier occasions, but also more recently when its share price had a sharp fall. However, Yes Bank faced multiple challenges in 2018 towards the end of the year. A further significant development caused us to reassess the entire business case and as a result we sold all our shares (2% position pre-disposal).
In brief, the ultimate reason to exit the position was erosion of trust and potential misalignment of interest with Founder and CEO, Mr. Rana Kapoor (10.6% stake).
Since the Reserve Bank of India blocked Mr. Kapoor’s reappointment, effectively ending his tenure in January 2019, Yes Bank has encountered further challenges, including the resignation of three independent board members, a downgrade of their debt, and share price capitulation (eroding the trust element to raise future capital).
Initially, we held a sanguine view of the bank and purchased some additional shares, but refrained from materially increasing due to uncertainties. We don’t make investment decisions on speculation; however, when facts change it is important to reassess our position. The new information that came to light was that Mr. Kapoor had borrowed on the basis of the value of his holdings in Yes Bank. These borrowed funds were then used as equity in certain legitimate family business activities. None of this was illegal, but it did go under the radar of the regulatory disclosure. While Mr. Kapoor complied in letter with regulatory requirements, we believe that this should have been disclosed. Additionally, the precipitous decline in share price could potentially make Mr. Kapoor a forced seller. This brought into question our trust and alignment with Mr. Kapoor as majority shareholder, something that we take seriously as part of our quality assessment. This tipped the balance for us, and along with other outstanding business risks faced by Yes Bank, led us to sell our entire position.
In the emerging world, family-owned businesses are prevalent. Some of these family-owned businesses are still run by the first generation, entrepreneurial founders who have managed to build multi-billion dollar businesses from nothing against adversity. Therefore, analyzing the net impact of these highly respected individuals can be hard once the business reaches an institutional scale.
An Indian Proverb says nothing grows under the shade of the Banyan tree
In the instance of Yes Bank, through our engagement we should have pushed harder for stronger oversight and long-term succession planning. Our continual learning and reassessment has taught us to be more cautious when considering investing in individually led organisations and ensure that supporting talent and governance around any key person is empowered and experienced, so they can step in as needed.
1 According to a CFA Institute research 59% of the polled investment professionals have less than three years to turn around underperformance or expect to get fired. https://blogs.cfainstitute.org/investor/2016/06/17/the-investment-risk-youve-never-calculated/
2 Margin of safety is a principle of investing in which an investor only purchases securities when their market price is significantly below the investor’s estimation of the securities’ intrinsic value.
3 Other ‘frontier’ nations taking advantage of extreme bond maturities by issuing Eurobonds were Tajikistan, Mongolia and Papua New Guinea.