156. We never thought China’s ambition was to be like America tomorrow

14 October 2021 (pre-recorded 29 September 2021)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION] 

Chris Salih (CS): Hello and welcome to the Investing on the go podcast, I’m Chris Salih and today we’re joined by Alex Illingworth and Simon Edelsten, managers of the Elite Rated Mid Wynd International investment trust. Thank you both for joining us today. 

Simon Edelsten (SE): You’re welcome. 

Alex Illingworth (AI): Hi.

[INTERVIEW] 

[0:16]

CS: First of all, the trust looks to tap into a number of worldwide themes. Could you maybe talk to us about how you go about determining these trends and what they are currently?

SE: Yeah, so it’s Simon Edelsten here, we build the portfolio, you may ask yourself, why do you want to invest in global equities? Well, we think you want to invest in global equities because it allows you to invest in long-term growth trends, long-term growth industries around the world, and to invest in best of class businesses. 

Which sort of trends are we looking for? Well, often they’re determined by changes in society, demographic trends, ageing society, for instance, and Alex will talk later about our investments in healthcare, but are also about changing requirements, like a need to grow productivity and profitability combined with technological changes, which leads us to investments in such areas as automation, which is another one of our larger themes we’ll go into in a bit more detail, but basically we’re looking for long-term growth trends. But then it’s our job to identify how profitable those businesses are, how profitable those areas are, and then critically to make sure that we’re investing in stocks, which are on sensible valuations in the stock market. Because even when you’ve identified a good long term trend, if you pay too much for a share, you won’t make any money out of it. So our job is not just to identify the themes, but also to make sure that we’re investing our client’s money, whether it’s good value for money around the world.

[1:52]

CS: And you mentioned those themes, obviously some of them are extremely long term, most of them are long-term to some degree, how often do those trends change? Are they, do you sort of review them on an annual basis? Is it ad hoc and maybe talk us through that as well, please.

SE: Yeah, so we review all of the themes every year. We’ve got a team of four people now. And although the themes are very long term in nature it’s amazing how rapidly things change. So four or five years ago, we were probably quite concerned, more concerned about the ageing population issues for instance, in Europe. 10 years before that we would have been concerned about the ageing population issues in Japan. And now we’re more concerned about ageing populations issues in China. As the years roll by these democratic change effects do move around the planet. Some of them are more critical in terms of rate of change of demographics. Some of them are more critical in one place than another, at different points in time. So you’ve always got to keep on top of them. 

In fact, it strikes us when we read the newspapers on these themes quite often, people are years out of the date just on the data. And then of course on top of that, we have to keep on top of industrial changes and technology changes and the valuation changes in the market. So everything’s reviewed every year. That said the themes in the fund we’ve got today, 90% of them have been in the fund for the last 10 years, as you would expect.

[3:26]

CS: I wanted to go into a couple of those themes specifically, you mentioned them both automation and healthcare. Firstly, on automation, could you maybe tell us more about that theme and sort of some of the trends that come out of there and also maybe an example of a holding as well, please.

AI: Yeah, I’ll take that. So automation obviously is a great beneficiary of near sourcing greater efficiency and productivity of plants, but also in terms of greater energy consumption efficiency. It’s also more over a beneficiary of US/China tensions. And of course the supply constraints that we’re seeing around the world today and the greater need for more products to be produced nearer to the market. 

It’s a theme that we’ve actually had in the fund for a very long time, but the roadmap, which is our sort of precursor work before the theme is evidenced through stocks was written many years before we were able to evidence the theme within the fund. And that was really because we were looking for certain capitalists to invest in the stock, mainly on valuation. And the fascinating thing about automation is that really the very best automation stocks are all in Japan. And that may not surprise you given the conversation we’ve already had about demographics and the need for worker efficiency. But given a global aspect, we can obviously access those ideas. 

And one example would be one of Japan’s greatest companies really in terms of returns, but a company called Keyence which is, you know, a world leader, the world leader, in vision and measuring instruments. And this all sells into factory automation to make factories more efficient, more productive and run at lower costs.

[5:09]

CS: The other trend I mentioned was obviously healthcare you’ve got just under a quarter of the trust in healthcare at the moment. Does that theme cover topics like affordable health care or a healthy lifestyle, or is it more geared towards sort of technology or innovation? Maybe just talk us through that theme and sort of a general view on it as well please.

AI: Yeah, so you’re correct to say that just over 20% of the fund is in the healthcare sector. It’s not quite fair to say that we have a theme which is just called healthcare. In fact, we have two themes that fit into this sector and the first theme is healthcare costs. And really what that theme is saying is try and find companies which can help the system reduce the cost of the provision of healthcare. We all know the cost of healthcare is going up. Demographics again, are driving that and it is particularly problematic in America, which focuses our attention on those companies in America, that are of aiming to help Medicare in particular reduce the costs of the provision of health care. And so one of the areas that we’ve been focused on there are the managed care companies, which are the insurance companies for private healthcare in America. And they’re really the gatekeepers to reducing the costs, the cost of healthcare because they’re going and making the negotiations with the large providers of healthcare kit. So that’s one theme. 

There is a second theme around scientific equipment, which is much more related to your question around technology and innovation. And these are the testing companies, indeed testing companies that many of us have the unfortunate ability to be get close to during the pandemic. But these provide ever greater testing, they do the PCR testing. There is an enormous amount of innovation in this area, for example, around sequencing, which is a lab, the innovation such as mRNA, et cetera. And these companies are playing a much bigger role in healthcare today than they ever have before, because they are able to test for various diseases much earlier than we might’ve been able to do before, but they’re also able to decode everything to allow us to build new ways of designing medical products, mainly drugs. So in conclusion, there are the two separate elements which build up to that large healthcare weight.

[7:32]

CS: And then one of your healthcare stocks was one of your larger holdings in general was obviously Pfizer. Could you maybe talk to us about why you added that and what’s your outlook for big Pharma also in the next sort of 12 to 18 months?

SE: Yes, we would generally we’re adverse to investing large pharmaceutical companies because the size of the bill, particularly in America, of drugs has become a political hot potato and particularly many members of the democratic party promised in the last election to try to get drug prices down in America, a lot of patients pay quite a lot of their own drug costs. So the insurance companies pay part of the cost and the patients themselves pay the rest of the cost. And often of course, these patients are quite old and often quite poor. So it it’s always a difficult political situation in America. The reason that we’re happy to invest in Pfizer, but we avoid the other companies is simply because the mRNA vaccine against COVID that they have managed to produce in massive quantities to an incredibly high specification very rapidly over the last year shows how powerful and effective the Pfizer company is.

Pfizer didn’t invent this mRNA drug themselves. It was invented by scientists in Germany, in a separate company, but they scaled up the production. So you’ve got billions of doses of vaccine being sold around the world, as I’m sure you’re aware. We also invest in Moderna, which is the other company that made mRNA. The exciting thing about mRNA vaccines is not just that the Covid vaccine works first time. This is the first time any mRNA vaccines have been given approval. Obviously it’s been given to billions of people with practically no side effects, whatever some people are saying on the web and it stops people from dying. So if you want value for money, that’s value for money. 

It also looks like this mRNA technology basic biochemistry may well be able to be extended into treating forms of cancer as well. So the applications of this is very exciting for the future. And it rather separates out the two mRNA drug companies who have got the most advanced technology from the others. 

And the last thing I’ll say you remember earlier, I said, whenever we pick a stock, find a theme, pick a stock, we then look for value for money. Many commentators have said the American equity markets wildly expensive, much too expensive for people to invest in it. I think in traditional valuation terms, Pfizer at the moments on a price earnings multiple, they’re probably not something like 13 or 14 times the next year, which is historically a very modest multiple to pay for a big stock with solid finances and has a running yield of about 3.5%, 3.75% in dollars, which again illustrates that this is not an expensive share which is quite surprising to us given what a good job it’s done for the world’s population over the last two years.

[10:50]

CS: I’m going to switch to China briefly. Obviously it’s taken up even more column inches than usual in the past few months. You’ve sold all your China holdings earlier this year, obviously in hindsight, that looks like a great decision. Could you maybe explain why you made that decision and also what your outlook for China is then going forwards?

SE: Yeah, absolutely. So there’s been a lot of talk quite rightly over the last 10 years about equity fund managers paying more attention to what’s called ESG, environmental, social, and governance issues. Governance to us, we take all of these issues seriously, but they’re more material in some stocks and some sectors, some themes than others. Governance to our mind is always a critical issue when you’re investing public’s money particularly overseas. And one of the key aspects of governance is the attitude of the government in any country we invest money. 

It has always struck us that China’s growth has come from introducing certain amount capitalism to country which remains a communist country, but we’ve never taken it as read that they have an ambition to become like America tomorrow. In fact it struck us particularly with the current president that they’re very skeptical about quite large parts of the capitalist model and certainly very slow to introduce any extra elements of democratic government. So we weren’t all that surprised, we’ve always been on the lookout, I think it would be fair to say for any steps back towards the more traditional communist approach. And we felt that those had started about a year ago, the signs were clearly there. There was going to be a massive IPO of a company called Ant Financial last November that was canceled by Beijing. And so we started reducing our position at that point. 

AI: And I think one of the points I’d make here is, being a global equity investor we’ve got lots, lots of places to invest money, and so we can set very high standards for governance and if we have any doubts about what’s going on somewhere, it’s easy for us to move away and just better safe than sorry, frankly, we don’t know where it’s all going to end. It may well be that there’s now a buying opportunity, but we prefer to be cautious on these things and give things time to settle down. And clearly there’s been a much more dramatic move back towards communist ways than the market anticipated. And there are obviously ways of playing China without actually buying directly in China. And indeed we do that through our automation theme and in particular through the sustainable consumer theme, which has a lot in luxury companies within it. It’s just that we feel that all shareholder rights are likely to be upheld there, which may not happen in China and therefore the risk for shareholders and for our unit holders is too great.

[13:38]

CS: Okay. You’ve talked a bit about ESG there obviously and I want to stick with that theme just for a moment. As I said, you’ve sort of gone into a bit more on how, how you access risks, the risks of the ESG. Could you maybe talk a bit more about how you find new opportunities and maybe give us an example of that on the ESG side?

AI: Yeah. So the risks we’ve covered a little bit. We also have some restrictions in the funds, meaning that there are certain sectors, such as oil and gas, that we don’t go to. We then take very seriously some of the issues around governance, we’ve talked about, but also on the environmental and social side. And we study the metrics that we think are material to the investment case, and what that can show is, in particular, what we’re looking for is to try and penalise companies for externalities, that they may incur, that they haven’t really been paying for in the past, such as penalising in terms of their cash flows, the cost of their scope one and scope two emissions, but also this process allows you to look at companies which have been improving over the last few years and have positioned themselves to benefit from this trend. 

And one example I guess, would be in the HVAC in the air conditioning market and a company called Trane, which is an American business, leading air conditioning company. And here they have shown their energy density to fall over the last 10 years, scope one and two have fallen over the last 10 years consistently. And it’s happened at the same time that there is an enormous extra demand for cleaner air, somewhat due to the pandemic, more efficient air conditioning, less use of chemicals. And they happen to have world-leading products in a sector which has seen secular growth.

[15:25]

CS: And maybe just to wrap up our ESG discussion  a little more and come back to the trusts’ themes, the low-carbon world is one of these worldwide trends we talked about. Do you foresee this low carbon portion of the portfolio growing significantly in the future?

SE: Well this is a very good example actually of putting together some of the things we’ve talked about this morning. The low carbon world theme for us was one that we started investing in perhaps six or seven years ago now. So we were quite early investors into the company’s building wind farms in the North Sea, particularly Orsted, which had been a fantastic investment for us over the first few years that we owned it as more energy companies have has got more and more coverage in the press and in the stock market. And many investors joined us in owning that company, which did a fantastic job. It’s a Danish company, and yet it became the world leader in terms of building wind farms. And once it had built wind farms, it would often sell the stakes in the mature wind farms to other companies releasing value for shareholders. So that was all quite clear. The valuation of the stock then went up a huge amount while we owned it. 

We were then rather concerned over the last two years, I would say, that as governments and particularly as the European Union and the European investment bank said, we will offer lots and lots of money to people to get into making wind farms. And the oil companies started saying, we want to start making wind farms. The rate of return or making wind farms was going down, the quality of the sites where people was making wind farms was going down because the windiest areas and the easiest sites have been used up. And so the rate of return on investment was falling just to the point in time when the rating on the shares had reached the maximum. So we started retreating from this. In fact, just recently, we actually sold the last of our Orsted, having made very good money out of it over the years. So that is an example of one of these long term themes, where the market’s just got rather carried away on valuation. Just as a point in time, volume may well carry on going up ,more wind farms will get built, but the profitability much, much lower than it was. 

On the other hand, we find new ways of expressing the same idea in parts of the market that people don’t expect. Alex mentioned Trane, you know new air conditioning going in for energy efficiency reasons that seems to have accelerated considerably because also people are putting in new air conditioning to avoid Covid going around their offices. And so you’ve got two drivers at once. 

Also we invest in things like railroads, because if you can get freight driven around by rail around the world, rather than by trucking around the world, that will considerably reduce carbon emissions as well. So there’s always different ways in which we can express a theme. And there are always, well, there were almost always stocks we can move on to. So that rather illustrates the point that we’re trying to pull together here in terms of explaining how we invest money. Yes, we look at long term themes. That’s where we think we’re going to make our investors wealth growth long term. But inside those themes, critical issues are keep up with changing valuations and keep up with changing margin issues, changing profitability issues in the real world. And it’s only by getting that combination together that you’ve got a really effective portfolio. So it may will surprise people that the best years we think of our low carbon theme in terms of the wind farm, part of it are behind us. But again, we find new ways of investing in this long-term trends, such as rail, such as better air conditioning, other energy efficiency measures, and some aspects of automation as well will come into this. And that allows us to keep the theme going, find new ways of making money and hopefully invest successfully for the future. 

And it’s a combination of that and then trying to find a good balance between all these different themes. We have eight or nine themes in the portfolio at any point in time, we’ve talked about two of the biggest ones, healthcare and automation. But we also try to have a balance in terms of other long term themes, such as more sustainable consumer stocks and also what’s going on in the digital world. And that way we build a well balanced portfolio between a number of different themes, which aren’t too correlated. Make sure we’ve got our eggs spread between different baskets and have a good balanced portfolio for the times ahead.

CS: Simon and Alex that’s great, thank you very much for spending some time with us today. 

AI: Thank you, pleasure. 

SE: You’re welcome.

CS: And if you’d like to learn more about the Mid Wynd International investment trust please visit fundcalibre.com and while you’re there, remember to subscribe to the Investing on the go podcast.