CRAIG MERCER | Return on Equity

· Podcast Episodes
Unpeeling the onion of Return on Equity. Craig Mercer from Dalton Investments

I've been thinking a lot lately about how little I know about the metrics that investors use to value companies. We had a look at the P/E Ratio a few weeks ago. This week Craig Mercer joined me again to discuss Return on Equity or ROE. But like all the best metrics, they become more complicated the more you dig into them. The warning for beginners is to not just take a measure on face value.

Craig Mercer is the Chief Research Officer and Head of ESG at Dalton Investments (Australia). Dalton Investments LLC is a value-focused investment management firm with expertise in Asia, Emerging Markets and global equities.

"If you buy a property for a million dollars and then you are able to rent that property out for say, a hundred thousand dollars, you know, after all your costs associated with running that, you're gonna earn a yield on that property of 10%. So similarly, if you buy a share in a company and it's generating a hundred thousand dollars of profit or net income, you are generating a return on equity of 10% on that Company.

Return on Equity - A measure of financial performance calculated by dividing net income by shareholders' equity Courtesy of Investopedia
  • Return on equity (ROE) is the measure of a company's net income divided by its shareholders' equity.
  • ROE is a gauge of a corporation's profitability and how efficiently it generates those profits.
  • The higher the ROE, the better a company is at converting its equity financing into profits.
  • To calculate ROE, divide net income by the value of shareholders' equity.
  • ROEs will vary based on the industry or sector in which the company operates.

"From an investor's perspective, what's really key here is to understand whether or not the return on equity is sustainably high so that you get compensated for the risk of investing in a company. So by way of example, if you think about the risk-free rate, let's just say for argument's sake, the risk-free rate is 5% and you have an ROE of less than that, I'm taking an enormous amount of risk to invest in a company that is inherently risky and I'm getting paid less than the risk-free rate."


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Chloe (1s):
Shares for beginners.

Craig Mercer (3s):
It's a very helpful tool, but should never be looked at in isolation because again, as I said, if you look at return and equity just alone and say, I'm just gonna target companies with a higher ROE, you might well be paying a huge premium. And, you know, price that you pay for an asset is probably more important than the return attached to that asset.

Phil Muscatello (25s):
G'day and welcome back to Shares for Beginners. I'm Phil Muscatello after a recent episode where we talked about the price earnings ratio, I've become more interested in talking about valuation metrics as they're never as simple as you think. I'm joined today by Craig Mercer from Dalton Investments to have a shot at return on equity. Thanks for coming back, Craig.

Craig Mercer (45s):
Thanks. Phill, thanks for having me back. Pleasure to see you again.

Phil Muscatello (48s):
Craig Mercer is Chief Research Officer and head of ESG at Dalton Investments Australia. Dalton Investments LLC is a value focused investment management firm with expertise in Asia, emerging markets and global equities. So last time we talked about the complications and nuances of ESG, which is much more interesting than you think at first glance. So we're gonna have a go at return on equity. Is it any simpler?

Craig Mercer (1m 15s):
Well, you know, the simple answer to the question is, is, is is both a yes and a no? I, I guess I would sort of characterize return on equity somewhat like an onion, you know, and first glance it's just an onion. But as you sort of begin to look at it in more detail, you're peeling back layers and layers. You, you come to the realization that actually there's a lot of things that go into understanding, you know, what return on equity is. Yeah. You know, at its core, return on equity is simply the return that you get as a, an equity investor in a company. So, you know, what is return on equity? It's simply calculated as the net income of the company, which is the profits, or you know, all the revenues after expenses and the taxes divided by it's shareholder equity.

Craig Mercer (1m 59s):
And shareholder equity is simply the assets of the company, less all of its liabilities.

Phil Muscatello (2m 5s):
So that's like slices of a pizza, I'm assuming?

Craig Mercer (2m 8s):
Yeah, yeah.

Phil Muscatello (2m 9s):
Each share's a slice of a pizza

Craig Mercer (2m 11s):
Yeah, e exactly. To some extent. So, so if you think about, say for example, the real estate market, if you go and buy a property for a million dollars and then you are able to rent that property out for say, a hundred thousand dollars, you know, after all your costs associated with running that, you're gonna earn a yield on that property of 10%. So similarly, if you, you know, buy a share in a company and it generates return on equity of say 10%, what that translates to is that, say for a million dollars of shareholder equity, which is again, all of its assets, less all of its liabilities, it's generating a hundred thousand dollars of profit or net income. So you are generating a return on equity of 10% on that Company.

Phil Muscatello (2m 53s):
Okay. So you mentioned that to calculate ROE, which we'll just refer to it as the acronym from now on, is to divide the net income by the value of shareholders equity. So how do you get those numbers? Where do you find the equity from

Craig Mercer (3m 6s):
The, These are numbers that are very readily available. So you can go into any sort of company financial statements and look at both the balance sheet where you, where you'll find the shareholder equity. And again, you know, if you just look at the, usually at the bottom of the accounts, you'll have the shareholder, the equity value, which is again, just the assets, less the liabilities. And then the net income obviously can come from the income statement, and that again is like profits off to tax or you know, all of the incomes generated after it's, you know, paid for all of expenses and, and taxes, very easy to find. Any publicly listed company will have to report that information, but you probably don't even have to go to a company's public accounts to find this information.

Craig Mercer (3m 46s):
There's, you know, an abundance of, you know, free to use financial websites that will, you know, more often than not, you just give you the ROE number itself. Yeah. But probably reports those kinds of metrics as well, because again, these are publicly available sort of data points. I guess the reason, the reason why I say ROE is more like an onion is that as you start to look into it, you can actually start to see that there's many, you know, facets to it. So if you, if you go back to the, the 1910s, you know, there is a famous chemical company called DuPont, which you know, is famous for developing things like Kevlar styrofoam, It still operates today.

Craig Mercer (4m 27s):
But back in the 1910s, a salesperson at DuPont was trying to build some sort of efficiency data points for an internal sort of meeting. And this particular salesman developed something called the DuPont analysis, which is he decomposed return on equity into three sort of individual sort of component pieces. Now, those component pieces were net profit margin, which is simply, you know, net profit of the company, less divided by sales, something called asset turnover. The sort of return on assets might be another way to, it's described in both those ways. And that's just sales divided by assets.

Craig Mercer (5m 7s):
And then something called the equity multiplier, which is also known as financial leverage, and that's assets of equity. You multiply those three things together and you, hey, presto, you get your return on equity. That methodology is really instructive for a couple of reasons. One is it helps you sort of understand, you know, where there might be inefficiencies in in your operations. So it allows you to understand if there are parts of your operations that can be improved upon to boost your return on equity. So, you know, for example, a company might have a very low profit margin. So if it reduces its expenses and sales remain the same, it can boost its profit margin and that will, you know, have an uplift in ROE.

Craig Mercer (5m 50s):
But similarly, you might just increase debt, for example. So financial leverage, if you raise your financial leverage, you'll again have the net, you know, effect of increasing your ROE. Now that allows a business, you know, the management team of a business to understand how efficient they can use their assets to generate returns to you as, as an equity holder. The very interesting part of doing that sort of decomposition analysis is that when you look at an industry as a whole, and you know, when you're looking at ROE, it's very important to be under, to understand what the ROE is for a wider industry so that you have a comparable point of reference. So if an industry, let's just say it's semiconductors, generates on aggregate a 10% ROE and the company that you are looking at generates a 15% ROE, well, it's generating outsized returns relative to its industry.

Craig Mercer (6m 41s):
But on the face of it, that might seem the case, but when you decompose it, you might see, well actually this company is simply using more debt on its balance sheet to basically boost its ROE. So it's actual profit margins might be comparable or even less than the rest of its peers. So it might not be necessarily making them more money than some of its peers. And that's a very useful part of, you know, understanding the returns that you're generating is where it's actually coming from. So

Phil Muscatello (7m 14s):
Is this like, are you describing it like a dashboard for management to, you know, tweak the way they're running the business? Or is it something that investors would be able to use as well?

Craig Mercer (7m 24s):
It's a combination of both. So management teams will, will use things like return on equity to understand that, you know, are they deploying their capital efficiently to generate returns? But as an investor, you know, clearly it's a good reference point. So all things being equal, you know, valuations are all the same. You preferably want to invest in a company with a high return on equity. But what's very important is, is what the reference point to that is. So for, for example, a company has multiple places it can, you know, raise finances to fund its operations, you know, debt equity, and then there's the whole sway, the things in between that. And that would be described as the capital structure. So at the top of the capital structure, you have debt, and at the bottom of the capital structure you have equity.

Craig Mercer (8m 7s):
Now what that means is, is if a company goes bankrupt tomorrow and a liquidator is brought in to sell off all the assets to the company and to pay out, you know, all the obligations that it has, equity holders are only paid what's left after all of the other obligations have been fulfilled.

Phil Muscatello (8m 23s):
So that's something that shareholders often don't know is that they're, they

Craig Mercer (8m 26s):
Rank, they're the bottom of the capital structure,

Phil Muscatello (8m 28s):
Right? Yeah, yeah. The, the debt holders will get money,

Craig Mercer (8m 30s):
They'll get it for, you know, they'll pay all the outstanding obligations first, then return money to the debt holders. And more often than not, the equity holders are left with nothing and they're the ones left holding the bag and, and stomaching most of the loss. You know, from an investor's perspective, it's what's really key here is to understand whether or not the return on equity is sustainably high so that you get compensated for that risk. Right. So by way of example, if you think about, you know, the risk free rate, you know, with in a world right now where, you know, interest rates are rising, that's having the effect of pushing up the cost of debt, you know, a whole range of other things. But let's just say for argument's sake, the risk free rate is 5% and you have an ROE of less than that.

Craig Mercer (9m 15s):
I'm taking an enormous amount of risk to invest in a company that is inherently risky and I'm getting paid less than the risk free rate that would really be,

Phil Muscatello (9m 25s):
Which is, which is putting your money in the bank, isn't it? And

Craig Mercer (9m 27s):
Putting your money in the bank, you know, you're better off putting your money in the bank than stomaching all the rest to get a fairly low return outcome. But you know, you also have to bear in mind that, you know, when you are looking at the ROE, you're not just looking at the company standalone ROE, that that in isolation is a useless sort of number. Yeah. What's really important to understand is, is how the industry behaves as a whole, what are sort of normalized returns for that industry for the risk that you are taking. So when you decompose the ROE, what's really fascinating, some industries have a natural inclination to have higher profit margins. And those might be, you know, industries or sectors where there are much higher barriers to entry, for example.

Craig Mercer (10m 9s):
They are, you know, there's a greater like moat if you like, around that company's sort of product. So something with very high intellectual property, very high costs of entry. So they might naturally to gravitate towards higher returns on equity. Higher profit margin might be the thing that's driving that higher ROE. In other industries, like for example, financials, the use of debt on the balance sheet is much more sort of prevalent,

Phil Muscatello (10m 34s):
Which is what banks do, isn't it? Banks? Well,

Craig Mercer (10m 36s):
They, they'll

Phil Muscatello (10m 37s):
Borrow, they operate on debt, don't they?

Craig Mercer (10m 38s):
They, they borrow, you know, they obviously have equity funding as well, but you know, they tend to use more debt or more leverage on their balance sheets than other kinds of businesses because that's part of the way they operate. So when you decompose it, it's very important, you know, not only to understand what the industry norm is for a particular business in terms of return on equity, but also what the norms are for the use of debt, what the norms are for say, profit margins. And if, you know, if there's a company that is, you know, maybe leveraging one of those levers more aggressively than another, that might be, you know, a bad thing. So for example, you might have a company that has a slightly higher ROE ROE, we, for its industry, but is using debt more aggressively now in an environment where the cost of debt is going up, that's obviously gonna have an impact on their debt repayment obligations, how they can service, you know, their, their long term obligations.

Craig Mercer (11m 31s):
And that might ultimately be a negative for the business longer term. So whilst it might look good on the face of it, you know, understanding those individual component pieces, you know, is very important.

Phil Muscatello (11m 43s):
So if we just use the property analogy again, and we're talking about debt funding, is there a way of demonstrating to listeners that the amount of of debt in that property when you're buying it, will have an effect on the return on equity?

Craig Mercer (11m 59s):
So in in it's, the simplest way to think about this is, is to go back to the original equation. So what is return on equity? It's net income divided by total shareholders equity. Yep. If debt goes up or is being used more aggressively, what that does is it increases your liabilities because debt sits on the liability side, the

Phil Muscatello (12m 19s):
Balance sheet. Yeah. So you're, so your own, your equity is only maybe 80% of the value of the property,

Craig Mercer (12m 25s):
Or Well, so, so think about it this way. So if you have a company with a hundred dollars of assets and $50 of, of liabilities, right? And then you raise more debt and you increase your liabilities, and that goes up to 70. So what happens to the, the shareholders' equity, it goes from 50, which is was the original a hundred less 50 to now a hundred less 70. So the shareholder equity has fallen to 30. So if your net income in this case says the yield stays the same, your ROE has gone up because the bottom, the denominator of that equation has fallen So effectively, you can increase ROE in, in sort of, in, in the simplest form in two ways.

Craig Mercer (13m 7s):
You can increase net income and you keep shareholder's equity the same, or you lower your shareholders equity and you keep net income the same, or you do both. Yep. And that can have quite a transformative effect on the overall sort of profitability of a business. The example that I like to use is, you know, dole investments, a as you know, we're in Asian focus firm, so we have a lot of our assets invested in, in the Japanese market. The Japanese market as a whole has been sort of plagued with problems for decades, right? And, and this all goes back to the real estate bubble of the 1980s.

Craig Mercer (13m 48s):
So if you wind the clock back to the late 1980s, there was a point time where the value of the land, say in Tokyo at the Imperial Palace in Tokyo, which is effectively say, you know, for those that don't know Tokyo, a piece of land that's, you know, equivalent to the size of, say, Central Park in the U in New York or Hyde Park in London. And the value of that land was worth more than the entire real estate market of California.

Phil Muscatello (14m 17s):

Craig Mercer (14m 17s):
Right. Which is,

Phil Muscatello (14m 18s):
Which is a huge market

Craig Mercer (14m 19s):
As well, which is insane. Yeah. Right. Okay. So that was a, an enormous asset bubble. So as sort of, you know, might be expected in 1989, the market crashed. Now a lot of that bubble was fueled by excessive use of leverage. So there was huge amounts of borrowing to fund the purchases of land and, you know, real estate investments that sort of really fueled that bubble. The consequence of that was, and this sort of comes to where we are today, was that from the 19, late 1980s and 1989 through to today, Japan has been through this sort of aggressive de-leveraging process. One of the problems with having excessive leverage, which is debt, which is which is debt, Yeah.

Craig Mercer (15m 1s):
Is that, you know, your business can ultimately fail to meet its obligations and go out of business. So the Japanese memory is long. So you know, many of these board members that were sitting on corporates in Japan in the 1980s, you know, there might have been 50 at the time, they're now in their eighties and they're still sitting on these boards because, you know, Japan has a, a very, is sort of old demographic. They can still recall that the problems with using excessive leverage, but they have taken it probably a step too far in that as corporate Japan as a whole today is sitting on no debt, it's like net cash positive. To give you an idea of just how problematic this has become, there are literally hundreds of companies that trade on the public exchanges in Japan today that have what's called a negative enterprise value.

Craig Mercer (15m 46s):
Now what that means in simple terms is, is that these companies have more assets on their balance sheets than the value of the market cap of the company. So all things being equal, you could close that business down today and just return all the assets to shareholders and you'd make a profit. One of the problems that that's led to is a massive decline in return on equity. Now why that's the case is, is as assets go up, to come back to what we were just talking about, you know, in this case assets have risen so much and liabilities have not really changed the bottom of that equation. The net income divided share by shareholders equity has gone up enormously, which has had the effect of lowering return on equity.

Craig Mercer (16m 28s):
Now the upshot of all of that is, is that the Japanese government back in 2012 sort of came to the realization that the economy really needed to reform itself. And this was probably in part stand by the sort of the regional rise of China and the fact that, you know, China has become such an, an enormous economic influence in the region and globally. And there was sort of an element of national pride here where the Japanese were like, well we need to reform our economy to boost things like return on equity to make our economy and our companies more attractive to investors, both domestically and internationally. So ultimately the goal of, you know, increasing the return on equity.

Craig Mercer (17m 9s):
Now we are very bullish on Japan at, at the moment for a multitude of reasons. You know, one of which is obviously that governance reform sort of backdrop, which is being sort of accelerated under the incumbent leadership. But the reality is there's also very cheap companies as a consequence of the fact that you're not getting any return on equity. The market has repriced those securities to a much lower multiple. The yin is also at like say 150 year low, sorry, a 50 year low. Those assets in foreign currency terms have become even cheaper. So when you have an environment where the government is sort of actively encouraging its corporates to enhance ROE, you know, what can they do to do that?

Craig Mercer (17m 49s):
And sort of, to put this in simple way, there, there's two core things that these, you know, companies could do. One is reduce cross share holdings, and I'll explain what that is in a second. And the other is to reduce cash. And the goal of that is simply ultimately to lower the asset base return the, you know, the profits from that to shareholders in some form, whether it be dividends or buying back their own shares that will lower the asset base and ultimately boost ROE. Coming back to cross share holdings, this is a unique sort of, it's a design flaw of a lot of the Japanese economy in that most companies in Japan will own pieces of other companies in Japan.

Craig Mercer (18m 31s):
And sometimes they can be sort of inconsequential small holdings, you know, it might be a automaker that wants a small share of a parts manufacturer, but in other circumstances they can be material investments. This is an incredibly inefficient use of capital because what this leads to is if the ROE in the market is say, you know, four or 5% and they could reinvest in their business and get a higher return, investing that capital on the balance sheet that they've generated an income into something that's generating a poor return is a really poor use of capital. So they can, you know, one of the things that the government is sort of you or the Tokyo Stock Exchange is really sort of said is they need to unwind a lot of these cross share holdings now that has the effect of them selling assets off their balance sheet raising cash, and then they need to return that cash in some form.

Craig Mercer (19m 21s):
So for firms like ourselves, you know, the key here is that you can engage the management teams of these companies and say, do more with the cash on your balance sheet or sell these assets and return it to shareholders. Relatively non-controversial things that will overall enhance the efficiency, you know, of, of those companies and make the returns on equity a little bit more attractive so that, you know, people will actually start to invest in their companies again, which has been the bane of the Japanese market for the past sort of three decades.

Phil Muscatello (19m 53s):
So that's a, that's a really extreme example, isn't it? And so it's a, it's also a lesson in that a good return on equity is not necessarily mean a good investment.

Craig Mercer (20m 4s):
Well, well in some respects, yes. If I go back to what I said before, you might have an artificially inflated return on equity. So in the, in the extreme case of Japan, they don't really use any debt financing. So here, here actually it's not a holy stupid idea to recommend that these companies start to use some debt financing. You know, there's many academics that have sort of, you know, provided studies that show that a mix of both equity and debt financing in the capital structure there is an optimal level of where those two things should be. But you know, so you could encourage a Japanese corporate to, you know, raise debt financing, return other capital to shareholders. But to come back to what you asked, yes, a high ROE can be artificially inflated.

Craig Mercer (20m 45s):
And if a company is using excessive amounts of debt on its balance sheet, so you know, at some point, you know, maybe its liabilities begin to exceed its assets and that would be what's called negative working capital. And ultimate that is negative shell is equity. So even if the company might be generating profits, it can't meet its debt obligations and its assets don't meet its debt obligations. So you end up in a situation where the company effectively is starting to, you know, cripple itself just through the obligations that it has to meet.

Phil Muscatello (21m 19s):
So how would you compare ROE across an industry, for example?

Craig Mercer (21m 25s):
So, so for example, you know, if you're looking at say the semiconductor industry, that's maybe, you know, reasonably good example, you know, if, if you are say then looking at the Asian subset, you know, there's a range of companies that operate within that industry that are sort of what fairly well known, they're publicly listed, you know, and you can easily find what those companies are. And then you might also compare them to, you know, international comparables. So you know, semiconductor makers in the US or Europe or in Japan, you know, across Korea, Taiwan, probably the main blocks. You can look at what the industry does as a whole, you know, over ideally a longer period of time so that you have some kind of normalization.

Craig Mercer (22m 5s):
And then you can gain, you know, do what I said before, decompose it to understand what degrees of leverage or debt usage are sort of normal for that particular industry. What, you know, what the asset turnover might be normal for that industry, and then what the profit margins might be normalized for that industry. And then if you're looking at a particular company, you can say, well here's the industry average, here are all those component pieces and here is the company I'm looking at, here's what it generates and here are all those component pieces. Now, you know, all things being equal, if the company is using similar degrees of, of, of debt to equity and it has a higher ROE, that would probably be driven by the fact that it has a higher net profit margin.

Craig Mercer (22m 49s):
So that would be a, in, in theory, a more attractive investment. Of course, the caveat all of this is, is that you also need to be mindful of the price that's attached to it. So often companies with much higher returns on equity. So for example, industries like the fast moving consumer goods industry, so you know, brand companies or you know, companies that make shampoos have that have very strong brands attached to them. They might generate much higher ROEs because of, you know, the fact that they have very high profit margin that usually comes with an associated the high, you know, equity valuation that might be the priced earnings ratio or price to book ratio depending on what industry you're looking at or an enterprise value multiple against say earnings before interest or something like that.

Craig Mercer (23m 35s):
But that's a topic of conversation for a completely different session. Cause that's a whole other minefield.

Phil Muscatello (23m 41s):
Oh it is a minefield. So a new investor, just looking at some of these, these metrics that come up on their screen for the first time, how important, how would you rank ROE in the, in the metrics that they should look at it?

Craig Mercer (23m 55s):
I guess it depends on, on the industry. Like, you know, so in some industries ROE is a, you know, a pretty unin informative measure because you

Phil Muscatello (24m 4s):
Like which, which ones.

Craig Mercer (24m 5s):
So for example, if an industry has, you know, is you know, primarily financed through, so debt financing and its equity piece is a small part of its overall sort of financing, you know, that's probably not gonna be the right way of sort of looking at that business. So there are other metrics that sort of accommodate for that. So you know, things like return on invested capital that's similar to return on equity, but it's not just looking at the equity component, it's looking at all the forms of financing. So all of the different parts of the capital spectrum that a company might be using. Now, you know, anecdotally, you know, this is more like the onion farm as opposed to the onion because in return on investor capital there are way more things to consider.

Craig Mercer (24m 45s):
You know, and I actually just received the other day a 40 page primer from a broker explaining return on invested capital because it's so complicated. You know, things like return on assets for example is another, you know, tool that you can use that's very common say in the financial services sector because again, there's a mix of different forms of financing, but in businesses that are primarily financed by equity capital, it makes some sense to use it. It's a very important tool for understanding how efficient the management team is at using its financing to translate that into returns. If you are giving someone, you know, $10 of your capital and they can only generate $1 of return on that capital, you know, I might as well give my capital somewhere else where I can get $2.

Craig Mercer (25m 32s):
It's a very helpful tool but should never be looked at in isolation because again, as I said, if you look at return on equity just alone and say I'm just gonna target companies with a highest ROE, you might well be paying a huge premium and, you know, price that you pay for an asset is probably more important than the return attached to that asset because if you're paying, you know, 50 times the sales of that business, you are only gonna get paid back your investment in in 50 years time.

Phil Muscatello (25m 60s):
50 years,

Craig Mercer (26m 1s):
Yeah. Which, you know, is not what most investors time horizons are. And that, that, that points to a whole other conversation around sort of, you know, this environment of, you know, the tech bubble that we've seen say in the last 10 years. Yeah. A lot of these growth companies have been basically, you know, pumping their, their growth at the top line, which is just, you know, their sales, you know, not their net income, which is the bottom line, you know, through aggressive forms of funding, right? So they've been quite a, you know, very active in raising money from the equity markets, very active in raising money from the debt markets to basically make sure that investors see these sales numbers keep growing. But when you start to look under the hood, what you quickly discover is, is that whilst the sales sales might be growing at a clip of say 15 to 20% per annum, the cost of sales or their, you know, expenses are growing at 30%.

Craig Mercer (26m 51s):
So in an environment where the cost of capital, you know, which is, you know, interest rates ultimately informing that is going up quite aggressively because of inflationary pressures. Unless a company can increase its sales at a much faster pace than the cost of capital, they're gonna lose money. And you know, what we've seen from a lot of these tech companies was the people were buying them on the expectations that at some point in the future, the negative income would eventually turn positive. But if their debt obligations and their costs of capital keep going up, maybe that might not be possible.

Phil Muscatello (27m 25s):
So is that like, is that like a software or service company software as a service company that basically they make good money because there's no basic costs of, you know, once they've set up the, the software, there's no extra cost really to run it, but it's then the cost of marketing it to generate sales is that cost,

Craig Mercer (27m 45s):
Cost of staff, cost of service, costs of real estate, all these associated costs, you know, as they, in a cost of marketing being a very important one here, as they continue to scale up to try and make those economies a scale, they have to obviously associate the increase all their costs of operation. And, and you know, interestingly enough, I looked at this about three years ago cuz I was getting really concerned with the exuberant valuations in, in the tech space as a whole, you know, we're a value focused firm. So, you know, thinking about this in the context of am I comfortable not owning this stuff or maybe as an opportunity to maybe short sell some of this stuff. And the interesting part of that analysis was, was that when I looked at it, is what you saw as very strong, you know, revenue growth, but as I said, the costs of sales were going up at a faster pace, which is not usually a good sign.

Craig Mercer (28m 34s):
So, you know, what you were seeing here was, was sort of negative ROEs, you know, into per perpetuity, which for the risk that you are taking as an equity investor, to go back to that capital structure discussion, I'm not really being compensated for the risk that I'm taking, particularly when you consider the valuation that you would be, you know, paying on the expectations of future earnings that have not yet necessarily transpired.

Phil Muscatello (28m 60s):
Okay. Well we're nearly at the end of the interview, but I just wanted to change a subject a bit. Sure. And ask you, is an Asia expert, why is China so on the nose for investors at the moment?

Craig Mercer (29m 10s):
Look, this is a really fascinating conversation, just to give you some background. So Dalton has been very sort of underinvested in China for quite a long period of time. And actually earlier this year we took more active steps to sort of more, you know, actively, you know, reduce some of that exposure. And so, you know, in the context of how Dalton thinks about investing is, is, is, I'll frame it that way. So because that's, you know, what we think about, So Dalton invests in businesses around sort of four key sort of criteria. One, it has to be a good business. Now good business business is something that generates, you know, more efficient returns on equity, has a, you know, better quality of balance sheet has high cash generation, you know, better esg, et cetera, et cetera.

Craig Mercer (29m 51s):
So good business first what we wanna see is an alignment of interest. And this is a really crucial part of this, an alignment, interest of interest between the owner operator. So that might be the major shareholder in the company or the management team of that company, and us as a minority shareholder by alignment of interest, what we mean is, is does the company have a track record of returning capital to shareholders, you know, in a form through dividends or does it have a track record of, you know, and this is the third part, reinvesting that capital successfully at high returns. So if we give them a dollar a capital, are they paying me back with, with more than a dollar a capital over an extended period of time? Mm. And then the final part is valuation. So we need a, you know, a material margin of safety.

Craig Mercer (30m 33s):
So we don't wanna buy something for $1 50 when it's worth $1. We wanna buy something at 50 cents when it's worth $1. Now in the context of China, owner operators tend to be entrepreneurial led businesses. And historically we did own a lot of entrepreneurial led businesses in China. You know, common examples might be things like Alibaba, Tencent, you know, these are really successful entrepreneurs that have made transformative businesses with huge, you know, success. Now what was fascinating is is the government started cracking down on these guys because ultimately China is a central, you know, state run economy. It's run by communist party

4 (31m 13s):

Craig Mercer (31m 14s):
Planned, Yeah, centrally planned. And they were making what the government deemed to be outsized returns that's not in the spirit of that central planning. So they regulated them to death where they started basically impinging upon their ability to generate outsized returns. There was one example which where they outright basically just killed the entire industry education. So there were a whole heap of really successful private education companies. You know, one particular one was called New Oriental Education. The government basically said sort of late last year that private education companies were no longer viable because they didn't like the stuff they were teaching students that might lead to dissent, you know, a different point of view to the central planning of the Communist party, et cetera, et cetera.

Craig Mercer (32m 2s):
So they said, no private education no longer, you know, can really be a, a sustainable business in China. So these companies that were hugely successful generating huge returns basically went from, you know, a hundred dollars to zero pretty much, you know, in the space, the blink of an eye. And so that really come, you know, from our perspective that really points to a couple of things. One is, can we align to a business in China where we are confident that the entrepreneur can make returns that can then be returned to us? And you know, the simple answer to that question is probably not so that when paired with the fact that valuations had become quite exuberant in China, it was very difficult for us to even find investments.

Craig Mercer (32m 47s):
But I guess, you know, why the world is sort of becoming so sort of disillusioned with China right now is more sort of centered around the geopolitical issues. You know, the Ukraine war and you know, with Russia has sort of emboldened, you know, China to a certain extent to be

Phil Muscatello (33m 2s):
Start thinking about Taiwan.

Craig Mercer (33m 3s):
Taiwan. And that has huge potential, you know, geopolitical implications because you know, as I mentioned semiconductors before, Taiwan is the number one center in the world for producing semiconductors. And Taiwan's biggest customers are US corporations, you know, Apple, you know, chief among those. But there's a whole army of others. You know, Invidia being probably one, an AMD being the other two key ones, you know, US chip designers that, you know, rely on the Taiwanese expertise to design and manufacture. And so you can see how introduction of things like the US chips sect, you know, China's posturing around Taiwan is creating a lot of anxiety.

Craig Mercer (33m 43s):
You know, that paired with the fact that people have become somewhat disillusioned with the ability for Chinese companies to generate, you know, superior returns because of potential, you know, regulatory intervention. And then that's then gotta be paired with the fact that China's going through a demographic problem, the zero covid, you know, stance, and obviously a real estate market that is hugely over indebted. So to come back to, you know, the question about, you know, ROE, we are gonna see a lot of companies fail with very, you know, unrewarding returns on equity. So all of those things sort of combined makes it probably easier at this point not to be too aggressive on China, but at the same, and that's, you know, for most investors that invest in Asia, not having an overweight, if you like the region has been hugely positive this year.

Phil Muscatello (34m 34s):
Craig Mercer, thank you very much. Thanks. It's been so enlightening.

Craig Mercer (34m 38s):
Thank you very much and thanks for having me back again.

Phil Muscatello (34m 42s):
If you found this podcast helpful, please tell a friend, especially if it's someone who needs to start thinking about investing for their future, you'll be helping them and helping me to keep this show on the road

Chloe (34m 52s):
Shares for beginners is for information and educational purposes only. It isn't financial advice and you shouldn't buy or sell any investments based on what you've heard here. Any opinion or commentary is the view of the speaker only not shares for beginners. This podcast doesn't replace professional advice regarding your personal financial needs, circumstances, or current situation.

Phil Muscatello (35m 11s):
And thank you for listening to my podcast.

Shares for Beginners is for information and educational purposes only. It isn’t financial advice, and you shouldn’t buy or sell any investments based on what you’ve heard here. Any opinion or commentary is the view of the speaker only not Shares for Beginners. This podcast doesn’t replace professional advice regarding your personal financial needs, circumstances or current situation