International to the Core

Where we have historically focused and generated a lot of our strong returns is on smaller companies with very focused businesses. We generally shy away from large global companies such as Nokia, Sony, and HSBC. We’re much more focused on the local companies–local banks, local service businesses in Asia, and homebuilding companies in the U.K. These are very much local businesses. In an environment where the British pound would strengthen against the U.S. dollar, these local companies are not going to be affected. We try and make the distinction between the smaller local companies versus the larger global companies. In an environment of a continued weaker dollar we tend to think our portfolio would do relatively better than some of those portfolios that are packed with the large global multinational firms that will feel a U.S. dollar impact. Many of our firms are largely immune to currency movements, but of course, that can cut both ways. We think that the companies we’re invested in are earning good profits, they’re well-established businesses in strong niches, and that they will earn good returns.

You mention homebuilders in the U.K. as an example. I know that’s a sector that a number of investors are strong on in the U.S. market. Are there sectors like that which tend to be good investments regardless of the country? Again it comes back to the fact that these are local niches. If the local conditions are strong, the market will be strong. But conditions in one country can be radically different than in another just across the border. To the degree that they are dependent on the local economy, you can’t say that [homebuilders] are globally attractive. If you think about the last 10 years in Japan, which has been going backward, homebuilding has been a horrible place to be, whereas in the U.S. and the U.K. homebuilding has been a very profitable business.

What you can say is that there are businesses like homebuilding or gaming–betting shops and casinos are another area where we’re heavily invested–where the businesses are local but geared into themes that are very uniform across countries.

If you think about the homebuilding industry, for example, household sizes are getting smaller, interest rates are getting lower, new geographic areas are being exploited and developed, people are increasingly mobile, so the overarching need for housing globally is likely to increase.

But in the case of many other local sectors, banking, for instance, the local economy can override those global themes. If you think about banking, people are getting more sophisticated about investing and more people are taking care of their own retirement because government’s not going to do it. So there are more savings products, more mutual funds, more home loans, more this, more that. This is a global phenomenon. But if the economy in California, for example, falls flat on its face, a bunch of companies will go under water and a bunch of bad loans will surface in the banking business. So no matter how strong the overall argument is for mortgages and consumer saving and mutual funds, a crisis in the California market will override that and cause the California banks to really suffer. That could conceivably happen in the U.K. It has already happened in Japan. It could happen in other countries as well. So there are attractive global themes, but these local businesses are driven by local dynamics, which can serve to override a global theme.

You mention betting shops and casinos. Is that a business that you see as strong across borders? Coming back to the argument we made before–we see more consumer confidence, increasing wealth, more time for leisure, people traveling more for vacation–all these things are playing into the gaming and leisure sector, whether it’s betting shops or lotteries or casinos, and we’re very positive about that. It’s a very profitable industry and government is realizing it can be a valuable source of revenue. State lotteries here in the United States have been a tremendous source of revenue for the local states in the same way that betting industries outside the United States are valuable sources of revenue and are being discovered as such by the governments.

So that’s the global argument in favor of this industry–more consumer appetite for these types of products, more supply, and more government willingness to tolerate it because they’re getting nice tax revenues. But you can always have, and it could vary from market to market, a change in legislation. You get a different government coming in that doesn’t like gambling. There is a very strong global theme, but on the local level the government could do something that derails it in any particular market, which could overwhelm the long-term sector growth. We think that if we’re spread across different markets and different leisure formats that we can offset that. But it’s always a risk in the same way that a banking crisis is a risk or a housing crisis is a risk. Those risks are going to be very much local risks rather than global risks in most cases.

Are there any countries about whose economies you’re particularly excited these days? We’ve been excited for some time about a few of the economies in Europe–Greece, Spain, and Ireland in particular. They’re all countries that are part of the EU with the euro currency. Historically they all had fairly high interest rates and now with the single currency everybody’s interest rates are set by the ECB, which is driven substantially by the Germans. So everybody in Europe that has the euro has 4% interest rates, and in these countries people were used to 10%, 15%, even 20% interest rates. So there’s been a huge boom to investment, to the banking system, to consumer confidence, to spending power, to real estate development, and to the economies overall in these countries. They’re smaller and they’re not as constrained from a policy perspective as countries like Germany and Austria and Italy are by the labor unions and political structure. They have low tax rates and they’re attracting investment. They’re getting reputations as very easy places to do business.

Would you care to talk specifically about some of the fund’s larger holdings, such as Anglo Irish Bank? That’s our number-one holding and has been for some time. It’s really just a tremendously profitable business and it fulfills all the criteria that we look for in a business. It’s based in Ireland but it’s not your typical bank. It focuses on supplying banking services to high-income entrepreneurs. Their prototypical customer is a dentist or a doctor who says “I want to buy my surgery,” or “I want to buy out my partner,” or “I want to invest in a property development.” They focus on delivering high-quality service to this very attractive customer base. These customers don’t want to be treated like a commodity. They don’t want to be put in front of somebody who doesn’t know what they’re talking about or talk to somebody from a call center. They want to know they only have to make one phone call to one person to get the deal done. The entire business model is tailored to customer service, which is the exact opposite of what most of the banking business is doing. This is pure relationship banking. It’s a very successful model making a 30+% ROE.

They’ve done very, very well in the Irish market and moved, as the name would imply, into the U.K. market, which is roughly 10 or 20 times the size [of the Irish]. They are now incrementally moving into the East Coast of the United States with a very clear focus on whom they serve and with what products. They’ve been growing at 20% a year in the context of declining rates, which is always very good for banks, and they’ve been tremendously efficient. Most people say if you’ve got a cost/income ratio of 50% it’s pretty attractive, while anything in the low 40s is phenomenal. With these guys it’s a cost/income ratio below 30%. It’s just an incredibly profitable, focused business.

What can you tell me about your investment in Vodafone? Vodafone is the other end of the spectrum that I talked about before. As I mentioned, some companies we like because they’re focused on their niches, while others have a competitive advantage just by the nature of their scale and size. Vodafone, which is the world’s largest cellular operator, falls into that second category. It’s in all the major markets, including Japan and the U.S., which is pretty unusual for a European-based operator, and they’re still growing customer bases. The cellular operator industry is moving from a pure focus on customers at any price and pure growth into a much more stable returns-based mindset, where they’re looking for the right customers, with the right offer and to serve them profitably. They’re doing this by focusing on better customer care, better customer retention, better customer service, and better scale.

There was a CEO change at Vodafone just under a year ago and [Arun Sarin's] very much focused on returns and doing the right thing with the cash flow. I think that’s going to drive the performance of that company. It’s trading at a discount to the market, so you get pretty attractive growth on the top line, and leveraged growth on the bottom line. The free cash flow from this business is very strong and it has a management team that appears to be committed to doing the right thing with that cash flow, whether it’s buying back shares or doing intelligent acquisitions rather than overpriced acquisitions.

Staff Editor Robert F. Keane can be reached at [email protected].