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Grab the Popcorn: There's No Dearth of Excitement in Global Markets

Krishna Mohanraj discusses international market disruptions, valuation-driven investment decisions, AI's impact and the importance of on-the-ground research in countries like India and Japan. (29 min video)

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Matt McLaughlin, CFA, CAIA (0:12)

Hello everyone. My name is Matt McLaughlin. I'm an equity portfolio specialist here at Diamond Hill. Today on the webcast, I'm joined by portfolio manager of our international strategy, Krishna Mohanraj. Welcome back to the webcast, Krishna, and thanks for joining me.

Krishna Mohanraj, CFA (0:29)

Thank you, Matt. Excited to be here.

Matt McLaughlin, CFA, CAIA (0:32)

Maybe, just jumping off as this is our first webcast of 2024; last year on this webcast, you talked about an event of some sort happening almost every year, and last year, it was the takeover of Credit Suisse by UBS, and the year before that, maybe inflation/interest rates and whatnot. So, let's just start off by going through just a few notable events in your mind in international markets this year.

Krishna Mohanraj, CFA (01:03)

Matt, as always, there is never a dull moment in global markets, and I feel 2024 is proving to be as exciting as can be — I would say even more exciting than in recent years. Huge amount of disruption in many places in the market, and that's kind of what's top of mind for us as 2024 seems to be the year of disruption.

So much to talk about, probably we have to start with AI. The changes that we are seeing are truly breathtaking. It's definitely captured the market's attention. There is, of course, a lot of hype, but no question that this is a significant disruption — also an enormous opportunity for many companies, especially the ones that are providing the picks and shovels of this technology. Semiconductors, case in point, but you also have so many second-order effects here. If you think about electrification, think about energy demand not just in the US but globally as well, has not really grown for decades, and now suddenly, in the US, it's projected to grow mid-single digits — once-in-a-lifetime investment cycle happening there.

And I guess related to that, you have global demand for materials, things like copper where it's becoming clearer that there's a huge supply deficit. So that's one big bucket of disruption we're seeing. Then you've got pharma, innovative pharma, specifically the companies that seem to have cracked the obesity puzzle with GLP-1 drugs. I mean it's really fascinating to think about what that's going to do to human health and consumption, but also what does it mean for pharma companies, pharma as a sector for the entire value chain in pharma, in hospitals, medical device players, and then even more interesting what happens to consumer habits, food and beverage companies? That's a space to watch for disruption.

I would also talk about the auto industry. Huge amount of disruption happening there. For many of the markets we invest in, whether it's in Europe, Japan, or South Korea, it's always been super important that industry for jobs, for GDP, manufacturing ability in general. Not just for the OEMs but also for, there's always been a healthy ecosystem of suppliers in many of these markets.

With the shift to EVs and the rise of Chinese companies, you're finding a really brutal environment in autos. Yesterday I was reading the CEO of Stellantis, which owns the Jeep brand. He called the space Darwinian and he said it's going to be Darwinian for the next few years. When you think along those lines, there are just so many second- and third-order effects, you immediately get into geopolitics and trade. You’ve already seen the US and a clear signal there with tariffs. And if I had to bet, most of the countries have no choice but to follow the US example. So it's fascinating to see what that would mean. The sector has so many links to global trade, especially with China.

And finally, while we are on the country topic, 2024 is the year of elections. So you've seen elections in pretty much most of the democratic world. This weekend I think we'll get results from the Indian election, so as they say, grab the popcorn. There's no dearth of excitement. And frankly, for our style of investing, we've said this many times in the past, this is an excellent setup, right? We like it when there's lots of volatility. We like it when there's disruption. Great businesses tend to be mispriced, so we find the best ideas when there's change. So we just are excited to keep looking and trying to find the best ideas we can.

Matt McLaughlin, CFA, CAIA (04:55)

Sure. It's a great overview, and I think for anyone who's interested in international markets, that's music to their ears because just a lot of interesting stuff going on, and you hit on so many of those interesting different things. Maybe let's start off with one of the things you hit on that we've been doing in the portfolio — we've been adding to our exposure in metals and mining. Can you talk about what we currently hold there and why we are positioned that way?

Krishna Mohanraj, CFA (05:21)

Yeah, let me start with what is the core thesis? The core thesis always in our mind has to do with supply. A simple question, where is it going to come from? Where are these materials going to come from? We take copper, a metal, we have good exposure in the portfolio. Where is it going to come from? Recently, I was speaking with the CEO of one of the largest mining companies, mining equipment companies — every mining major, whether that's BHP or Rio, they're all customers of this firm, Epiroc. And the CEO, her comments were very clear that in the case of copper, there isn't much supply; there isn't much capacity coming on. We are seeing some pockets of brownfield expansion but absolutely no greenfield, because there hasn't been much exploration in the last few years, and whatever exploration there has been, the success rates have been so poor.

If you look at the current mines that are producing, the trend you're seeing, a clear trend is a depletion in all grades year-over-year, which means the incremental, the marginal metal is costing more and more to extract. So that's the issue with supply.

And you're also seeing, I would say, a structural change in how the industry is being operated since maybe if you go back 10 years ago, the boom years of 2009, 2010, 2011, there was so much indiscipline across the sector, there was so much money chasing growth. Those days are over. The industry is in a much more healthy situation where miners are thinking about how to sustainably operate mines rather than simply dumping capital into more capacity. So, you put those two together, you're going to have supply constraints for the years to come. Okay, now look at the demand side, right?

Demand side is always harder to predict, so we typically focus on the supply side, but the demand side is looking pretty exciting. If you think about the growth in electrification, AI, a typical data center, I think takes about 50,000 tons of copper per gigawatt of applied power. So, if you think about the data center additions that are coming in, copper demand could start running like 400,000 tons a year just in the US, which is about 2% of the entire global copper market. Now, 2% doesn't sound like a lot, but when supply is tight, it means a lot for copper prices. And you're beginning to see that on the copper side. So I know there's a lot of hype around LLMs and software companies, but if you are really thinking about the AI team, the simplest way probably is to gain exposure to copper. And we have that in the portfolio through a range of different investments. Glencore, Capstone, Epiroc, which is the mining company that I mentioned, Mitsubishi, which is a Japanese company — all of them have exposure to copper. And for us, it is a much more risk-averse way to play because in each case, our thesis, again, is a bottom-up intrinsic value-based thesis. So yeah, really excited about that opportunity and how we are positioned there.

Matt McLaughlin, CFA, CAIA (08:40)

It may not feel like it to many investors, but markets have been trending upward for a couple of years, which usually means valuations are getting a little bit higher. That's true around the world for the most part as well. Can you talk about a recent sale or two that we've had that was driven in part by valuation getting full and us exiting the position?

Krishna Mohanraj, CFA (09:07)

Yeah, I think, I would say since October, right, there's been a rally in many parts of the market, and I mean, thankfully, many of our names have benefited from that too. In general, we want to be disciplined. When our investments get too far outside our estimates of intrinsic value, we start to question their sizing in the portfolio, start trimming, and eventually exiting because ultimately price matters — we're very valuation conscious, especially so with companies which have, I would say, which operate in a very narrow space, which tends to have a more narrow range of outcomes. We tend to be more aggressive in managing the position as the stock does well.

I would call out one recent example, the Polish retailer Dino Polska, we've talked about this name in the past, and we've owned it for quite a while. We like many aspects of the business. It's one of those rare gems, which has a very strong entrance position in the Polish grocery retail landscape. And what we really liked about them, and I mean continue to like about them, is that they have a very specific and successful playbook that matches the opportunity that they have in Poland. So, they target small towns, they replicate the same small store formats, which makes them super-efficient, and they have a very vertically integrated meats business. So meats are a big staple in Poland, and fresh meats make a big difference in that market. So structural advantages and a very good management team. Tomasz Biernacki, who's the founder, he still is a significant owner, very much aligned with our interests. Everything is positive except that the stock has done really well. It hit a peak valuation, I think early this year, and we had to say goodbye for now. I hope we will be owners again in the future if the price gets more attractive. We simply found better opportunities elsewhere to deploy capital.

Matt McLaughlin, CFA, CAIA (11:18)

Building on that question, we are disciplined intrinsic value investors, but sometimes, that intrinsic value in a business grows. So maybe you can provide an example of a holding that has seen good recent performance but where our outlook for fundamentals and our intrinsic value increased. So, it's not yet sold; it's still in the portfolio.

Krishna Mohanraj, CFA (11:41)

I would say our estimates of intrinsic value, they're not static. We continuously reevaluate every one of our portfolio companies, and when things change in their fundamentals, in their operating environment, we adjust our estimates, and when things get better, our estimates get adjusted upward. And fortunately, we are seeing that in a few of our investments recently. In fact, with several investments, we've had to revise our view of the business.

One example that comes to mind is Taiwan Semi (TSMC). It's actually a great example of that. You can think of TSMC as literally a tollway on semiconductor manufacturing because more than 90% of high-end chips are made by TSMC. Over the last year or so, we are coming to the realization that the AI opportunity for TSMC is bigger than we originally thought. Currently, TSMC gets only a small percentage of its revenue from AI processes, mostly from Nvidia, but that picture is changing fast.

We are seeing, if you listen to some of the hyper-scalers, the Googles and the Amazons, if you're seeing the investments that they're making and bringing some of the chip design in-house with their own custom accelerators, instead of relying solely on the generic Nvidia GPUs. If you play that out, that is bound to increase the TSMC opportunity set by a magnitude. At the same time, who is there to compete with TSMC? The only possible competition in foundry is a distant second, Intel, and they're struggling to put up a challenge. So, you put those two together, our estimate of TSMC'S value has increased, and even though the stock has done well, it continues to be a decent-sized position for us.

Matt McLaughlin, CFA, CAIA (13:35)

We've mentioned a couple positive outcomes, but in any portfolio, there's going to be outcomes that you don't want to happen that happen. What are a couple of stocks recently where performance has been disappointing, and what actions have we taken as a result of that disappointing either stock price or fundamental performance?

Krishna Mohanraj, CFA (13:54)

As I mentioned, intrinsic values are not static, and that works both ways. When the fundamentals, the operating environment turns for the negative, we have to be careful and disciplined to bring our estimates down.

One example of that would be Ambev. Ambev is the leading producer of beer in South America. Beer is an interesting business because it's quite expensive on a dollar-to-weight basis to ship. Breweries tend to be local monopolies, and in many markets over time, especially in Latin America, it's ended up being a monopoly or a duopoly between Ambev and Heineken. So that's really our thesis for Ambev was that the markets in which it operated, it had a dominant position just by design, just structurally, and over time, what Ambev was done is through acquisitions, it's built up this lead and, in many cases, it has 90% share of the beer industry, which is amazing. So far, so good: great business, great management, and a good track record of capital allocation.

But what we've seen is the operating environment for them change drastically in the last few years. A couple of things have happened. One is Argentina is a decent-sized market for them. They're essentially a LATAM brewer. So Argentina is roughly 10% I think of that business. And that market, as we all know, has its struggles both in terms of hyperinflation, currency issues, and then a consumer essentially having to deal with hyperinflation. In fact, I was in Brazil late last year and I met with Ambev's head of treasury, and he was explaining to me the kind of effort that goes into managing cash flows and currencies of the Argentina business. And I was just amazed. It was great news in terms of management's ability to handle this, but at the same time, you want to think about this as a huge negative in terms of how long this will last and what it means for cash flows from Argentina.

The second aspect of this, and probably the bigger aspect, is tax changes; and Ambev has a peculiar setup where it benefits from tax advantages related to dividends. That is going away or that is most likely going away. And we have had to incorporate that risk into the valuation as well. So, I think the key here is the operating landscape when it changes, especially in emerging markets, you can get the business, you can get the management right, but when the environment changes, you have to be aware of it and you have to be open-minded enough to make a change and that's what we did.

Matt McLaughlin, CFA, CAIA (16:52)

Any other examples come to mind of stocks that we exited or chose to keep in the portfolio that haven't done as well?

Krishna Mohanraj, CFA (17:03)

There have been a few names, especially, I would say, I would call out the consumer staples sector. We own a few names, Diageo as an example, where the stock has not done very well, but we've been, I would say, a little circumspect in terms of adding and building a position. And some of the changes have to do with the slowing down of the US consumer, potential questions around maybe there are structural changes on especially high-end alcohol, but those, I would put them in the bucket of still open questions. And I think, again, going back to the highlight is that we always have to keep an open mind. We love the companies in our portfolio, but every day you have to wake up and see what is the best portfolio for the customer that you can put up today. So that's the thinking on a daily basis for the entire team.

Matt McLaughlin, CFA, CAIA (18:03)

Sure. Turning to a couple of countries we've talked a lot about in the past, India and Japan. Has the team done anything with positions in India, Japan, added, taken away? What's been the activity there in the last six months or so?

Krishna Mohanraj, CFA (18:21)

I think the short answer is yes. In both cases, we've had new ideas come into the portfolio and I would say the one common theme across both these markets is that they have a lot of listed companies from which to fish. So both these countries for us, I think, is a place that we'll continue to be very interested in and continue to look in-depth all the time simply because there are more opportunities over time, but outside that Japan and India couldn't be more different, right? Japan suffers from a huge demographic headwind while the Indian consumer picture is one of the best in the world. So the kind of ideas that are coming in also tend to be different. With Japan, it's a lot about the balance sheet. The theme is improving returns on equity, corporate governance reform, simplification of the investments in the balance sheet and the cash in the balance sheet and returning that capital to shareholders.

Whereas in India it's more income statement driven. It's about strong franchises that are facing potentially huge, long runway from a rising middle class and on strong growth and the income statement. And then how do you take advantage of that at the right valuations, given that everybody sort of knows the story? So, I have to, and I say this many times before, is we invest in companies, not countries. Our focus is, again, in both those cases, whether you take a Mitsubishi in Japan or HDFC Bank in India, the ideas are driven by analysis of the business, is bottom-up, and our estimates of intrinsic value, and I suspect we will find more over time in both those markets.

Matt McLaughlin, CFA, CAIA (20:07)

You mentioned in your opening comments about AI and the frequent topic of conversation, both for US and international investors, but with most investors when they hear AI, they think of companies like Nvidia or a few select companies with big exposure here in the US, but does the portfolio hold any stocks that will benefit either directly — say supply chain of chips, like TSMC, that you mentioned before — or indirectly from the growth and the rise of AI?

Krishna Mohanraj, CFA (20:40)

Whenever you see a disruptive change like AI, the question we are always asking is where is the supply constraint? I think the smartest way for a value-conscious investor to invest in AI is to go where the supply is limited, where you don't have to take the risk of demand being at a certain level. So, if you think about the usual suspects: software, so much money going into software development, pretty much every VC (venture capital) deal now is about AI. It's very difficult to figure out what happens with software companies when who has the better LLMs, who wins? Is it going to take all or not? It seems to be like if we had to guess the more commoditized side of things where there's tons of supply coming in. So, we look for where there could be potential supply deficits. I will caveat this by saying we're not thematic investors. We're not saying, oh, AI is a theme, let's go find something. It's more thinking bottom-up and then incorporating AI demand into our analysis. So that's always the direction we are coming. We are attacking this problem.

So, we spoke about Taiwan Semi, the fact that it's a unique toll road business on chip manufacturing, huge barriers to entry, supply constraints. We spoke a little bit about metals and copper in particular. The opportunity set coming from the energy transformation side of AI, so much easier to access. Again, where is the capacity going to come from? Supply constraint, right? One company we haven't talked about is Samsung, the Korean electronics company, predominantly a memory company. One of the beneficiaries of AI is high bandwidth memory. There are only three players in that space, SK Hynix, Samsung, and Micron. High bandwidth memory, you can kind of think of it as given the speed of AI operations, the memory that is used in AI processes and systems has to be faster as well. And that's where high bandwidth memory comes in. It is a huge opportunity for these companies, and Samsung is right now not getting the benefit of its, I guess, significant presence in memory because it's sort of lost the lead in high bandwidth to SK Hynix, but we think structurally Samsung will benefit and it's just a matter of time before that shows up.

So that's a huge positive we see on the AI theme for Samsung. Now, we've been investors in Samsung way before AI was headline news. So the thesis for Samsung is that it is a memory company with a strong structural advantage, but now that thesis just has a little bit of cream on the top, if you will. So that's a few different ways in which we have exposure to AI.

Matt McLaughlin, CFA, CAIA (23:47)

And the last question: you get on a plane frequently and go visit these countries and these companies. Where have your travels taken you to so far in 2024, and what are some observations you've had when you're traveling?

Krishna Mohanraj, CFA (24:01)

Travel is very important for us. So, I would want to say a little bit more on what travel gives us just for the context: information, especially the written word, is being commoditized today. So, if all you're doing is sitting at your desk reading a bunch of reports and investing based on that, if you are an armchair investor, if you will, it's becoming a very crowded competitive space. And that really doesn't take full advantage of what we have. What is unique to our team, we are a close-knit team of senior investors. Almost all of us have 10-15 years of experience on the team, and we've spent a lot of years meeting with businesses, engaging with the management teams, and simply turning one rock after the other. Our advantage is the context we bring. It's our ability to understand people and travel, for us, especially continuously engaging with management teams, keeps that edge very sharp.

So, we are meeting management teams constantly, and it's not just the management teams. We are also visiting factories, warehouses, mines. So we really get to kick the tires and understand operationally what it takes to run the business. What I think travel gives us is the ability to frame the investment in the correct local context. And that is super important, especially in international markets. It's really about getting your head out of the numbers, out of the analysis, out of the spreadsheet, and actually trying to understand what's going on. Also, in this business, if you sit at your desk, you get a lot of received wisdom all the time because everybody's an expert, everybody's a strategist, and after a point, you don't know what to do with all that piece of conflicting advice sometimes. So travel really helps us, grounds us and fixes that problem for us.

At any point in time, if you call us, one or more of us on our team are likely on a research trip just in the last few months. I think our team, we've been in the UK, we've been in France, Switzerland, Brazil, Japan, and there's a constant itinerary when we go there. There's a constant itinerary that's built around either conferences and individual management visits, and then, like I mentioned, store visits and warehouse visits. So we are getting a full picture of both companies in our portfolio and companies we're interested in, and we could potentially be interested in the future.

So, in the last two or three weeks, I met with many different management teams. I met with the CEO and CFO of a chemical company based in Germany. I met with the management of a grocery retailer in Mexico and an apartment REIT in Germany, a Brazilian jewelry brand, kind of like Pandora, and the operator of the Brazilian Stock Exchange. So think about it, that's a diverse group of businesses. Each one is a story, a life story impacted by various macro craftsmen. And when you do that constantly, if you spend time day after day, week after week as a team turning over rocks, you begin to see many interesting themes. As an example, one common idea across many of these, my recent meetings is debt levels and interest rates. There's so many of these good businesses and we think good management teams that have enjoyed maybe a decade of low interest rates in Europe.

So, the right thing at that time for them was to build up the balance sheet a little bit, go for a few acquisitions. Now, suddenly, rates have gone up, and they find themselves with maybe a slightly excessively levered balance sheet at high interest rates, debt coming due, having to deal with daily cashflow worries. Of course, you can read about it, but to actually talk to a CFO and hear his day-to-day just gives you that little bit of extra visceral feel of what it takes to run a levered business when rates are high, and you're going to have to think about planning for different rate environments going forward. So that is what I mean by getting a true context of what is going on on the ground. Some of these businesses we are interested in, but as you can imagine, balance sheet is a big part of the investment equation. So we want to get a good true feel of what we're getting into.

Matt McLaughlin, CFA, CAIA (28:33)

Well, Krishna, all the questions we had for you today. Thanks for joining the webcast, and we look forward to talking with you later in the year.

Krishna Mohanraj, CFA (28:39)

My pleasure. Thank you, Matt.

As of 31 May 2024, Diamond Hill International Strategy owned shares of Ambev SA, Capstone Copper Corp, Diageo plc, Epiroc AB, Glencore plc, HDFC Bank Limited Mitsubishi Corporation, Samsung Electronics Co Ltd and Taiwan Semiconductor Manufacturing Co Ltd.

The views expressed are those of Diamond Hill as of June 2024 and are subject to change without notice. These opinions are not intended to be a forecast of future events, a guarantee of future results or investment advice. Investing involves risk, including the possible loss of principal. Past performance is not a guarantee of future results.


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