Dalton Investments

Research structure pays off for Asia Fund

Originally published in the June 2013 issue

Dalton Investments is one of those firms that is run on principles laid down by the founders at inception in 1999. What the firm has chosen to get involved in is a function of those principles, and it applies as much to Jamie Rosenwald, manager of the Dalton Asia Fund, as it does to Steve Persky (who runs the Dalton Distressed Credit Fund) and Gifford Combs, the laconic manager of global fund Pacific and General Investments. As in all the best hedge fund management companies, the portfolio managers believe in the strategies they are implementing to such a degree that they commit a significant portion of their own wealth to their own funds. This is what James Rosenwald III has done through most of his career in investing, stretching back to the mid-80s.

During his career Jamie Rosenwald has applied a couple of value-based investment styles to (mostly) Asian investment opportunities. For instance, from 1985 onwards he invested for the Grace Family in Japan and Korea. He was an outside advisor to George Soros from early 1992 up to 1997 for the Quantum Emerging Growth Fund and the Quota Fund: Rosenwald helped identify potential longs and shorts in Korea and elsewhere in Asia. With fellow outside advisor to Soros Nick Roditi he set up Rosenwald, Roditi & Company to launch a succession of specialist investment vehicles. These focused on specific investment opportunities such as Korean life companies, then a fund dedicated to Asian insurance companies, the VOC Fund (a pan-Asia fund that took the Dutch East India Company as a territorial template), and finally, in 1996 the RR Russia Fund, launched as Yeltsin took control of the country. The Russia Fund could invest in Russian debt on a leverage basis and in Russian equities to take advantage of the country opening up to capitalism.

The final fund launched by Rosenwald, Roditi was a joint venture with Coronation Capital to take advantage of the multi-year opportunity to invest in South Africa as the black majority came to power. Rosenwald himself says that these fund launches were often contrarian investments as there was blood on the streets in both Moscow and South Africa at the time. All the fund launches and investment opportunities given were deep value in nature and consequently required patience and a long holding period to see that value realised. That way of addressing markets is what Jamie Rosenwald brought with him to Dalton Investments when it was set up in 1999.

Right through his time as a principal of Dalton Investments Rosenwald has run long-only money on a dedicated basis for clients who long ago spotted and backed his talent for investing in Asia. These managed accounts have had various mandates including Japanese equity and Asian distressed investing, and Rosenwald also managed the JMBO Fund (launched in 2003) that focused on management buy-outs in Japan. To this day he manages long-only separate accounts in Asian and Japanese equities.

Best opportunities were in Asia long/short
Like the other partners at Dalton Investments, Rosenwald periodically asks himself what are the best opportunities for his own money. Dalton Investments is unusual amongst hedge fund management firms in being willing to recognise when long-running investment strategies are waning in potential return. Funds have been wound down and closed at the behest of the managers rather than the external investors in the funds. This reflects the true alignment of interests at the firm, and applies to Jamie Rosenwald specifically.

He found it difficult to execute the running of the JMBO as he would have liked so wound it down. He decided to put his own money to work in long/short in Asia, and several of his long-standing investors thought it sounded like a good idea and backed the new fund, Dalton Asia Fund. The fund started investing in January of 2008.

Dalton Asia Fund is a long/short equity fund that invests opportunistically across Asia. So do many hedge funds, but having a fundamentally driven style within the broad label is less typical. On the long side the Dalton Asia Fund has a bias towards mid-cap stocks, and the fund shorts for profit. The style of management on the long side will be looked at first.

The analysts and portfolio managers of the fund have processes to identify shares that over the medium to long term will benefit from the dramatic growth and structural changes taking place in Asia. Given Jamie Rosenwald’s history it can be no surprise that a prime factor for potential investments is that they must represent value at the time of purchase. As he is a CFA charterholder it is unsurprising too that value is made evident through the difference between intrinsic value and the publicly traded value of shares. EV to EBITDA is probably the most common metric used across the stock universe of the Dalton Asia Fund, but others apply according to sectoral and country-specific biases in valuation.

Whichever metric is perceived to be best applicable to a stock, there must be a margin of safety built in to the investment under consideration, and typically that is at least a 50% discount to fair value in new positions bought by the managers of the fund. In the style used by Jamie Rosenwald and his colleagues, with long holding periods, it is important that the whole portfolio as well as positions at initiation keep/refresh the cheapness to a fair long-term value proposition. Whilst the prices of securities obviously change every day the markets are open, over the medium term (say quarter-to-quarter in this context) the intrinsic worth of the companies also changes. Looking at the portfolio as a whole the publicly traded value of the constituents of the Dalton Asia Fund was at a 57% discount to the manager’s estimate of the true worth of the companies when last assessed.

This characteristic of the fund is important in a couple of regards. It reflects that, through time, as the Asian economies and companies grow the margin of safety, implicit in the measure is still very much part of the portfolio quality of the Dalton Asia Fund. This will help the long book of the fund weather the inevitable downdrafts of the stock markets, as it did in 2008. That year the long book fell 22.3%, against a market down 41.8% (the MSCI TR Net Index). So the particular way that stocks are selected for the long side helps implement the stated Dalton investment philosophy that preservation of capital is a primary concern. The large margin of safety also allows a better than market price/earnings expansion when stock markets go up. For example last year the MSCI Asia Index went up 16.8% and the long book of the Dalton Asia Fund was up 34.1%.


Another point on the margin of safety of the whole portfolio is that the measure is across seasoned positions. That is, through market cycles, the stocks to which the Dalton Asia Fund is exposed must have grown better than the respective markets to still keep the same scale of large margin of safety having delivered superior returns (see Table 1 and Fig.1).

The inference is that the managers of the Dalton Asia Fund have alpha on the long side. This is explicitly confirmed in Fig.2 which aggregates the long-only mandates in a composite for comparison purposes.

Jamie Rosenwald and his team see opportunity in Asia for a couple of reasons that apply to both long and short sides. The Asian markets are still inefficient (and volatile) compared to Western markets, and the sell-side coverage can be limited within the manager’s universe of stocks. For the long side specifically, Dalton Investments like that there can be high operational and regulatory barriers to investing throughout Asia; that there is an expanding group of nascent global companies; and that there are company managements willing to partner with investors to unlock value.

This last point derives from Rosenwald’s experience running the JMBO Fund. This time around Rosenwald wants management on his side from the off. “Having management thinking like owner/managers is the best way for the long term to get the power of compounding working on your side as an investor,” he says.

On the short side
On the short side the managers of the Dalton Asia Fund short for profit. That is they don’t short a stock to hedge out a factor in a long (a relative performance play), but expect the short to decline absolutely. In particular Rosenwald and his two co-portfolio managers, Yuya Shimizu in Tokyo and Tony Hsu in Shanghai, have a penchant for identifying state-owned enterprises (SOEs) as short candidates. State-owned enterprises in Asia can be used to implement state policy – in which case commercial considerations can rank much lower than employment and lending targets, or the management may be obliged to utilise locally provided technology rather than the global standard.

The same factors and standards are required for a SOE as a short as for any other short – an over-valuation such as a high multiple of price to cashflow; typically there is a heavy debt burden to produce financial leverage; and often the current business model is challenged by a change in the operating environment. For example, Dalton Asia Fund has shorted China Mobile.

The challenge to China Mobile’s business model comes from the growing appeal of messaging apps, such as “WeChat” in China. Messaging apps allow users to text and voice chat using the carrier’s data network. A WeChat user can send over 200 messages for the same cost as one traditional text message. China Mobile derives 80% of its revenue from conventional voice and text messages, and will be heavily hit by the growth of messaging apps. As it is, the SOE has lost 10% market share in the last three years, and the latest year-on-year statement of operating income showed a fall for the first time in 15 years. China Mobile trades at a price to book of 2x, and the majority of sell-side analysts covering the stock have it as a buy or hold.

Like all mature hedge fund managers, the managers of the Dalton Asia Fund size longs differently from shorts. The stated absolute size limit for a long is 10% and for a short 5%, but more usually, the operational size guide if you like, is for longs to be up to 3-4% and maybe one or two longs larger than that. The risk manager for the Dalton Asia Fund, London-based Craig Mercer, tends to raise the size of the shorts with Jamie Rosenwald if a position gets to 3% and is still growing (losing).

Craig Mercer, the risk manager for Dalton Asia Fund, describes his role in his own words: “My principal role at Dalton is to act as chairman of the firm’s risk management committee and as head of risk for the Asia business.  The risk management committee is comprised of the CEO, CCO and CFO with additional input coming from the valuation committee (which is a key issue with respect to RMBS).  The committee oversees all of the firm’s associated risks – operational, investment, pricing etc. – but my day-to-day role is focused on the Asian equity business, which is where my expertise is strongest and has been most relevant throughout my career.

“The greatest challenge we have at Dalton is trying to convince people that long-term-oriented investing with a tolerance for volatility is the right way to accumulate wealth over the long term.  Patience and inactivity are traits that seem to have abandoned the industry.  This ultimately means that we can spend long periods seemingly not doing all that much when the industry feels you should be “active”.  Trying to transform such an entrenched belief system is the single greatest challenge we face as a firm.  Of course working with such dynamic and intellectually demanding professionals is a challenge, but agood one. In terms of time the largest part of the focus is on monitoring and researching our investments so that I am armed with a cohesive set of tools with which to challenge and play devil’s advocate to the team in an independent fashion.”

The research process on the Asian side of Dalton Investments, like at most equity hedge funds, is mostly about staying on top of the stocks owned and under active consideration for inclusion in the portfolio. So although there is a valuation and qualitative screening that maintains a long list of over a thousand companies across Asia that are actively monitored, most of the time and resource in research are devoted to in-depth analyses of the 80-100 stocks in the portfolio and another 200 stocks which are at some level of active consideration by the team.

This many stocks can be actively followed at some depth because of the experience and resources in the research team. The analysts in Tokyo and Shanghai are generalists, each under a co-portfolio manager of the Dalton Asia Fund. Jamie Rosenwald has long followed the Japanese markets himself, and Dalton Investments first opened an office in Tokyo in 2000, but as a signal event the opening of the Shanghai office three years ago carries equal significance.

Structuring and growing a pan-Asian research effort
Shimizu and his number two in the Tokyo office travel to Hong Kong, China, Singapore etcetera to see companies in these countries for themselves, just like their colleagues in the Shanghai office. “Of course, as a result of their own experience, each member of the team has sectors and companies they know a lot more about, but conceptually we are trying to create a pan-Asian expertise as a team,” explains Rosenwald. So Shimizu travels frequently between the Tokyo and Singapore offices to build up expertise in the ASEAN countries. This also feeds into his understanding of where Japanese companies are making their profits, as much of the growth for Japan, Inc. is now coming from outside Japan, but in the region. The co-operative operating style works at the next level up too.

Rosenwald travels a lot with his two co-portfolio managers, and the three share e-mail input from across the region – that is all the (in-house) research material goes to all three all the time. “When you spend as much time together as we three do, you know how each of the others thinks about investment matters,” explains Rosenwald. An operating principle is that on the long side a new idea won’t go into the Dalton Asia Fund unless Jamie Rosenwald has met the management. And the closeness of the team makes this final management meeting much less likely to be a veto of the investment concept than it would in many hub-and-spoke structures around a key hedge fund manager.

Any member of the research team can come up with an investment idea, and once a report is produced it is distributed to all members of the team for review. Everybody can send back questions on the report. The weight of the responses and questioning allows the initiator of the idea to calibrate how well accepted (or well rounded) the investment hypothesis is. Even if there is some resistance to the idea in the team, the idea may be put into the portfolio as a half-percent position until Jamie Rosenwald has met the CEO, an executive director, or, if it is a family-run business, a ranking member of the family. He concedes that it is not always easy (or indeed possible) to arrange a dialogue at the appropriate (and necessary) level of the company, but his bad experience of the attitudes of some entrenched managements makes this step strictly necessary. In checking for an alignment of interests between external shareholders and company management or family ownership interests Dalton Investments has worked up a preference list for the state of affairs. Internal company management should:

I. Have skin in the game;
II. Allow external investors into the top entity of the corporate pyramid;
III. Act long-term greedy rather than on any other timeframe;
IV. Live on dividends;
V. And/or show they can beat their competition.

It is always affirming to come across a hedge fund manager that has found a way of working that really suits them. Sometimes this is about the manager’s personal style, but more often it is about finding a way of investing that uses the key principles of addressing markets that the fund manager has acquired on their career path. In the case of Dalton Asia Fund Rosenwald avoids the value traps in Asia because of his experience of trying to put Japanese companies into play in the last decade.

The manager states that they believe that Asia will evolve into one big market. This is not mere punditry, because Dalton Investments is organised in Asia to explicitly recognise this emerging truth. The firm is developing a pan-Asian approach to investing by breaking down country and regional silos in research, and through running research trips with staff across the team. Results to date for the Dalton Asia Fund confirm that collectively the portfolio managers can add value on both longs
and shorts.

The principle at Dalton Investments is that the fund managers eat their own cooking, and put at least half of the bonuses generated into their own funds. Rosenwald wants the committed capital to dwarf the salaries of the researchers. Jamie Rosenwald himself believes that the evolution of the research process also has allowed team members to buy into (intellectually or emotionally) their own outcomes to a greater extent. He says, with approval, that the PMs and researchers of the Dalton Asia Fund are increasingly acting like owner/managers of the fund. If the management team are showing increasing confidence in the processes driving the returns of the Dalton Asia Fund, then external investors should do the same.