Dhananjay Phadnis: 'ESG Investing Is Still at a Very Early Stage in Asia'

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Our guest this week is the Dhananjay Phadnis. DJ is the manager of the Fidelity Sustainable Asian Equity strategy, which he has run since 2013. DJ joined Fidelity as an analyst in 2004 and has served in a number of roles during his tenure, including stints managing Fidelity Indonesia Fund as well as Fidelity's director of research in Hong Kong. DJ graduated from Pune University in India and holds a postgraduate degree in management from the Indian Institute of Management. He is a CFA charterholder and an associate of the Institute of Chartered Accountants of India.

Background

China

"Fund Update--Sustainable Asia Equity," by Dhananjay Phadnis, fidelity.co.uk.com, Aug. 25, 2021.

"Capitalising on Asia's Sustainability Transition," by Dhananjay Phadnis, fidelity.co.uk.com, July 12, 2021.

"On the Hunt for Sustainable Growth in Asia," by Dhananjay Phadnis, fidelity.co.uk.com, April 21, 2021.

"Seven Themes That Investors in Emerging Asia Have to Watch," by Gary Jackson, trustnet.com, Feb. 15, 2019.

ESG

"Sustainability Is Key for Value Creation," by Dhananjay Phadnis and Flora Wang, fidelityinternational.com, March 2, 2021.

"DJ Phadnis: A Commitment to Sustainable Practices Can Improve Long-Term Value," YouTube video, Fidelity International, March 25, 2021.

"An Active Approach to ESG Investing Is Key for Investors Trying to Drive Sustainable Change in Asia," by Dhananjay Phadnis, linkedin.com, Sept. 20, 2021.

"Investors Eye Early Stage Sustainability," esgclarityasia.com, July 15, 2021.

"ESGenius: A Sustainability Lens Can Help Discern the Trends That Matter," by Dhananjay Phadnis, fidelityinternational.com, June 10, 2020.

Investing and Stocks

"Jason Hsu: China Is 'the Last Great Remaining Alpha Reservoir,'" The Long View Podcast, Morningstar.com, April 21, 2021.

"Martin Lau: Now Is a Better Time to Buy China," The Long View Podcast, Morningstar.com, Aug. 3, 2021.

"Asia Equities: Bottom-Up, Stock Specific Opportunities Abound," by Dhananjay Phadnis, fidelity.com.

"Macau, China's Casino Capital, Has Enjoyed a Decades-Long Winning Streak. It Might Finally End," by Eamon Barrett, fortune.com, Sept. 16, 2021.

Transcript

Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, chief ratings officer at Morningstar Research Services.

Christine Benz: And I'm Christine Benz, director of personal finance and retirement planning for Morningstar.

Ptak: Our guest this week is the Dhananjay Phadnis. DJ is the manager of the Fidelity Sustainable Asian Equity strategy, which he has run since 2013. DJ joined Fidelity as an analyst in 2004 and has served in a number of roles during his tenure, including stints managing Fidelity Indonesia Fund as well as Fidelity's director of research in Hong Kong. DJ graduated from Pune University in India and holds a postgraduate degree in management from the Indian Institute of Management. He is a CFA charterholder and an associate of the Institute of Chartered Accountants of India.

DJ, welcome to The Long View.

Dhananjay Phadnis: Thanks for having me.

Ptak: It's our pleasure. Thanks so much for joining us. We're really excited about this conversation. Most of our listeners are here in the U.S., and therefore, they're less likely to be familiar with you and the path you've taken to here. Can you give a quick thumbnail sketch of your career to this point?

Phadnis: I have a degree in accounting, and I also did my MBA equivalent from one of the Indian Institute of Management's in India. I spent a couple of years on the sell-side as a research analyst, which was in Mumbai, before joining Fidelity to help build out its investing team in India. And then I moved to Hong Kong in 2006. And I've covered many different sectors--also had a stint as a director of research, managed several different funds, including country funds as well as regional funds. And more recently, I've focused now on managing our sustainability franchise here, so our Asian ESG products, based out of Hong Kong still.

Benz: You were recently holding about a third of Fidelity Sustainable Asian Equity's assets in Chinese-domiciled stocks. You're an experienced hand when it comes to the Chinese market. Given that, we're hoping that you can place the recent market turmoil there in a broader historical perspective. When we look back on this, what do you think we'll take away? And what implications does it have for investors like you in the future?

Phadnis: It's a very relevant question, especially considering what we've been seeing in the markets. But I would say, if you think about emerging markets, volatility, and changing regulations, and in some countries, changing political landscape, this is part of the overall picture, which emerging-markets investors do need to consider when they think about allocating money into different markets. But more specifically, Christine, to your question on China, the way I see what's going on, simplistically, I would put it into three different buckets.

The first one is a regulatory catch up. So, if you think about some of the recent regulations around anti-monopoly, privacy regulation, significant market power, I see a lot of these as being a catch-up, where till now, companies were allowed to kind of run their operations without significant oversight. But I think some of that is changing and kind of aligning with what we already have in some of the developed markets like U.S. or even in Europe. So, firstly, that's the regulatory catch-up.

The second thing has been an ongoing exercise in China, which is to control financial excesses. And you've seen that several groups, even though they could be called as being loosely linked to the state, have been sort of allowed to default and restructure, and in a way, they're taking the moral hazard out of the system, which is kind of the second point. And the third aspect, which I think is a little bit isolated, and I won't extrapolate a lot of that, is some of the China idiosyncratic measures to deal with some of the problems that the country sees. For example, they're looking at a population decline, a demographic headwind in the years to come. And some of the regulations we've seen seem to tackle that particular aspect of it. I would say that the first couple of them, which is the regulatory catch-up or the push toward deleveraging and better balance sheet management, I think those are both positive. The third one, which is a little bit more specific to the challenges of the country, I think those are a little bit difficult to call. But I just use this framework as a way to sort of simplify what's going on. And as long as you can kind of slot it into one of these three buckets, I think it helps you develop your investment strategy in terms of the risks you take and the positions you want to allocate to.

Ptak: Maybe building on that, you can talk a little bit about how that has changed the way you invest, if at all. There are arguments for investing in the stocks of dominant firms that throw off lots of cash. And, in fact, I think you preferred owning those kinds of high-quality names in the past. But if their dominance invites scrutiny, does that have to be factored in in ways that it hadn't been previously? Maybe you can discuss it in the context of your stake in a few of the high-quality names that you own?

Phadnis: The environment is continuously changing. And I think any analysis has to build in some of the changes that are coming through. But then again, like I said before, you need to think about it in the three different aspects in terms of what's going on. And that kind of helps you simplify your framework. And once you've done that, I think historically, what we've seen is companies, which are able to comply to the new regulations, they're able to adapt, those are also the companies which can continue to grow and add so much value. And we've seen that again and again in history where regulations come and go, market environments change, but the good businesses run by good management teams are able to come through it and still continue to add value quite significantly.

But if you think about the more recent phenomena around the regulations in China, I would say, we've been materially underweight some of these Internet-driven sectors for some time now. And I would say, we've seen a couple of challenges around things. E-commerce, for example, we are seeing significantly heightened competition, which is putting pressure on market share of some of the incumbents, but also leading to significant margin pressure. And on the other side, you also have companies which are involved in gaming or advertisement-driven businesses. And there again, the recent regulations, as well as a potential macro slowdown--which we might be expecting into the near future--those are going to again become headwinds for earnings. So, it again, I think all boils down to the earnings outlook. And I think what's happening in China, we are tempted to attribute a lot to regulations. But if you actually think about competitive dynamics, the impact on businesses, I think it all boils down to earnings. And we are potentially going to see an earnings slowdown in some of these sectors, which have historically grown very fast.

Benz: We wanted to switch over and talk a little bit about supply chains and inflation. We're continuing to hear about snarled supply chains, especially in Asia. So, what are you seeing and hearing from the companies that you follow yourself, or from your analysts who cover them, on your behalf?

Phadnis: Supply chains have been an extremely topical issue. We're still seeing significant dislocation in supply chains across the region and across the world. If you think about some of the biggest manufacturing hubs in Asia, we've gone through a few lockdowns, countries like Vietnam, and even in most of the manufacturing parts around Asia, we are seeing some dislocation there, and that's leading to very tightened supply chains. But also, what happens when you see a potential for supply chain disruption is an extremely strong inventory-rebuild cycle. So, if you're using a certain commodity or using a certain product into your supply chain, there is a tendency to build buffer stocks and safety stocks. Having said that, what we are noticing more recently is that some of these shortages are beginning to ease off. So, you can see already in some of the semiconductor industries, maybe even in the auto supply chain, toward the end of the year, we could potentially see easing in some of the tightness we've been seeing so far. Another sector is container shipping, which is again, showing signs of easing so far in terms of supply chain pressure. So, I would say supply chain pressure still exists, depending on how we get out of the lockdowns in some of the key manufacturing hubs. But I see signs that some of those supply chain issues are being resolved, and inventory in the system is reasonably high. And to that extent, the unwind also can be quite meaningful.

Ptak: A related issue is inflation. Do you think we've shifted into a different regime that will see higher inflation? Or do you see the recent uptick in prices, some of those being supply chain related, as something that will recede over time?

Phadnis: This is again hard to call. As a bottom-up stock-picker, I spend pretty much most of my time looking at stocks and understanding how some of these things going on can affect my companies in terms of earnings. And inflation is an important variable. It's just really hard to call. What we are seeing in terms of inflation--more recently, we've seen a big surge in commodity prices, which is beginning to feed through in the cost structure of some of these companies. And the analysis I tried to focus on is which of my companies have strong pricing power to be able to pass that on and which of these companies could go through cost and margin pressure.

So, supply chain disruption will have a somewhat of an inflationary impact. The key question in my mind is how much of that is permanent and how much of that is transitory. And again, which of my companies are able to pass on and absorb some of these pressures and which of them cannot absorb these pressures? So, I know I've not answered your question, Jeff. It's a hard one to call. But we're really approaching this on a stock-by-stock basis and understanding where earnings could be impacted.

Benz: We've spoken to a few managers who focus on Asia. We have talked to Jason Hsu, Martin Lau, and now you. Based on your experience, what are the biggest adjustments an investor who is accustomed to investing in, say, U.S. stocks, would have to make if they were investing in Asian stocks instead?

Phadnis: Investing in emerging markets is a whole different story, a whole different approach required generally when you think about versus developed markets like the U.S. In terms of more specific differences, I would say, compared with the U.S., for example, which is one country, when we think about emerging markets, or even Asia, we are talking about many different countries, each of them has a different economic construct, a different system of governance. So, I think it's very important to take into account some of these specificities that you see. And then, when you think about analyzing stocks, you have to put that into the context of the environment that they operate in.

I would say it is a more complex kind of area to be investing in. But I think that's where there's a huge opportunity for an active investor who has ideally an on-the-ground presence to be able to decipher some of these issues and to be able to piece together a portfolio, which is picking up some of the best parts of the universe and to be able to put together with full understanding of what the on-the-ground realities are.

The last thing on this I would say is that an awareness of history is extremely important. We've gone through many different cycles in emerging markets, and it's important to take that into account. For example, one of the first things I did when I started managing money in Asia was to study the history of the Asian crisis. And I think even today, some of these lessons from the Asian crisis are extremely relevant. And I think taking that into context can also help any investor who's trying to approach emerging markets.

Ptak: Since you mentioned it, what are some of those lessons that you think are especially relevant right now?

Phadnis: I think a few lessons from history are relevant in the sense that, firstly, focus on balance sheet is extremely important. And if you think about different crises we've had in different parts of Asia or even emerging markets, it's important that you understand balance sheet, balance sheet strength, think about FX mismatch--foreign-exchange mismatch--in terms of debt levels that any company might be carrying. I think that's really important. I would say the biggest one is an appreciation of cycles, where we do get boom-and-bust cycles around some of these emerging markets. The boom-and-bust cycles have become a little bit less volatile compared with what we've seen in history. But still, you can't escape those cycles. And I think the ability to understand what an upcycle looks like, where the excesses build up, how the macro environment changes, and that affects companies. And then, to think about the other side where you go from positivity potentially to extreme bearishness, and again, the sense of what it feels like, which companies do you want to bet on, which companies are going to survive these crises and emerge stronger. So, I would say appreciation of cycles is probably the most important lesson to draw from history.

Ptak: If somebody were to look at the portfolio, the portfolio that you manage, which we mentioned before, and decipher who it is you are as an investor, how it is you structure the portfolio--they'd see that you spread assets across 70 or so names, you concentrate to a certain extent in your top 10 holdings, which I think soak up more than 40% of assets. You can make other choices. You could concentrate to an even greater or lesser extent. Why have you built the portfolio as you have and what do you think an investor looking at that should glean about your investment philosophy and portfolio-construction approach?

Phadnis: Firstly, I think I would say I'm supported by a really strong investment team and research team on the ground here in Asia, and it's something we're very proud about at Fidelity where we have been investing in research as part of our DNA in terms of the research that we have built out here. And I think that helps me a lot in terms of picking stock ideas and trying to build a portfolio which aligns also with my core style and process. But in terms of the number of stocks, I would say, it kind of boils down to my own mental bandwidth, in terms of my ability to be on top of my stocks and understand each and every stock in the portfolio really well. I feel like that's kind of my comfort zone in terms of between 50, 60, 70 kind of stocks, depending on new idea generation versus what's happening in the core portfolio.

But on the portfolio level, so when you think about the concentration within the portfolio, for me, the bet sizes are really driven by three different aspects. Firstly, is the conviction I have in the stock position. Second is the horizon, which typically my horizon tends to be three to five years, and that's very important for how I size the bet. And third is liquidity in the portfolio. And liquidity is a really important criteria and something, again, worth bearing in mind if you're investing in emerging or Asian markets. In these markets, typically, in a bull market there's plenty of liquidity in stocks. But when the tide turns, there's hardly any liquidity to unwind your positions. So, that's why I think liquidity is extremely important. And that's why that's built in as a key part of my process.

So, I look at conviction, horizon, liquidity. That kind of drives the level of concentration in the portfolio. You will see that some of the core positions in my portfolio have been there for a really long period of time. They are what constitute the biggest part of the risk. And then, there's a middle section of the portfolio, as well as some of the entry-level stocks, where I'm typically building conviction, doing more work, doing more analysis, or potentially waiting for a valuation catalyst before I size up these positions for them to then go into the core positions.

Benz: We wanted to switch over to discuss ESG investing. You see sustainable investing is additive to traditional investing approaches that didn't take such factors into consideration. Can you explain why and also where you think your process gets the most bang for its buck in terms of incorporating sustainability?

Phadnis: Sustainability to my mind is an extremely broad process or a broad concept versus traditional investing. So, if you think about traditional investing, it's essentially been concerned with maximizing return per unit of risk. And I think this is a very narrow concept in that traditional investing pretty much ignores the externality any business can have. And by that, I mean, an externality which affects all stakeholders. So, when we think about sustainable investing, we are thinking about the effect any business has on its wider stakeholders. And these could be employees, customers, communities, the environment, which are aspects which a traditional investing process may completely ignore. And that's what kind of induces risks sometimes to some of these traditional analytical models, which just fail to acknowledge the risks that a business faces by ignoring or working to the detriment of some of the key stakeholders in this business. And if you think about how our investment process around sustainability has come about, it's very much a process which has always focused significantly on investing in quality compounding businesses and traditionally following a little bit of a narrower definition. But I think when you think about it in a broader context, I think this is the right way to invest in a business, which it mitigates the tail risks that come with ignoring stakeholders, for example, but also to invest in businesses which can be long-term compounders.

And to your question, Christine, about how we make a difference in that approach, I would say, some of the biggest advantages we have here at Fidelity is our proprietary ESG rating system, which leverages our key strength, which is our fundamental analyst research team, which has a very strong connect in understanding businesses. And we can leverage that to put our understanding of businesses and put our ESG understanding in that context to have a much better robust and forward-looking analysis of the ESG processes of any company. But also, that's helping us drive a lot of integration into how we look at each and every stock idea. But most importantly, one of the core pillars of our process is around engagement, and this is where we spend a lot of time ourselves speaking with companies, sometimes educating them, but most importantly, working with them as partners in their investing journey, in their sustainable investing journey, which is kind of underpinned by our belief that businesses which are investing for the long term and working in a sustainable manner are also the same businesses which will mitigate risks and deliver long-term compounding value. And that's exactly where we are aligned with our companies. So, we see ourselves as partners. And I think the last thing I'll say is that we also are trying to make a very genuine approach and genuine progress on this. So, we're still learning, we're still improving. But we very much think of our role as investors and asset allocators as having a wider benefit to all the constituents involved.

Ptak: That's helpful. I wanted to talk about the rechartering you did of the strategy. I think that took place earlier this year where you labeled it as sustainable investing strategy. It didn't seem to entail a lot of portfolio changes. But I think one of the things that you and your team have said is that you're stepping up your engagement with company managements, especially in non-governance matters, things like their carbon footprint. So, my question is, what is your rationale for why the market wouldn't have already priced in these firms' anticipated efforts to do things like shrink their carbon footprint, because there could be a lot of other analysts that are having similar engagements with the same management teams, drawing conclusions similar to yours that there's an opportunity to shrink the carbon footprint, and it might have been priced in. So, what sort of situations are you looking for where you think engagement of this sort can make a difference?

Phadnis: I think that's a very important question. I think it boils down to the fact that ESG investing is still at a very early stage in Asia. So, if you think about some of the reporting requirements, the details you're getting from different companies is still very scarce. It is improving very quickly. But we are also seeing disclosures as being so far, at least, very early stage. And I think what is required here, and what is very clearly required here is an approach, which just goes beyond these scant disclosures to be able to put in context the ESG issues that a company is facing, and the fundamental context that they are operating in. And I think that's where it's very important to have, firstly, an understanding of what the issues are. So, you can go through materiality mapping, and that's where our internal rating system, we think, makes a big difference in understanding their actual key issues.

And I think the second part is very important, because while a lot of investors seem to be involved in engaging with companies, I still think very few of them have a dedicated approach to it. So, in many cases, I feel like the conversations are a side conversation to what essentially is a stock discussion. In our case, we're making a genuine dedicated approach toward engaging with companies and talking about a wide range of issues that every company faces. So, it encompasses, like you pointed out, E and S factors, which is environmental and social factors, but also, of course, governance factors, too. And I think by being partners of these companies, by being long-term investors, I think companies also see us as trusted partners who are aligned with them to drive long-term returns. And that's what allows us to have a very constructive two-way conversation, and that's where I think the power of engagement is coming through. And it's been a short period, but just over the last one year, we've had so many fruitful and engaging conversations with companies, which we're already seeing our ability to be partners in those companies' journey as they move forward with that process.

Benz: What's an example of a name in your portfolio that you wouldn't own if not for its ESG merits? And conversely, perhaps you can provide an example of a name you would own were it not for its poor sustainability profile?

Phadnis: On this one, one thing I would like to highlight is that we are running the funds, the Fidelity Sustainable Asia Fund, based on a dual objective. So, not only do we want to invest sustainably, but we also want to generate a return as we go about it. So, on this principle, we would not own a stock just for its ESG merits if the projected returns don't make sense. For example, if a whole ESG thematic is widely overvalued, we would stay away from it because it will contravene with our second dual objective, which is to generate returns. So, in Asia, there are many companies which you will see actually have a poor sustainability rating, especially when you look at it through a third-party-rating provider lens. But I think that's where we see it differently. We see it as an opportunity to engage with the company and help drive that ESG improvement. Like I said before, these companies, which we like to term as ESG improvers, are actually the companies which can also drive a significant delta in your portfolio in terms of helping you capture the significant value addition that this business can drive by better disclosure, better processes, much stronger alignment with ESG metrics.

Again, no company, except, of course, companies which are in our core exclusions part, every other company, we look at it and say, can this company improve? What is the direction of travel when it comes to ESG metrics? And if this is an ESG improver company, which we think we can engage with and help drive that positive difference, we would still want to own companies which fall in that category. So, our portfolio is a blend of at least 70% in already validated high-quality ESG raters or ESG issuers. But also, up to 30% of the portfolio is dedicated toward these ESG improvers. And like I mentioned, we are trying to drive that improvement and capture the value that gets created from such things.

Ptak: And so, I take it that in that other 30%, we're unlikely to find something like the stock of a mining firm that's a really poor environmental steward, but maybe it's gotten crushed, and so, it's dirt cheap. In situations like those, they wouldn't even make it into your 30% bucket just because the sustainability profile is so poor, and it can't be improved through any engagement or other efforts that you would undertake?

Phadnis: Yes, exactly. So, if there's a company with questionable practices, and having looked at that company, and we validate that company, and we see really no potential for engagement or improvement, this is a company we would classify as not investable for our funds and park that on one side. When our analysts also rate companies via our proprietary internal rating, they also have a momentum score in terms of is this company improving, stable, or deteriorating? And this company is a company that you described, Jeff, would typically fall in that deteriorating category, which is going nowhere, and has questionable practices and would not meet our investment criteria.

Ptak: If I can follow up just to take the flip side--so maybe it's a firm that checks all the boxes from an ESG standpoint, and therefore fetches a high multiple. I think you've already said that you're not going to pay through the nose to own it just because it's ESG good, so to speak. But I'm curious, whether as ESG is gaining traction in the region, albeit it's still in a nascent state, are you seeing pockets where maybe it's gotten a little bit out of hand, and investors are loving a certain firm or sector to death because it's perceived as being ESG good?

Phadnis: I think whenever there's a big rush into one new area, or there's investors looking at whole new thematic or area, there are very likely to be bubbles. And we've seen that through history. Every new concept or new thing that comes up, there is a little bit of exaggeration that happens. So, bubbles will form, and I would say in some sectors bubbles probably have formed. So, we're very mindful of valuation. Like I said, we have a dual objective, so we can't compromise on the return objective just to chase an ESG thematic.

Having said that, if you look at the portfolio, Jeff, you'll see that we've managed to get access and exposure to several good, I would say, ESG thematics. If you look at some of the battery manufacturers in Korea, we had exposure to that from a very early period, and that's helped the portfolio. But even in the Philippines, we are seeing a position where there's a utility, which is clearly making a remarkable transition toward renewable energy, and that's been another successful position in the portfolio. And even in China, you think about stocks in the wind energy sector and the renewable space, a lot of these positions in the fund have been where we've managed to get these positions at very attractive valuations. And that search continues. So, we're very much mindful where bubbles are forming. We want to avoid those areas. But because our approach is a bottom-up stock-selection approach, we're continuously looking for new ideas. And I can say in Asia, we are blessed with a very rich pool of stock ideas. And so, that journey continues. And as an active investor investing through our research team to understand stock by stock, I think we're still managing to find some really good ideas.

Benz: Shifting over to talk a little bit about how you approach selecting specific stocks and how you approach certain sectors, I wanted to talk a little bit about the semiconductor space. Can you talk about how your view of what is a fair price to pay for a company in that space has evolved and explain why, because it was pretty routine in the past to pay a lower multiple, mid-teens multiple, to own the shares of even the best firms in that space five or 10 years ago, but they were recently trading for around double that. So, maybe you can just address how your thinking of what is a fair price in that space has evolved?

Phadnis: I think the semiconductor space particularly has gone through quite a bit of evolution in terms of market structure over the years. So, you look at the business like foundry, where given the changes that Intel has gone through, you're pretty much left with two leading players in TSMC and Samsung. And even if you look at the memory space, you will see that from being six or seven players maybe a decade ago, we are now down to essentially three companies, which is Samsung, Hynix, and Micron. And when you get a more reasonable market structure, you actually reduce some of the cycles or some of the cyclicality in the business. So, historically, we would see a lot of capacity being added, a huge dive in prices. And then, you need a couple of players to go bankrupt before the cycle comes back again. But now, when you have a market structure--and there is a moat around this market structure given the huge amount of money and capex required for any company to go back into these businesses. And I would say that's been the biggest change where it's a much more rational market, investment cycles are much more rational, capital allocation is reasonable. And to that extent, you will probably see less volatility in cycles; there will be cycles, but these just will be less volatile as we go forward.

The other thing that's kind of changed is that we're still seeing strong demand for advanced nodes and memory. That outlook seems to be quite strong and that's somewhat reflected in the valuation multiple that you referenced, Christine. One of the things though I would call out is that to our initial discussion around supply chains, like I mentioned, supply chains are beginning to ease somewhat. There's a lot of inventory which has been built up at some parts of the supply chain. So, as this inventory unwinds and as supply chains normalize, there is potential for the semiconductor sector to go through a lower growth patch in the coming quarters, and investors should probably watch out for that. But I think if you are a long-term investor like me with a three- to five-year horizon, you will sort of see the benefits of the change in the industry dynamics as well as the long-term outlook for growth. And I think some of these stocks in the sector would still look quite compelling on a long-term view.

Ptak: Maybe if we can ask you to generalize--building on that previous example concerning semiconductors, you described the industry competitive dynamics, and in some respects, it seems like it's maturing and coalescing around a group of very dominant, competitively advantaged names. What are some other industries where you're seeing a similar sort of dynamic play out? And then, conversely, are you seeing some industries where there are signs of competitive decay where the quality is eroding for whatever reason?

Phadnis: I think it's a really interesting question, and I'll try my best to answer that. In terms of where some of the biggest value generation can happen over the medium term, especially in Asia, one area, of course, is where we've seen significant disruption because of COVID and the near-term issues have dominated the discourse, I would say financials, quality financials in the region have taken quite a bit of knock as we've gone through COVID. There's still a fair bit of restructured assets sitting there. But as we see normalization, and we are seeing data in countries like India, or even in ASEAN, some of these companies are coming through in a really good shape. And some of the concerns investors have had are going to be overcome. And here again, if you've been a lower-quality company, you've been under-capitalized as a financial institution in any of these countries, I think it's going to be really hard for some of these companies to come back. But if you're one of the well-run, well-managed, well-capitalized financial or bank in the region, I think you are going to be able to come back much more strongly as the cycle improves. And these companies are coming in with strong levels of capital, and that should help them grow. The other the other area within financials I like is around insurance, which is still very underpenetrated category. And as some of these companies continue to grow, they will be able to get significant compounding returns.

The other area, which is a little bit complex, but I think it's complex in that it's not easy to identify winners as it has been in the semiconductor space, is potentially around healthcare. And here again, you're seeing companies in Asia now pretty much come onto the global stage. Indian companies did that a few years ago, where they very much cracked the generics market by supplying into developed markets at a much lower cost. But what we are seeing now is a whole wave of biologics, large molecule, and innovative drug companies, which so far historically or might have been focused on their core market, for example, in China. But I think in the next few years, we will see some of these companies break out onto the global stage and can become substantial value creators when it comes to growing the business and getting re-rated in turn.

Benz: You own some stocks in the Macau gaming industry. Given that these casino operators hold just a handful of prized gaming licenses, they boast economic moats, but they can also court significant regulatory and ESG risks. And some have really gotten crushed this year. So, can you discuss the outlook for companies in this space? And what gives you confidence that the regulatory and ESG risks have been more than priced in?

Phadnis: So, I think the recent sell-off that you've seen in some of the Macau gaming names has been due to some discussions around the concession renewal. So, as you might know, most of these concessions are rolling off. And this has been kind of well-known. I think the recent correction in the market has been around the current paranoia around changing regulations. But I think what we're seeing in Macau has been well-anticipated and should be expected to come through. So, I feel like there's been a little bit of extrapolation that's been going on in this sector.

The other complication, of course, is around COVID-19 and the fact that we're still seeing periodic outbreaks. And as a sector, which depends on people traveling into Macau, that's clearly affected with the COVID restrictions that are in place. So, I think both those issues are of course relevant, but also potentially very transitory. And maybe when you look back at this three years from now, these will not register as being big events when you think about the forward outlook.

So, again, with the caveat that it is really difficult to call regulations, so far what I see as being proposed seems in line with what we've been expecting. And to that extent, where, if due process is followed, we should probably see many of these companies back on the track of growth. These businesses historically generated significant cash flows. And when we are at the other side of the regulatory reset, or the concession renewals, we should see the potential of some of these businesses to deliver significant value creation in the years to come.

Ptak: Another area where you're active is biologics development and manufacturing stocks. And you might have alluded to it earlier in the conversation. You've been very successful here. You've had a few huge home runs there. As biotech and pharma firms have turned to outsourcing, development and production in those firms have grown and that's been reflected in the stock prices. But it is a competitive space and some of your holdings look expensive. Can you talk about how you manage valuation risk in this particular area, and then maybe more generally, in the portfolio, how you try to manage valuation risk?

Phadnis: Yes, I think like I pointed out, healthcare is sort of one of the more trickier areas to think about how a company grows and how you create value. If you look at some of the standout companies in the sector, for example, if you look at WuXi Biologics, WuXi AppTec, and many of their peers, what we have seen is just a phenomenal level of execution, where a company like WuXi Biologics is now the global market leader when it comes to their business model, which is, follow the molecule strategy from start to finish. And they've also been now developing significant manufacturing facilities across the world and that allows them to handle the customer from very early stage toward the go-to-market kind of strategy. So, I think what we are seeing slowly and surely is that companies like these are kind of breaking out. And what we focus on when we think about investing in these companies is that we're looking at, of course, management, quality, and execution, but we're also looking at the level of innovation that they're investing in and the kind of teams that they're building around it--talent retention. Some of these aspects are extremely critical.

And an example like WuXi, again, is a clear example of a valuation analytical thesis where at the start you looked at what the business was delivering at the time of the IPO. Over time, not only have they executed far better than those expectations, there's also been a meaningful royalty stream, there's also been innovation, for example, on bispecific platforms. But there's also now the whole manufacturing side which has developed. And that's what a good business creates. A good business continues to create optionality around their core businesses. And as those optionalities are fulfilled, you will start seeing value creation there.

But to answer the question, Jeff, I think the approach that an investor needs to take is one of probability-weighted scenarios to understand some of these different optionalities. So, it's important to lay those optionalities out there, to put a probability weighting on them, to understand what the payoffs can be, and then to construct your portfolio and construct your bet size taking that into account. So. again here, I think bet-sizing in a portfolio is very important, where you are expressing valuation sensitivity even where some of the underlying thesis looks super compelling.

Benz: What do you think is the most misunderstood company in your portfolio where the market just doesn't seem to grasp the business fundamentals or outlook, and why is that?

Phadnis: Rather than call out a certain company or so I would say, at a fundamental level, where I think we, in the portfolio, are trying to drive an advantage is through what I like to call a horizon arbitrage. In that, we are just trying to make sure that we are looking three to five years out in a market which is focused on being extremely myopic. So, the market tends to focus a lot on what's happening now. And I think if you are willing to stretch your horizon into three to five years, I think you will be able to sidestep some of these near-term, both euphoria as well as downbeat feelings people might have, or the market might have, about stocks and sectors. Of course, it's very important when you take a long-term view to ensure that your companies have a strong balance sheet that can survive some of the near-term negativities. For example, COVID, which it was very clear that it was first important as a business to survive before you could think about buying into these stocks to see them compound and grow.

I would say that most of the differences in the portfolio are around that horizon. I did mention some of the quality financials in the region, where if you see your company as navigating some of these issues really well, when you are three to five years out and you will look back, some of these companies are going to become the best value generators possible in the market. And that's extremely what I'm focused on. I'm trying every day to reduce the noise in the market and try to make sure that the process is focused on the medium to long term.

Ptak: We've been spending a lot of time talking about financials, but they are a big emphasis in the portfolio. I wonder if maybe there's a name in the portfolio that's high conviction for you, but where there is a bear case, a well-developed bear case, that you've had to consider and basically, surmount, if you will. Is there an example that jumps to mind that you think is emblematic of your process and how it is you've approached financials in general?

Phadnis: I think maybe I'll just give you a slightly longer answer here in terms of when we think about financials, there are very different types of financials. So, I kind of put financials in four key buckets, especially when it comes to Asia. The first ones are what looked like very much developed market financials. These are typically rate-sensitive financials. These are banks, I would say, in Hong Kong, Singapore, Korea, Taiwan, which mimic European or Western banks. I tend to not like these banks generally, because I don't have a view. I don't take a view on the interest-rate cycle, which is extremely hard to call. The second ones are state-owned banks, which often are not in control of their own destiny. There can be significant misalignment between minorities and management. And so, we're very selective in this space, again, a space which generally we don't invest in or don't like, but aside from a couple of them, which could be very different from the rest of the pack.

The third and fourth categories are where I put most of my money. The third one being private sector banks. Typically, you have HDFC Bank or Axis Bank in India, Bank Central Asia in Indonesia, and banks like those where they're well-run, well-capitalized, they've navigated cycles reasonably well, and going into the future, we think these banks could create quite a bit of value going forward. And finally, I think another sector which I did mention is insurance, which like I said, is a highly underpenetrated category. You think about companies like AIA or Prudential and the opportunity that they see in front of themselves, especially in China. I think that could be a meaningful game-changer in the years to come.

Going back to your question, Jeff, I think it's really important to understand that alignment between management and minority shareholders, which prevents the business from making short-term decisions, which can come to haunt. And in financials it's particularly important, because you have to remember, these are leveraged businesses. They are built on other people's money--depositors, for example. And so, it's really important that they don't make mistakes in a downcycle, but they're able to keep their processes to continue to grow in a growing market. And I think that's the framework we've always used for managing our positions in this fund. And so far, it's worked out quite well.

Ptak: One other thing I neglected to ask you about is India. We know you're a bottoms-up stock-picker and aren't going to do the top-down thing where you pick a country to focus on. But that has been an area where you've found opportunities through the years. So, maybe you can give a quick thumbnail of what it is you are, or aren't for that matter, seeing in India at the moment in terms of good opportunities that you feel enthused to invest in.

Phadnis: I think India is an extremely interesting market in that it is really diverse. And you see a lot of good-quality businesses run by just phenomenal management teams. And it's amazing, even some of the newer companies which are coming to market--there's a lot of innovation, a lot of drive, a lot of alignment with minority shareholders. And to that extent, as a quality investor, India is a great market to find some really good-quality ideas.

I think the challenge in India has historically been around valuations. And even if you look at the situation today, where India has been one of the standout market performers this year, we are now seeing a lot of stocks now get into overextended territory. I think I would caution on valuations a little bit, which is a perennial concern. But more recently, that seems to be a little bit more exacerbated, mainly driven by the fact that India has come through quite reasonably well from the COVID 2 wave, which as you might remember, was quite severe. But it seems like the economy is bouncing back really well. And there's a lot of interest in capitalizing on that opportunity. So, I still very much like India. Like I pointed out, we are sensitive to valuations. So, we will make sure that we are not overpaying for businesses generally. But it remains a fantastic stock-picker's market.

Benz: One question that we like to ask portfolio manager guests is what is the most hotly debated subject on their teams at the moment? Can you share the topic that your team is actively debating today?

Phadnis: We talk about a lot of issues. And they tend to be a little bit more near-term focused. We do break out twice a year as a team to discuss some of the really long-term ideas. But if you look at what's going on recently, it's not surprising in that we've been discussing the route to normalization from COVID in countries in ASEAN and India, for example, which have been significantly affected by COVID. And here comes a discussion around supply chains as well, which obviously is a big topic right now. Regulations in China has been quite topical more recently. And, like I pointed out, we are trying to find companies which can comply and adapt, and we're trying to put our portfolios behind these companies. China property is an extremely hot topic right now, also dominated by our fixed-income colleagues for whom this space is also quite important. And we're trying to make sense of the deleveraging trend there. We're seeing a couple of large property developers in some sort of distress and trying to understand the implications of what's going on there.

And, like I pointed out on the India discussion, valuations in India is also quite topical. So, it's understanding where things might have gone a bit too far and where the opportunity still exists. So, very much focused on some of the key issues that we see today in Asia. And again, our focus here is to not get caught up in the short-term noise, but to understand what's going on and try to think about the longer-term implications of some of these events.

Ptak: One final question. You used to be the head of research in the region, as we mentioned earlier in the conversation. Now, you're obviously a portfolio manager. Knowing what you now know based on your experience as a portfolio manager, what would you have told your younger self at the time you were heading up research?

Phadnis: It's a great question. And I think I find myself in a privileged position because, going through the director of research route is not a typical route. Most people will join as analysts and become portfolio managers. And I was very fortunate to be given the opportunity, not only to be an analyst and a portfolio manager, but also to work with so many talented research analysts during that period.

And when I look back at my career then and over the years, I would say a few things stand out in terms of what I would advise my young self. Firstly, I think it's extremely important for an investor to invest in understanding yourself. So, everyone is different. We all react to different pressure points differently. Some of us gravitate toward certain types of stocks. Some of us have very different investment preferences. And I think even in my case, it took me some time to understand myself. And I think it's extremely important that everyone spends time to analyze themselves. And there are many techniques that can help you. Writing an investment journal is one of the best techniques there. And I think it's extremely important as early as you can in your journey as an investor to understand yourself. And then, once you've understood yourself, I think it's important to build a process and stick with it. Still even now you find so many people with a process which is all over the place, but I think it's really important to nail down what works for you and then build that into your core process.

And I would say the final step is that once you have the confidence, you need to take risks. So often we find talented stock-pickers, but they kind of lack the conviction to take the risk. And I think it's really important to go that final step to take the risk, to make sure you're taking risk in the portfolios once you're confident about your process. And even today, we have a lot of new joiners, we have a lot of summer interns who come work at Fidelity. And the three things I tell them very consistently is that you need to focus on conviction in your stock ideas, communication so that your stock ideas get into the portfolios, and finally, ownership, which is to have strong ownership of a stock idea regardless of how well it does or how poorly it does. You need to handhold that stock idea all the way through as it makes its way through the portfolios.

Ptak: That sounds like a wise advice. Well, DJ, this has been a really enjoyable conversation. Thanks so much for your time and insights. We really appreciate it.

Phadnis: Thanks, Jeff. Thanks, Christine.

Benz: Thank you so much.

Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.

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Benz: And @Christine_Benz.

Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)