Greg Carlson: Let's turn to emerging markets. This is an area where the funds traditionally haven't had much of a stake, but that stake has been increasing lately due to some stock-specific choices here. Perhaps we could touch on China and particularly, the consumer to the extent that you have a view on that, and talk a little bit about that in context of a couple of holdings in China, Baidu?
Dan O'Keefe: Right. So, you're correct in that we have not historically been large owners of emerging-markets assets over the last many years and that's a function primarily of valuation for many years. In the past 10, for example, emerging-markets assets were priced very highly by the market based on expectations of--remember the commodities supercycle and we remember the Chinese consumer stories, which you don't hear so much about today, I guess the bloom has come off the rose to some degree there. And as a result of the prices, we just weren't able to find anything interesting.
In addition, generally emerging-markets assets are lower-quality businesses. There are agency risks. The corporate governance is not particularly robust for protecting the interest of minority shareholders. So, really, that's a long way of saying it's hard to find things in general that meet our quality criteria and then you add on a demanding price, made it almost impossible for many years.
So, lo and behold, as security prices came back in emerging markets and growth has slowed down, Brazil has--I think, what, five, six, seven years ago we had the BRICs, Brazil, Russia, India, and China. I think now enthusiasm remains possibly for India, that's the only one of the BRICs that remains in the wall. So, as the wall crumbled, so to speak, we sorted through what was available and we were able to find some interesting stocks.
Now, again, this is independent of any macro call on emerging markets, but we have invested in Baidu, which you mentioned, and Baidu, simplistically, is a Google of China. And this is a business that's growing very, very rapidly. Internet penetration in China is around 45%, 50% compared to, say, 88%, 90% in the United States and that business has been growing its top line 25%, 30% as the Chinese economy really goes directly digital. In many ways, its leapfrogging some of the retail and consumer institutions that have built up in more developed economies and going directing digital. Because, if you go to China and you go to a Tier 2 or a Tier 3 city, you're not going to be able to find a modern retail store to buy whatever it is you're interested in, in fashion, electronics. So, those consumers without access to modern retail trade will bypass and go online. So, the Internet is developing very, very rapidly in China and as a result, Baidu is growing very, very quickly. And we think the valuation of Baidu, given the long-term growth of that business, is very attractive.
Carlson: Have you seen any changes to margins at Baidu? What's your expectations for the future there?
O'Keefe: Well, margins have gone through a bit of a revolution over the last several years at Baidu. Effectively, they've taken two big steps down, and we think those steps down are rational. So, the first step down was a few years ago where the, as I said, the Chinese Internet industry is developing very, very rapidly, and a few years ago it became very clear to Baidu management that the industry was going to transition from a PC-based industry to more of a mobile industry. The Chinese adopted cellphones and smartphones very quickly and so the transition from desktop search to searching on your handheld device was very quick. And Baidu management recognized this and they thought, you know what, we're willing to sort of blow up our margin structure today to invest in this rapidly developing frontier because if we don't, we're going to be disintermediated. So, they took the margins down from well over 50% into the 20s. That turned out to be the right call. They protected their market share. They successfully transitioned the business to mobile search and now mobile search is what is driving the business. So, it's a very good example of a management team thinking long term and making decisions to trade off current profitability for long-term valuation creation. So, we are very in favor of that type of behavior.
More recently, they are taking another step to take down the margins. So, this situation is they look at the market and they see the rapid development of consumption in China going online and they see an opportunity to build a bridge between online search and offline consumption, what they call, O2O services, offline to online services. And what that effectively means is bringing people together. Someone who is searching on a device will search for, say, a movie ticket or order a meal at a restaurant, and that search will direct the consumer to a bricks-and-mortar retailer or a delivery service or a movie ticket. So, in order to control that flow of goods and services offline to online Baidu is investing in a number of areas to make sure that they have a strong seat at the table as that online to offline business develops.
Again, we think it's a rational investment decision. We think it's unclear exactly what the economics of O2O will be, but we think the management team is rational enough such that if the investment pays off, the investments that they are making which took the margins down, will be NPV, net present value, positive over time. If they fail to be NPV positive and the area ends up effectively becoming R&D, we think they will just halt the investment and the margins will rise back up.
Carlson: Right. Let's turn to another member, that BRICs conglomeration, Brazil. You've owned Telefonica Brasil since late last year, correct?
O'Keefe: Yes, that's right.
Carlson: And that's been a great performer this year. Can you talk about your thesis at purchase for that?
O'Keefe: Yeah. So, boy, I mean, just a few years ago Brazil was going to take over the world and now Brazil is in the largest recession, I think, in the history of that country. So, it's been a rapid turnaround. And that's something investors should always internalize when we go out in the marketplace and invest and when we listen to people's recommendations. It was commonly assumed that Brazil was going to grow to the moon and now they find themselves, sort of, in the gutter.
As Brazil started to retrench into recession, we became interested, of course, because security prices were falling and Telefonica Brasil was the stock that we chose get involved in. The question is, why? Really, it comes down to all of the characteristics that we look for. The valuation was very cheap. Let me describe the business first before I go into that.
It's the dominant mobile network operator in Brazil. So, they have 45%, 50% market share of mobile postpaid subscribers. Postpaid are the more valuable. They have the best network; they have the best brand; they have the largest market share. They are actually taking market share in the industry. So, they are a great operator. It's a good business. We think over a long period of time the Brazil telecommunications industry has room to develop and grow. The balance sheet is very strong. It's effectively unleveraged. It's the only large-scale dominant telecom operator that I know of anywhere in the world that has virtually unleveraged balance sheet. We like the management team. The gentleman who runs it was the CEO of a company called GVT, which is a broadband business that Telefonica acquired from Vivendi in France and he is an entrepreneur and he built that business up and now he is running the large entity. Then, of course, the valuation, which is the most important issue, we paid we think around 9 times unlevered earnings for that business. So, cheap valuation, a good balance sheet, a nice business that has long-term development potential, and a management who we think is going to take good care of our money.
Carlson: OK. Thanks very much for your time, Dan.
O'Keefe: Thanks for having me, Greg. Great to see you.