Fund Manager Q&A

Emerging markets have been in the headlines for all the wrong reasons; slowing growth, trade tensions and political risks. However, they can also offer deep value, and they have massive secular tailwinds behind them. 

With interest in the EM rising, to better understand the opportunity, we reached out to Rasmus Nemmoe, Portfolio Manager of Global Emerging Markets at FSSA Investment Managers (part of First Sentier Investors). 

Rasmus explains what makes the theme so compelling but why you need to look past the index, how he goes about finding the hidden gems among the 40,000 stocks in his universe, and then runs through a couple of examples of holdings to illustrate his process. Read on to find out which.  

Q: Rasmus, what makes Emerging Markets so compelling?

Consider the following: over the next 15 years, the United Nations expects the working-age population in emerging markets, excluding China, to grow at an annual rate of 2% (the equivalent to 700 million people entering the labour force). 

Likewise, Boston Consulting Group estimates that between 2010 and 2030, the population in emerging market cities will increase by 1.3 billion people, which is higher than the total population residing in present developed market cities. 

Secular drivers including demographics, urbanisation and productivity improvements, should continue to create the prerequisites for large, growing profit pools that can be tapped by our holdings as they provide basic goods and services to this segment.

  • For example, in China, premium beer consumption stands at 15% of total volume compared to the global average of 30-40%. This represents a backdrop of strong demand for our Chinese brewery holding, China Resources Beer, which has a tie-up with Heineken and has been expanding its premium range. 
  • In Indonesia, private sector credit penetration is just under 40%, with less than 30% of the population able to access a bank account – this supports the investment case for our Indonesian bank holding, Bank Rakyat
  • And, in Latin America, despite having an addressable market of 230 million people (Mexico, Columbia, Chile and Argentina combined), the Starbucks franchise operator, Alsea, operates fewer than 1,100 outlets compared to almost 15,000 in the US alone, making the case for long-term growth in the region.

The central investment case for all of these companies is that they benefit from the secular trends we find in emerging markets. But, more importantly, they have all established strong competitive advantages (in the form of brands, distribution and innovation), which enables them to create value across the business cycle. It is the continued strength and dominance of these business models that we believe are the strategic reasons to invest in emerging market companies over the long term.

The key to investing in emerging markets has always been to sidestep the default exposure embedded in the index and take a strong active approach in order to benefit from the region’s secular tailwinds.  

Q: How does the valuation look for emerging markets today?

While emerging markets from an index perspective may look cheap, we believe this is mainly optical and to some extent a meaningless indicator of potential future returns given the dominance of low-margin, capital-intensive companies in the index. 

The conversion of earnings to free cash flow for the majority of companies is generally quite poor and thus unlikely to generate serious value for investors over the long run. Instead – and as argued in response to the previous question – we believe it is critical to have an active approach in emerging markets in order to find the best opportunities over the next five to ten years, as these are typically not well represented in the index.

More importantly, it is probably also worth pointing out that valuation is usually not the best place to start for long-term investors. It is far more important to pay attention to the quality of the people you are backing and the characteristics of the franchise you are investing in. 

While we are disciplined on valuations, quality companies very often trade at a premium to the broader markets. However, what many investors tend to underappreciate is the ability for these companies to continue generating healthy earnings and free cash flows sustainably and into the future. Because of these characteristics, the premium valuation they are trading on today is usually turned into a discount a few years later; and thus is attractive for investors like us with a longer investment time horizon.

Q: EM has nearly 40,000 stocks in your universe. How do you narrow it down to 40 holdings?

As a team, we carry out fundamental company research to find the best long-term investment opportunities. Each year, we meet with hundreds of companies to generate investment ideas, paying particular attention to the quality of management, the strength of the franchise, the structure of the balance sheet, the long-term growth prospects of the company, and the market valuation accorded to the business. We enhance this analysis with a 360 degree review of the company’s competitors, suppliers and customers and highlight any environmental, social or governance (ESG) issues.

Our investment philosophy is based on the simple belief that the best way to create wealth is to own the best businesses and hold for the long term. 

The best businesses to own, in our opinion, are those which can grow free cash flow at a high, sustainable rate and are stewarded by outstanding people. Within the team, we refer to these businesses as ‘structural compounders’. 

The typical characteristics of structural compounders are: 

  • above-average sales growth and pricing power, 
  • strong cash flows and balance sheets, 
  • an outstanding management team,
  • formidable industry barriers-to-entry, and 
  • predictable/stable competitive dynamics.

Often, these structural compounders can be found among the leading consumer, financial or industrial companies in the less developed parts of the world. Not only are penetration rates low for many goods and services, which provides a favourable long-term demand backdrop, but also, the high level of informality in many of these countries raises the barriers-to-entry substantially. This typically facilitates a benign competitive environment, allowing many dominant companies (with brand, distribution or scale advantages) to generate high margins and thus strong free cash flow, which in turn should lead to high returns for investors in these businesses.

A key feature of our investment process is to assess not only the franchise strength of our holdings, but also the people running and controlling them. While a company’s financial performance is in many cases more dependent on the quality of the industry than the quality of management, a weak or misaligned management team or a dishonest controlling shareholder can destroy any investment case. 

The primary trait that we seek in management teams is therefore stewardship – we will tolerate no uncertainty around management integrity and alignment, and strongly favour managers that balance the interests of all stakeholders, including the environment and society at large (an executive team that abuses one set of stakeholders is just as likely to do the same where investors’ long-term interests are concerned). 

Secondly, we look for great capital allocators – independently-minded thinkers whose approach is long-term and at times countercyclical. 

Finally, and this is admittedly more intangible, we look for the right culture – management teams which can attract and retain employees and have a good track record of recruiting internally for senior positions, are some of the traits we look for.

Q: Can you run us through an example?

Colgate India, which we purchased last year, is a good example of our investment approach and the way we think about companies. Having been present locally in India since 1937, this 51%-subsidiary of Colgate Palmolive occupies a leading position and has for several years been ranked “Most Trusted Brand” in oral care in India.

The senior management team at Colgate India, like many multinational (MNC) subsidiaries, is well-educated and has worked in various emerging markets. The current CEO, Ram Raghavan, has been with Colgate since 1997, previously running Colgate’s businesses in China and Brazil. This experience is invaluable to ward off potential competitive threats and to spot emerging opportunities. The company’s board is dominated by independent directors and the overall standard of corporate governance is high.

Colgate has a strong franchise and spends around 15% of sales on advertising and promotions to support this. It is endorsed by more than 70% of all Indian dentists, which, combined with a distribution network reaching 240 million households across India via 6 million points of sales, has cemented Colgate’s dominant position of more than 50% market share – roughly 3x that of its nearest competitor, Unilever.

For any FMCG category, growth can usually be explained by some combination of the following three conditions: 

  • increasing penetration (more consumers use the product)
  • increasing consumption (existing consumers buy more) and
  • premiumisation (consumers upgrade to value-added products with higher unit prices). 

We believe Colgate India should continue to benefit from all three trends in the coming years.

Firstly, toothpaste penetration in India is yet to reach 80%, meaning that around 250 million people still do not brush their teeth using modern oral care products. 

Secondly, the potential to capture additional consumption in other categories represents a huge opportunity. Globally, Colgate has a significant presence in personal care categories such as skincare and deodorants, which have not yet been introduced in India. We believe that the company will, over time, utilise its massive distribution network and strong brands to launch more products in India. 

 And finally, Colgate India has benefitted from consumers trading up / premiumising in line with overall income growth and spending patterns, due to the strength of its brand.

This is a trend we expect to continue for many decades to come. As it stands today, the average Indian spends just one US dollar on oral care products each year. This compares to around USD4 in China and USD11 in Brazil.

In summary, we believe that this combination of excellent stewardship, a strong franchise and good future growth prospects makes Colgate India an attractive long-term investment opportunity.

Q: You are also quite overweight financials. What’s the rationale here and which financial in the portfolio are you most bullish on?

This not a sector call, but simply the residual of where we happen to find some of the best investment opportunities in emerging markets. The kind of banks we tend to own are what we call plain vanilla banks – ie simple financial intermediaries, often supported by a strong deposit franchise or a specific loan niche positioned in markets with low financial inclusion, which gives them the potential to generate high margins and thus high returns across the cycle. 

Typically, these banks tend to be more defensive than their average peer but would often benefit from the same drivers as consumer companies (demographics, urbanisation, productivity improvements, and so on).

However, most importantly the banks that we own are known for their risk-aware, countercyclical management teams, which helps to ensure low levels of stress when times are tough. 

As a result, the banks that we have invested in have, on average, generated a ROA of 2.4% and compounded book value per share (assuming dividends reinvested) at 15% in US dollar terms since 2007 – despite the global financial crisis in 2008-09 and a substantial slowdown in many emerging markets in 2014-16.

A great example would be our largest holding - HDFC Bank in India - which over the past 15 years has compounded its book value at 21% annually (and increased in price more than 20-fold). 

The main reason behind this impressive track record is first and foremost, a strong deposit franchise (HDFC Bank has more than 5,000 branches across India and 50 million customers), which has given the bank a funding cost advantage. 

The second reason is a diversified loan book focused on retail customers, which has generated high, risk-adjusted yields without incurring the same amount of stress most other corporate lenders in India have experienced.

The ability to avoid stress and asset quality problems is where the bank and its long-time CEO, Aditya Puri, has performed better than most other peers globally. Since 2007, non-performing loans (NPLs) have steadied at an average rate of 1.3% and has never exceeded 2%. This has allowed HDFC Bank to grow earnings and book value per share at a high and consistent rate, without the usual volatility seen in other banks whose earnings profiles follow the ebbs and flows of cyclical credit costs. 

 While HDFC Bank has grown phenomenally over the years and now commands a 9% market share in India, we believe there are still substantial opportunities to capitalise on – especially in non-urban areas which account for 40% of the economy and 65% of the workforce. To quote Puri from a meeting with him last year: 

“India feels like its 1994 all over again (just after India introduced financial reforms and issued banking licenses for the first time to private players such as HDFC Bank). Back then the opportunity was in the cities; today it is in the rural areas!”

Q: What’s the last thing you read that really amazed you?

I have just finished reading Henry Kissinger’s On China which provides a good historical context for the current trade conflict between China and the US. 

I have also just started reading The Narrow Corridor by Daron Acemoglu and James A. Robinson. They are the two authors behind Why Nations Fail which I think is a must-read for anyone who is interested in political systems and economic development. 




Saju VARGHESE

Good picks. How do i access your 40 holding names?