Don’t lose sight of the long-term

Emerging markets were volatile throughout 2018, especially during quarter four as they sold off and took some valuation froth out of the market. This has continued into 2019 thus far, but as investors, it’s important to step back and take a longer-term view of the situation. I recently sat down with Alex Duffy, Portfolio Manager of the Fidelity Global Emerging Markets Fund to discuss the current situation. We discussed some of the risks, opportunities, and unique dynamics that emerging markets have to offer. Read on below to hear Alex’s views.

Why do you love investing in global emerging markets?

I think that the key attraction of global emerging markets is the breadth of the opportunity set. You’re dealing with markets that are relatively nascent and that creates an opportunity for good companies to deploy significant amounts of capital at accretive rates of return. If you combine that with a long-term investment time horizon, it creates intrinsic value over three, five, 10 years. That is a unique opportunity set.

The macro is incredibly important to this region and the macro backdrop, at this point, is more uncertain than we've seen in previous years. So how are you approaching both analysing it, seeing it as a backdrop for your investments and then allowing it to influence your investments?

Some of the challenges that are being presented right now result from the impacts of trade wars between the US and China. How that manifests itself in Chinese demand and competitiveness for China has implications for the value of the currency.

The importance of China to emerging markets cannot be understated. That has push-down effects across the rest of the asset class. One of the challenges that presents is that ultimately growth is slowing. We're on the back of a very, very strong period of global growth over the last few years, particularly in the US, but also in China, following that stimulus in 2016 and 2017. We’re digesting some of the implications that stimulus created. It's about finding opportunities and managing against that cyclical backdrop.

My base case is that we’re going through a softer period, you must identify good businesses that can manage that, that have strong balance sheets and can consistently generate returns. You have to have a strong focus on valuation to provide margins of safety, but most importantly you have to be prepared to embrace some of the volatility, not lose sight of the long term opportunity and actually use that to your advantage, which is really what I'm doing with the portfolio and have been doing over the last six to 12 months or so.

I’ll also add on the macro that the hawkish view of the US Federal Reserve has abated somewhat in the last three months. This is material for emerging markets as the outlook for US rates is very important for EM FX and most importantly for China which has been facing challenges of liquidity tightening due to the rising USD and rising US rates. As these headwinds abate, the pressure marginally comes off the RMB, and the Chinese authorities have a little more headroom to stimulate the economy through credit easing. I do not think that this is the start of a major new stimulus cycle, but it does make the environment considerably easier than where we were at the beginning of Q2 2018.

What do you do specifically that would help investors get invested but weather that volatility?

I focus very much on the companies that I'm invested in. Understand the governance structures. Understand the balance sheet structures of those companies. Ensure that both of those parameters provide you with downside protection, so you defend against probability of permanent capital loss. The balance sheets and the incentive structures of management teams should enable the company to invest assertively in its business over three, five, 10-year time horizons. Then finally, ensure that you don't overpay for that at the outset.

You're selecting companies with that type of filtering so that you're selecting investments that are aligned with the end investor's needs?

Absolutely. I think that being invested in this asset class does require something of a long-term view. It requires the ability to weather and be prepared to embrace some of the volatility. But if you do that through good companies, I think that that will be a successful outcome.

As an investor managing the fund on a day to day basis, I'm dealing with some of these more macro and shorter-term currency volatility and overlays from a sector and a country positioning to ensure that we're alive to the opportunities that are presenting themselves. We're also helping to mitigate some of the downside risks through prudent stock selection.

Given the noise in markets, why do you think now is a good time to invest in emerging markets?

I think some of the challenges are very real. There's no point in shying away from the fact that the challenges in China with respect to the deposition, the threats to potential weakening of the RMB because of trade wars. It is very real, but it has to be viewed in the context of the price that you pay for the company that you're buying, that you're invested in, and also the strength of that individual business model.

Now there are some companies that have great brands that invest in technology, who have weaker competitors that are unable to continually invest in their competitive advantages. These companies will strengthen their position over multiple years. They’re the companies that I want to be investing more of my capital in today, those companies that can continually invest and take market share, cycle to cycle.

If you were to pick two to three things specifically, how do you differentiate between a good long-term proposition versus a company that's hot right now, but could be overinflated?

What's most important to me is understanding the consistency of return profiles. You manage downside risk by ensuring you've got appropriate alignment from a governance perspective and ensuring that the balance sheet is strong and can survive the vagaries of the economic cycle.

Then it's about understanding consistency of return profiles; the ability of a business to consistently generate a return on capital above its cost of capital and to sustain that over time. We'll look at competitive intensity in the industry structure. What is it that's unique about this particular business from a brand perspective, from a technology perspective, from a geographic natural resource perspective, that enables it to perpetuate that return on invested capital? Then how we value in that cash flow stream; does the valuation give us a margin of safety?

Often emerging markets as an asset class can be very thematic. The advance of passive investing and indexation can create a wall of money going into sectors or certain areas and inflating companies way beyond fair values without a true understanding of the sustainability of those return profiles.

Rising US yields are a real valuation headwind for all assets, not jut emerging market equities. That’s resulted in the derating of those valuation multiples for high growth companies. And if you've got companies that are priced for delivering very strong returns, then that return profile isn't sustainable, it creates a real risk of a permanent loss of capital through the multiple derating. So, I focus much more on consistency of returns, deliverability of returns, and a margin of safety from a valuation perspective.

If we were to look at the portfolio today and think about themes and stock stories, what would you highlight today?

If you look at the fund today, there is a focus or that's a dominance of financial companies within the portfolio, so around 30% of the fund is invested in financials. The common theme amongst all of those financials is that they tend to be, in their own market, a very strong deposit taking retail facing banking entity for the most part.

So, you kind of get the demographic play through that?

Absolutely. 100% correct. You've got under-penetrated consumer financing in a lot of these markets, more importantly, deposit taking tends to be under-penetrated. It's all very well lending money, but you need to raise deposits to fund that. So, having a strong deposit franchise provides stability to the balance sheet and it ensures if you've got low-cost deposits, that gives you a competitive advantage in both loan pricing as well as funding risk. So those banks tend to be very interesting. Names like HDFC Bank - very strong franchise in India, under-penetrated market, an ability to deploy huge amounts of capital at attractive 20% rates of return. That drives value over five, 10-year time horizon.

I also think you've got areas of the consumer market in China which look interesting. There is a cyclical slowdown going on that's creating a drawdown in equity prices, but valuations are compelling for certain businesses that are gaining market share. Stocks like Midea, which is cyclical. It sells air conditioning units, so the end market is cyclical. It’s had a very strong up-cycle over the last 24 months or so. I do think the way that company is investing in its distribution base to improve incentive structures for its salespeople, which will prevent inventory build in the end channels, prevents discounting, delivers more stability of margins and profitability. Those are companies which are creating value, in these market environments.

Within the demographics theme, which areas are of most interest to you at the moment?

The consumer market is clearly an area where you've got under-penetration of various consumer products all the way from housing and bank accounts down to end consumption of basic products. There's an opportunity to grow brands and to increase penetration levels there, that's an area where demographics clearly play a role.

Education, medical care, etc; these are very large markets in the developed world that are underrepresented within emerging markets because of the base we're starting from, over time they are going to develop. That generally tends to be inevitable.

I think that using technology to enhance adoption of consumption financial products is something we're witnessing right now. If you look at bankerisation within emerging markets, India is an interesting case study. Technological adoption is fast tracking the rate at which the market bankerisation increases, the rate at which financial penetration increases. Often technology is looked at in isolation, but technology is being embedded as an enabler within multiple businesses, so maybe we should move away from the technology sector? I think more about how technology is being used by individual companies and the value that creates in some other areas of the market, be that financials, be that consumer… They're some of the areas which are interesting.

I do think the financial sector, from a penetration perspective, from breadth of products, whether it's insurance products, healthcare products, et cetera, et cetera. I think those areas, on a thematic over the next five, 10, 15 years, are going to be areas to focus on.

But the final point I'll make on demographics is that thematic investing, while being valuable and incredibly relevant, is also dangerous if you don't couple it with an understanding of the return profiles. The housing example's a great one. I remember housing in Brazil in 2009, 2010. - so post-GFC. There was a big thematic around the shortage of housing. A lot of investors were buying home builders to play that theme, the home builders were being forced to buy land at increasing values. They were raising capital to do that. Ultimately, competition was increasing in that house building market because so much capital was being thrown at the theme. The share count grew as fast as the homes that they were building and that led to dilution for the minority shareholders, despite the theme being delivered.

While the thematic is a very important structural driver of returns, you have to combine it with financial discipline to ensure that, as shareholders, you get paid to execute the theme. It’s a slight nuance to the approach of thematic investing.

We want to get a view on your thinking and positioning for 2019. How’s the year going to unfold? I think we're finally coming around to the view that it's going to be a more volatile environment for investing.

Going into 2019, there's a huge amount of economic uncertainty. We've had sizable declines in equity markets in 2018. Equity markets move ahead of economic fundamentals. But there is an opportunity today to buy very good companies in emerging markets, at more attractive valuations than we've seen in the last two to three years. For the asset class generally, we should be looking to identify those key opportunities within EM. I do think that certain pockets of the market will remain vulnerable to volatility, currencies, and particularly the interest rate environment.

I like the technology sector, I like the way that technology is enabling multiple other industries to grow and develop. There are areas of technology that are relatively highly valued, and maybe there's some regulatory headwinds. Within emerging markets over the last few years we've become very fixated with growth in Asia and it's important to keep in mind the breadth that global EM offers.

There are good businesses throughout emerging Europe, Middle East, Africa, throughout Latin America, that are not as correlated with some of these challenges that we've talked about. There are some potential signs of improvement maybe from a political perspective. There's also low inflation in these markets that creates this a relatively more stable backdrop for investing in companies with compressed. Names like Itaú Unibanco in Brazil are interesting, I also think Lojas Renner in Brazil, which is a consumer business, fashion retailer, very good management team, great execution, limited competition. Those areas of the market remain interesting to me.

Equally, a couple of names in South Africa; AVI, which has been held in the portfolio over a long period of time, keeps generating returns, paying strong dividends. They're areas of opportunity and it's important to use volatility to your advantage. 

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