Five high-conviction themes Joseph Lai says will drive the emerging market equity rebound

James Marlay

Livewire Markets

When it comes to investing and markets, there's a necessity to talk about the averages. And in the context of 2021, no doubt you've seen multiple headlines declaring that, on average, markets are expensive.

For example, popular indices such as the S&P500 and the ASX200 currently trade on PE multiples of 26x and 25x, respectively*. Well above their long-term averages.

The NASDAQ, buoyed by surging tech valuations, trades on a lazy PE of 113x*. Expensive in anyone's language.

But not everything looks expensive to Dr Joseph Lai, the co-founder of the recently launched fund manager Ox Capital. In his view, Asian stocks are unequivocally cheap, which comes from the perspective of an investor who has spent the last 17 years navigating Asian markets.

Managed Fund
Ox Capital Dynamic Emerging Markets Fund
Global Shares

The numbers support this view with China's CSI300 Index trading on a PE multiple of just 16x, while Hong Kong's Hang Seng Index struggles to retain a double-digit PE of 10.7x*. A recent Bloomberg article nominated the Hang Seng as among the world's worst-performing primary equity gauges tracked by the firm. Even Charlie Munger couldn't resist the allure of depressed valuations, recently doubling down on his position in Alibaba.

The narrative supporting an investment into the growth story of emerging markets is compelling. However, the last decade has seen emerging markets underperform many developed market indices.

So, what is the catalyst to see that trend change?

Lai has spent the last decade thinking about that question and says a low starting valuation is a key ingredient. With that backdrop now in place, Lai and his colleagues at Ox Capital are investing in quality business leveraged to under-appreciated, long-term growth trends.

"We can find good companies growing at 20% per annum that are trading on a 15x price to earnings multiple."

In the first of a two-part interview series, I spoke with Joseph about why we are at a turning point for emerging markets, and the five themes he believes are under-appreciated by investors.

*All data sourced from Bloomberg


Transcript

James Marlay

Hello, and welcome to another in-depth interview brought to you by Livewire Markets. My name is James Marlay. I'm a co-founder of Livewire, and I'm joined today by Joseph Lai, founder of Ox Capital, a brand-new fund. We're going to find out why he has been inspired to go out his own and learn a bit about the opportunity he's seeing in emerging markets. Joseph, great to have you. We're talking in a week where the headlines are being dominated by one of the largest Chinese property developers having some serious issues. I'm talking about Evergrande, and you're looking at launching an emerging markets fund. I just want to make sure: are you okay!

Joseph Lai

Well, we can talk about the Evergrande situation a little bit later in the interview! But really, the reason why I started Ox Capital is I spent 17 years at my old shop, Platinum. I was managing $7 billion and the performance was good. The logical next step for me was always to build a good investment organisation. That's been a dream of mine ever since I started in the industry about 20 years ago. I think that with the experiences I've picked up, we can do a great job.

We can improve the way things are done. The way it's going to play out here in Ox Capital is that we are going to focus solely on emerging markets in which Asia is a big part. We are going to manage the market risks more systematically. We have a team which I believe has the experience to deliver that great performance.

Fidante also was looking into this area. They believe in what we're trying to do and they wanted to be part of the journey. And we're quite grateful for that because Fidante's got a great middle office and back office. So we know that our infrastructure will be well looked after.

We believe the talent and the structure we have is pretty special, and not just in the Australian funds management context. There's not many funds which are looking at this part of the market, but the way we are doing things is unique relative to most emerging market funds you can find anywhere in the world. So we're excited and we are very glad we're getting started.

James Marlay

You mentioned you worked at Platinum for 17 years, but could you give me a flavour for how you think about investing? What represents a good investment for you? What are you looking for?

Joseph Lai

The process is not that different to what I've always been doing, but I think we've made some improvements. If we take one step back — if we think about what is in shortage in the investment universe for the next five years — I believe it's growth and pricing power of companies.

So we'll focus. The focus of the fund would be on companies with a long runway of growth, with good management, and therefore good pricing power.

The reason why growth is in short supply is just because in most parts of the world, there's a lot of debt. And with debt, it's actually hard to generate growth in these economies. And the economies are oversupplied with capital, so there's a lot of money chasing after starting new businesses.

So it's actually very competitive in most industries. It's hard to get the pricing power. So growth and pricing power. But I may bore you if I tell you what we do, because like most good fundamental, bottom-up managers, we do something quite simple, but it's easier said than done. The first thing we look for in a company is a long-term secular trend or theme which is under-appreciated by the market. The second thing we look for are good quality businesses which can be leveraged to these themes. And the third thing — now this is the important thing, and it's very hard to do. Do not pay up.

Don't pay up. I'll repeat that. So first is, the long-term good theme that is underappreciated; second, companies that you have confidence can deliver on the promise of number one; and third, do not pay up, so that the valuation that you pay for can double in the next three to five years.

So if you work backwards, doubling the stock price in three to five years implies around 20% return. And that's 15% a year, the long-term return objective for the fund. It's easier said than done. It requires curiosity to look for the new stories, the experience to know what is a good company, and the discipline to not chase the hottest story in town.

James Marlay

As you mentioned, there aren't many products on offer in emerging markets in Australia. What is the compelling reason for people to invest in emerging markets right now?

Joseph Lai

This asset class is interesting for the next five to 10 years, because there's a lot of growth and there are a lot of quality companies. So, a little bit of information on emerging markets. You would know that emerging market basically refers to stock markets of developing countries. Emerging countries already make up more than half of global economic output — it's 60 or 70%.

And of course, there are lots of people in this markets. There's literally billions of people just in Asia, right? But if we look at the MSCI Emerging Markets representation relative to MSCI World, it's like 12% of MSCI World, when the global output is much bigger and there's much more people in these countries.

What that tells us is that there's a lot of under-investment in emerging markets and there should be a lot of catching up to do. So that's interesting. The second thing is this: the valuations of emerging market companies are cheap.

We did a study before launching the fund. Looking at the long-term performance of equity markets, emerging markets over the last four decades have outperformed developed markets by a long way. In the last 10 years, however, that has not been the story. We know that in the US market, the NASDAQ has gone up five-fold since the GFC.

If you go back to 2008, if someone told you the NASDAQ would go up five-fold, you would not believe it. I believe we are in a similar situation in emerging markets right now, where there's a lot of concern over various things. China is front of mind but there are other concerns as well, and this market is very cheap because of all the concerns.

That's why we are excited, and because I've been looking at Asia for so long, I'm seeing the dynamism of the place. A lot of local companies are becoming local champions. And because the market has been reasonably weak, we can find good companies growing at 20% and they are literally valued at 15 times price to earnings multiples, with a long run of growth. They're good companies and we're happy to get them.

In a way, the starting valuation of a stock is often a good predictor of how much money you make off it. And I think we are in a very good place right now for the next three to five years.

James Marlay

You talked about the decade of under-performance in markets. What do you think caused that and why do you think it's going to change now?

Joseph Lai

Over the last 10 years, the market has been choppy. I have thought about this question for 10 years, managing money in Asia. It hasn't been easy. But we did achieve good returns in the last 10 years. I think there are two reasons. One is that China joined the World Trade Organisation and then they were growing like the clappers.

Their GDP in nominal terms must have been growing at 20% plus in the early years. And the stock market got very excited for China and for emerging countries. A lot of them are linked to China because they supply resources and what have you to China. So the starting valuation a decade ago was expensive for emerging markets. So that's one reason: high starting valuation.

The second reason is after the global financial crisis, China, the big locomotive of the world and emerging markets, overstimulated its economy. They piled up a lot of debt, which you all know about, and it is still taking them a little while even now to reduce the burden.

What we are seeing now is the last stage of this big de-leveraging, or reduction of the debt burden, for China. The last bastion of questionable debt, I think, is in the property market. They're hitting it right now. After this, there's not a lot of room for them to continue to deliver.

We're on the cusp of them clearing the deck. That will turn. So those two conditions, I think, would be in the rear-view mirror as opposed to in front of us. And the starting valuation is cheap.

James Marlay

In terms of particular themes or opportunities that you're excited about, could you talk me through a couple of the high-conviction areas you are finding?

Joseph Lai

The story for most of the emerging markets remains reasonably constant. It is actually the consumers, and to some degree, infrastructure for some of these economies. For the big elephant in the room, China, they have moved on from demanding more and more commodities and infrastructure. They'll keep building it, but the volume they build won't be growing every year, which means demand for commodities is not going to grow that much and may even shrink a little bit. So, that's behind us. Going forward, however, is consumer-related stuff. That would be the focus of what we look at.

I'll tell you five themes: healthcare, insurance, internet, technology, and consumers. I'll talk about two in more detail. First, healthcare. If we look across the whole of emerging markets, particularly in Asia, people are getting richer. But if we look at the penetration of modern medicine — diagnostic machines, radiotherapy machines, linear accelerators to shrink cancer — in the bulk of Asia, it's under-penetrated on a per-capita basis.

There's a lot of room for modern healthcare — drugs and devices — in those markets. Governments are allowing cutting-edge devices or drugs to be imported into these countries because people want them. That's a very interesting theme, and we're putting a lot of effort into looking for the best cutting-edge technologies that can sell into the region.

A slightly more boring theme is consumers. Everyone knows about the consumers, but I want to tease out the nuances. To our team, it's not enough to say consumption is going to grow. Everybody knows that. Even people who are negative on China know consumption is growing in China. We've done a lot of work to try to work out what is the mix of the products that are changing. What we found is that there's a rising demand for the more differentiated consumer products, particularly for younger people.

That's not me — it's probably not you either, James — but it's more the generation Zs. They still like luxury goods, but there's a greater willingness to embrace their own domestic brands. There's a greater willingness to go onto the domestic websites that are specifically catering for them. Gen Z tastes in Asia are not different to most other gen Zs in any parts of the world. But, as you can appreciate, their taste is different to people older than them. We are looking looking at which opportunities are best slotted into the portfolio to take advantage of the new trends.

James Marlay

Can you talk us through some of the local brands that are appealing to that gen Z audience? What are they buying? Computer games, phones — is that what it is?

Joseph Lai

It's about that, but if you can indulge me, I'll tell you a story. Fifteen years ago, when I first started looking at Chinese consumer stocks, there were a lot of sportswear companies locally. It was very competitive — there were about 50. They had no chance against the likes of Nike or Adidas, because everyone liked the typical good brands. Nike, Adidas, represent, I guess, wealth and also the functionality of them — whatever.

The local brands were relegated to the bottom. There was not much brand value and not much loyalty there. But in the last three to five years, the young people are embracing the local brands a lot more. People who are middle-aged would look at those brands and think, that's not a status symbol, right? The local brands. The Nike, Adidas, Louis Vuitton or whatever — yeah, status.

The young people are embracing the local brands in a much bigger way, and they're willing to pay up. They're paying $200 Aussie for one of those hoodies with a local brand on it, which I could never have imagined 10 years ago.

We've got a big range of age groups in our team and also different backgrounds, languages and genders. There's some websites which the younger members of my team, they told me, "Look, that's what the people there are logging onto. This is the app they're using to share videos."

I took a look at it, and I thought, "Wow, this is amazing. Young people are doing that." This company is called Bilibili. What a funny name, right? And in Chinese, it sounds very similar. It's growing revenues by 100%, and it's growing users by 40%. I've never seen anything like it. I've been buying it.

It highlights this new taste for services or products which are particular for the new generation. And it's not just China — it's universal across the world that people have different tastes. It depends on what generation they grew up in and whether they've gone through the hard yards or whether, like the current generation of young people in China, they haven't gone through the hard yards at all — perfect, good last 15 years, great.

James Marlay

It would be remiss not to talk about why China's cheap, knowing that it's not an exclusively China fund, but that's obviously where you're finding some opportunities. How do you manage the risk and what are some of your views on those things that are happening right now?

Joseph Lai

I think — not just for emerging markets, I just think in terms of investing — one has to skew the risk in our favour. Investing is basically taking risk. When you buy a property, you are taking a risk, right? If we can skew the risk in our favour, that will help. That's the foundation of investing and risk management.

How do we skew the risk in our favour? First, look for what is attractive. So, growth and pricing power. Second, be aware of which way the wind is blowing. That means being able to contextualise what the company is going to do and what the government is like. Try to stay away from the ones with a lot of headwind. A little bit of headwind may be okay, but a lot? Stay away.

Third, do good work so we can contextualise what's going on and manoeuvre around difficult problems. Fourth, and this is part of the investment process, do not pay up. Once you've done the good work, you know what you buy, and then if you don't pay up, you actually have a nice margin of safety. That protects the downside and that is risk, right? What is risk is downside risk in most cases.

You can do all that and then you have a good lane to move in, but can you be 100% sure that you are going to be 100% correct? You can't be. So the next thing is diversification. Have names in various sectors and countries so you are not going to be drawn into these sector risks or country risks in one go.

There's benefit in that, but don't be too diversified. I reckon 30 to 50 names in a portfolio would be good. That's more than enough to diversify away those risks and look at the sectors they're exposed to. The second-last thing is to have a guide to show where true North is.

We've got this model, which we've called a moat, which can tell us what is going on in the world, in the different economic sectors, in the different companies and markets almost in one go. It sucks in a million data points at a time, and it is very helpful to have a sense of where the true North is.

You can try to listen for the narrative that's in the market. You can see what people are fearful of, then look at what is the true North. And if that's different, it is a wonderful time for you to make extra money or reduce the downside risk. And that's what we'll do in the portfolio. That's helped during COVID. When everyone was concerned, we were not; when everyone was not concerned, we were, at the beginning of COVID.

The last thing is ESG (environmental, social and governance). ESG is integrated in the process. I believe in it, because one thing that can protect investors from really bad idiosyncratic risk is good governance, and social licence to operate the business.

A good ESG company will not give you the headaches that some of the very dodgy companies would. Over the years, I've seen companies, especially in emerging markets, improve their ESG credentials then do better. We can do the right thing and make money at the same time. Why not?

James Marlay

You told me you've been working 20 hour days to get the fund up and firing. Best of luck on the journey that you're about to undertake. And thanks for taking the time to talk us through some of your thoughts.

Joseph Lai

Thanks very much, James. It's been great to be given the opportunity to communicate with clients and your audience.

Take advantage of the rapid growth in Asia and emerging markets

Joseph's investment approach is to identify the immense changes taking place in Asia and other key emerging markets to find investment opportunities. To learn more, visit the Ox Capital website, or see the Fund Profile below. 

Managed Fund
Ox Capital Dynamic Emerging Markets Fund
Global Shares

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