One of the greatest growth stories remains under the radar
In a world hungry for growth, it seems odd that one of the greatest growth stories is being almost entirely ignored by investors. Despite boasting over 6 billion consumers, fast growing economies, and many high quality growing businesses, Emerging Markets (EM) has been shunned as an asset class since the GFC. But perhaps, as the proverb says, the darkest hour is just before the dawn?
Many investors have ‘thrown in the towel’, say Edward Su and Michael Roberge from the Paradice Global Emerging Markets Fund, with some even calling the asset class ‘dead’. But with several possible catalysts on the horizon, such as a falling US Dollar, or an economic de-coupling from China, fortunes could soon turn. In this Q&A, Edward and Michael discuss three key trends that have accelerated in 2020, some of the most exciting opportunities they’re finding today, and the most important thing for EM investors to consider.
18 months on from the launch of the Paradice Global Emerging Markets Fund and I imagine it’s been a wild ride! What advice would you give yourself if you could go back to early 2019?
Well if we could go back to early 2019 we’d certainly jot down a few names to concentrate heavily in! Overall though we’ve been happy with how the first 18 months have gone. We’ve been very fortunate to have gotten some early support from a few industry super funds and to have had a decent start from a performance standpoint.
The advice we’d probably give ourselves is to never lose sight of the longer term objective. There’s a tendency for everyone to place a disproportionate amount of value on certainty and on what’s happening over the short term, however, so much of the news flow and market gyrations we experience on a day to day basis is just noise. Having the ability to quickly filter the noise from the events that will actually have a long-term impact, such as COVID-19, is an essential skill in our industry which suffers from information overload.
Does it take a different mindset to be an Emerging Markets portfolio manager as opposed to Australian Equities?
We don’t think our core philosophy of focusing on compounding and capital preservation would change. One primary difference would be a focus on one country vs many countries. Emerging markets is a very heterogeneous asset class. Each country has its own unique political situation, government policies, and intricacies that one must understand to effectively allocate capital across such a diverse landscape.
Additionally, we’d suspect many of the EM businesses we gravitate toward would be at an earlier stage of their life cycle and have a larger penetration story. It’s this latter opportunity that really excites us about the emerging markets over the long term.
In comparing the indices, Australian Equities has much more exposure to cyclical sectors such as financials and materials while Emerging Markets has evolved over the years to be more focused on consumer and technology. Our biggest exposure from a sector standpoint is in consumer discretionary which also includes ecommerce companies.
Keep in mind, there are over 6 billion consumers living in the emerging markets. This is roughly 85% of the world’s population.
These consumers are likely to see some of the most remarkable relative improvements in spending power. At the same time, digitalisation and urbanisation will act as accelerants to drive faster growth in consumption as purchasing friction diminishes.
What do you think it would take for investors to regain an interest in EM?
Unfortunately EM has been an underperformer over the last decade and thus there are a number of people who have potentially thrown in the towel and prefer to get exposure to EM through Global funds. We’ve even seen articles suggesting that the EM asset class is dead. If history is any guide, caution is warranted whenever you see these kinds of extreme statements.
Given how challenging it can be for the majority of investors to swim against the tide in an attempt to be early and contrarian, Emerging Markets may not become an easier sell until we see some evidence of sustained outperformance versus other equity indices. This outperformance could be driven by any number of factors, but we believe the most plausible catalysts might be sustained weakness in the US dollar, economic decoupling from China, and a valuation premium eventually being ascribed as investors more fully embrace the structural growth story in emerging markets relative to developed markets.
We’ve even seen articles suggesting that the EM asset class is dead. If history is any guide, caution is warranted whenever you see these kinds of extreme statements.
Urbanisation that changes middle class consumption habits, disruptive technology and the rise of mega-cities are all key points when discussing the potential of emerging markets. Which of these themes do you see as ascendant over the next year?
There are a few themes we’ve been seeing play out in our markets over the last couple of years. While these were all themes that were playing out before COVID, the trends have accelerated as a result of the impact of the pandemic. They are:
While it is reasonable to expect digitalisation trends to moderate somewhat as the economy begins to open back up, we believe there will be enduring changes in consumer behaviour. For example, online purchasing, food delivery, online bill pay, and virtual meetings have all quickly achieved much deeper penetration in the lives of consumers which are unlikely to completely revert back to their pre-COVID behaviour.
Regarding localisation, some of this will depend on how Sino-US relations continue to evolve, but no question the pandemic has prompted many businesses to reassess their supply chains. This will have a lasting impact on global trade and will continue to shape business decisions among the companies that we follow.
Lastly on consolidation, the impact of the pandemic has unfortunately been rather uneven. The larger companies have had more access to funding and have greater bargaining power with key partners to reduce their costs. Additionally, in a more digital world, scale becomes even more important as it helps to lower customer acquisition costs and also provides companies with valuable data that they can channel into artificial intelligence or other research and development to increase their advantage.
Please take us through the biggest weightings in your portfolio at the moment. What do you find so compelling about these countries and sectors?
Our biggest weights in the portfolio at the moment would be Alibaba, Taiwan Semiconductor, Reliance Industries, and Tencent Holdings.
While these are all substantial weights in the benchmark, we are benchmark agnostic so we own these businesses at large weights because we believe the market underappreciates the enduring nature of these franchises.
Additionally, when we determine our stock weightings, we focus quite a bit on the potential range of outcomes versus simply maximising for expected value.
Alibaba and Tencent are the two leading digital platforms in China. Alibaba started as an ecommerce company trying to put sellers in touch with consumers and Tencent started out first as a simple messaging platform. Over time these companies have invested substantially in other business areas and built themselves into dominant digital platforms. Today Alibaba represents not only the leading ecommerce platform in China but also a leading cloud computing, logistics, fintech, local services, and digital entertainment company. Tencent represents not only the leading messaging platform in China but also the leading games platform and has a strong presence in cloud, fintech, and commerce. Given the digitalisation tailwind coupled with the time spent and level of engagement that Chinese consumers, and increasingly businesses, have with each of these platforms, it is difficult to imagine these companies being disrupted in a big way.
Taiwan Semiconductor is another top holding and while it is a Taiwanese company, it is the world’s leading semiconductor foundry with over 50% market share and will be a key driver to digitalising much of the EM world. Semiconductors are increasingly found in everything we use and many of the most advanced technologies require smaller and more powerful chips. The leading edge is becoming more and more consolidated with only two remaining players (Taiwan Semiconductor and Samsung) as Intel has recently fallen behind and indicated they might begin to outsource their leading edge.
Reliance Industries is the least established of our top holdings despite being India’s largest company by market capitalisation. This is a business that is looking to make the transition from refining and petrochemicals to become a leading consumer company. While much of the foundation has been laid and the company has brought in a world class group of investors including Facebook, Google, leading private equity and sovereign wealth firms, the company still needs to execute. If they are successful, they would have a dominant consumer facing telecom company in Jio Platforms and a dominant retail franchise capable of tapping into the still largely underpenetrated informal market in Reliance Retail.
The common bond for these investments is that they are:
- Exposed to large and growing addressable markets,
- Led by strong management teams that excel at capital allocation,
- Have strong moats that would be difficult to disrupt.
You follow a strategy of deliberate diversification across geographies, business models and market caps. Can you suggest an example from each of these categories to keep an eye on over 2021?
As part of our goal to minimise correlation risk at the portfolio level, we implement a basket approach that we believe should allow us to have businesses that will be able to realise value in different environments and over different time periods. It is important to note that all the companies we invest in have passed through our quality filter and stock selection process which includes the following:
- Exposure to a structural demand opportunity,
- Enduring business model characteristics,
- Potential to make us money over a 3 year period.
The majority of our portfolio (60-70%) would be invested in ‘compounders’ which are quality franchises with a stable/growing moat, that earn above average returns on capital and have low business model variability. Another 10-20% would be invested in ‘discounters’ which are currently out of favour and tend to be more cyclical. Lastly another 10-20% is invested in ‘incubators’ which are companies we hope will eventually graduate to be a compounder and where we see a lot of potential but currently their moat, return profile, or cash flow profile isn’t best in class.
An example of a compounder we like for 2021 would be Country Garden Services which is a leading property management services company in China. The company has strong parent backing, high revenue growth visibility and a high return profile thanks to its asset light services-oriented business model. The property management industry in China is still highly fragmented and offers ample opportunities for leading players to consolidate and grow.
An example of a discounter would be SK Hynix which is a leading semiconductor manufacturer of memory chips that is trading at trough valuation levels but could re-rate substantially when the DRAM cycle turns. Longer term, the DRAM industry has consolidated down to 3 players and with Moore’s Law slowing the likelihood of aggressive capacity expansion is low. On the demand side DRAM IP traffic will remain resilient bolstered by cloud computing.
An example of an incubator would be Tencent Music Entertainment. This is China’s dominant online music company but TME is still significantly behind its global peer, Spotify, on monetisation despite having more than 2x the users and even behind the online video companies in China. The company, and music streaming as a whole, has yet to prove out that it can be a sustainable and profitable business but we believe over time the negotiating power of labels should come down and margins should improve.
For investors thinking about investing in emerging markets, what would you say is the most important issue for them to consider?
Coming at this question from a slightly different angle, we believe two of the most important characteristics for an EM investor to possess are a long-term time horizon and a good amount of patience/tolerance to successfully ride out inevitable bouts of volatility. It’s important to understand that price volatility isn’t necessarily an accurate reflection of a company’s fundamentals, now or in the future. In fact, it is this detached volatility that often presents us with the best investment opportunities.
So, back to the original question. We think potential investors should take an introspective approach in deciding whether their time horizon and risk tolerance are a good match with the asset class.
How would you best describe the investment opportunity that you are pursuing?
The investment opportunity we are trying to pursue really starts with the EM consumer and the potential purchasing power of these people. We believe the size and runway of the EM consumer can drive decades of compounding and as a result we focus our opportunity set on these domestic demand businesses. We also believe that the market consistently underestimates the ability of high quality franchises to sustain their growth and as a result undervalues them over a long term time horizon so our strategy focuses on the principles of compounding through owning quality.
What excites you most about your role?
There are a lot of things that are exciting about the role but the main ones would be:
- The travel,
- The objectivity, regular feedback and continuous learning from the markets,
- The ability to help regular investors compound their capital for retirement.
As EM investors, at least before COVID, it was quite exciting to be able to travel to a lot of fast growing geographies to see first hand how that EM consumer is evolving and developing. It puts in perspective a lot of things you take for granted in the developed world. Investing is also a zero sum game and not only do you learn fairly quickly whether you’re doing a good job but the market system is complex and dynamic where the best investors are ones that are open minded enough to learn and adapt over time.
Lastly most of our FUM at the moment comes from the industry super funds and many of these super funds have younger employees that are relying significantly on their savings in these funds to provide them with a comfortable retirement and we certainly do not take that level of trust lightly.
2 funds mentioned
3 contributors mentioned
Patrick was one of Livewire’s first employees, joining in 2015 after nearly a decade working in insurance, superannuation, and retail banking. He is passionate about investing, with a particular interest in Australian small-caps.
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