In today’s low-growth world, companies that can grow their earnings attract a premium. Whether it’s emerging Australian companies like Afterpay and Appen, big US tech firms like Zoom or Apple, or even low-but-steady growers like Johnson and Johnson or Sydney Airport, prices today are at a level that wouldn’t have seemed reasonable in other cycles. But one area where reasonable valuations can still be found is emerging markets, and David Paradice, founder and Managing Director of Paradice Investment Management, believes he’s got just the team for the job.
“When you're comparing some of our businesses, such as Ali Baba and Tencent, relative to some of the leading internet companies in developed markets, the valuations are probably not all that dissimilar, but the growth characteristics that are provided for in the emerging markets are usually much faster.”
Edward Su and Michael Roberge have worked together on emerging markets portfolios for six years now. David believes they embody the principles of accountability, responsibility, and performance that he’s always looked for in the other Paradice funds.
In this video, Edward, Michael, and David discuss how they filter their investment universe down to identify pockets of opportunity, how valuations in emerging markets compare to those in developed markets, and which countries are currently throwing out plenty of investment opportunities.
David Paradice: Hi. We have Ed and Mike here from our emerging markets team. They're based in San Francisco. We haven't done a new product within Paradice Investments for 10 years. We've been going for 20 years. This is our fifth product. All our other four products have performed very well since inception. The key things that we look for, when we're researching or doing due diligence on our team, is that they are focused on accountability, responsibility, and performance. Generally, our products are limited capacity, so they need to be happy to do that. They need to focus on performance for clients, and capital preservation. It's really important for us that we continue to deliver good numbers, but we are concerned about the downside of investing in stocks.
Ed and Mike, do you want to just talk briefly about your background?
Edward Su: Sure. Mike and I met about nine years ago. First, we met at Thornburg, in Santa Fe, where we were on two separate teams, but working actually quite closely right next to each other. And then about three years later, we got the opportunity to leave with one of the PM's at Thornburg to launch an emerging market strategy for a firm called Artisan Partners. And that's where Mike and I, again, were for about three years working as associate portfolio managers.
Then in 2017, we had the opportunity to meet, Kevin Beck and yourself and learn more about Paradice. I think what appealed to us was the philosophy was well aligned to kind of how we thought investing should be done. Some of those things that were quite interesting to us were the fact that there was high accountability, high autonomy, and the ability to kind of focus on what matters, which is a performance for the client.
David Paradice: I think what's important, too, is that these products are generally limited capacity type products, emerging markets because they can be significant. But if you have limited the funds under management, as with all our funds, we can focus on the performance. The emerging markets is a very big index with about 26 countries. How do you filter or breakdown where the funds go in that universe?
Edward Su: Yeah, it's a good point. You know I think it's a very disparate list of countries in the index. What we would say is it's hard to draw too many generalisations. Many of the countries are in different stages of development. For our purposes, I would say that firstly we are bottom-up focused, not top-down asset allocation driven. Secondly, we also focus on the underlying economic exposure as opposed to the geographic domicile of the companies we invest in. And thirdly, we're very much focused on the domestic demand of the companies that we're investing in. We're focused on companies that benefit from the rising per capita income levels over time, which is what we think EM investors are really excited about, as opposed to some of the export driven opportunities that had been a big part of the index previously.
At the country level, in practice, we have been more overweight China, India, and Brazil. Those are some of the larger participants in the index with very deep capital markets and very good business models. And then we're also very light on Korea and Taiwan, as we don't view those markets to be all that emerging and quite similar to developed markets.
David Paradice: I remember when I was investing in small caps many years ago. There are lots of opportunities in Australian small caps and I looked through your portfolio and I can see similar traits that I look for in a growing company. Can you explain how the valuations in emerging markets compare to developed markets?
Edward Su: Looking at it from a valuation perspective. If you look at just the forward PE - I'm choosing PE just because that's a metric that is widely followed and widely talked about - the forward PE for the MSCI Emerging Markets Index is about 12 times, while the developed market indices like the S&P 500, are 18 times. The world indices are somewhere in between.
What's interesting to us is if you take a step further and you look at the sector multiples, it tells a much different story. At the headline basis you might think that EM is very cheap on the surface, but when you look at where that valuation cheapness is coming from, it's really coming from sectors like financials, energy, materials, and utilities. Those aren't really areas that we prefer to invest in. We prefer to focus more on the consumer side of things, the internet businesses, the healthcare, the discretionary side.
So for us, if you were solely focused on valuation, paying no attention to the quality of the business model, the growth characteristics, then you might say, well let me go buy the energy businesses, the financial businesses because that's where the valuation arbitrage is. What we would say is that low valuation doesn't really equal lower risk. And some of these companies are actually some of the worst offenders of the ESG side of things. They're also businesses that aren't really run for shareholders. They're businesses that don't earn above their cost of capital. We prefer to focus on the businesses that are, and that's where we think active management can really play a role.
David Paradice: How do you manage the risk in the portfolio?
Michael Roberge: In terms of the emerging markets being a volatile place, I think sometimes people equate volatility with risk. But in reality, risk is, in our opinion, in a practical investing sense, more the risk of a sharp downward movement in a stock that results in permanent capital impairment. So, what we're trying to avoid is permanent capital impairment.
In terms of the asset class itself, it's very hard to paint with a broad brush, the emerging markets, cause it's very heterogeneous. You have 25 plus emerging markets, each with their own political situation, their own macro backdrop, their own rule of law. So, you need to look at each individual country. From a macro perspective, we have a framework that allows us to kind of look at each situation independently and determine where the risks are and what kind of hurdle that we need to be compensated for that risk.
At the stock level, it's all about business model for us. We're very focused on companies that help us mitigate the risk by having sustainable free cashflow generation, high returns on invested capital. We're looking for very well managed balance sheets that are appropriate for the business that they're involved in. At the portfolio level we're looking to mitigate risks both through a macro framework and through a very specific stock selection process. Finally, we like deliberate diversification across geographies and across sectors to further dampen the overall risk of the portfolio.
David Paradice: I noticed that you do have a reasonable weighting in consumer discretionary and the consumer, not so much weighting in technology. With regards to the volatility compared to other emerging market funds and the index itself, why do you think that you guys are different to the standard emerging markets portfolio?
Edward Su: There are a number of things. When we look at building our portfolio, we're really focused on mitigating that or minimising the correlation profile that we have. One of the ways that we go about doing that is that we're not willing to just pay any price for any business. I think it's very easy to say you're a quality fund and you're willing to pay up for all the businesses that we would have heard of and create a portfolio of Alibaba, Tencent's, TSMC's, Samsung's. But for us, while that might be the majority of our portfolio, we do have a portion of our portfolio where we will invest in some of the more cyclically driven value names out there, where there is still a structural growth story underpinning them.
We might also invest in some of these companies that are going through some sort of turnaround where they're not being viewed yet as a compounder, but where we can see a noticeable change at the company level. So those are the things that we'll look at to try and diversify our correlation profile and ensure hopefully that we have kind of a smoother return over time.
David Paradice: It's interesting, I do see the portfolio is like similar to some of the Aussie funds. A lot of the big companies that exist in Australia were once smaller companies. That's the opportunity set for investing in something like an emerging markets fund or high growth, small cap portfolio. You've spoken recently in the papers about an exposure to China. Can you talk about that and why you see that as still an existing opportunity?
Michael Roberge: Yeah, so you're right, China is a large portion of our portfolio. I think one of the things we really like about China is the fact that they're leapfrogging the West in terms of technological innovation in many regards.
One area that really comes to mind for us is the payment sector. In China you have over 800 million internet users and already you have 80% of all transactions done through mobile. This is way ahead of the West in terms of penetration of mobile payments. This is being enabled by very large, innovative companies like Alibaba, Tencent, that are basically changing the game in terms of how payments are done in China.
What's very interesting is China actually skipped the whole credit card penetration step. When you go to China, it's actually kind of foreign to them for you to come and try and pay with a credit card. I remember last time I was there, I got looked at very strange when I presented a credit card for payment at a convenience store, because the vast majority of payments are done through mobile, and mobile payments is just one example of the innovation that's taking place and it's actually outpacing the West and creating unique investment opportunities for us.
You also see it on the artificial intelligence side of things and the fusion of AI and FinTech and the list goes on. I think from a long-tail growth opportunity, the play here has really increased productivity, new business models, disruptive business models and leading the way in terms of tech innovation.
David Paradice: What would derail your enthusiasm for investing in China?
Edward Su: Yeah, there's a couple things that would worry us. The first would be, China has been more focused recently on opening up their financial markets, which is good for us. But if China were to ever go to the other extreme and somehow changed their rule of law, or somehow instruct some of their VIE (Variable Interest Entity) owners to begin to take back some of the companies that are listed in the U.S. under this VIE structure. That would be a huge red flag and that would lead to a lot of capital destruction, and probably set China back and also make us quite wary about investing in China.
The other area where you would need to watch out for is the overall debt problem that China has taken on since the global financial crisis. Their debt to GDP has gone from essentially about 160% to over 300% today. And it seems like for them to continue to grow, they will have to continue to use leverage as a tool. So for us, what we would be watching out for is any meaningful deleverage from them that would slow their growth, any big issues on the property side, which a lot of people use for savings and wealth creation, those things could begin to signal a turn in the overall economy.
David Paradice: What other countries would you be looking, or are you looking at, at the moment, which generate great investment ideas?
Edward Su: Brazil is an area that we're quite excited about. Latin America, over the last decade has shrunk in terms of size and contribution to the overall emerging markets index. And, Brazil particularly has also shrunk, but we're seeing some signs of turn-around in Brazil. The main thing is they've had a change in government, so they have this new president, Bolsonaro, who's in place and he's been able to more recently pass-through this pension reform bill. And that's the start of hopefully more reform to come through.
Our hope is that should bring down the country-risk premiums. That should bring forward some more foreign investment and that should hopefully position Brazil on a path of longer-term growth. And within there, there have been a number of stocks that we have invested in that have provided us with good alpha.
David Paradice: Why do you use PE ratios as opposed to some other valuation methodology when you're comparing the value of your portfolio to the index?
Edward Su: For us that's just a widely reported statistic. So therefore, it's just easy for us to be able to pull up the PE of the index and the PE of emerging markets versus developed markets.
In practice, when we're thinking about evaluation, we make a number of adjustments to what we think the underlying cash flows represent, and for us our focus has always been on cash earnings. That's what we think drives value over time. So we look for what the underlying growth could be in the cash earnings.
For us, on the valuation front, multiple is usually a secondary discussion for us. What we care about is the quality of the business and the ability for that business to compound over a long period of time. Because when you're holding a business for 5 years, 10 years, 15 years, really what's going to drive the outperformance is that underlying compounding as opposed to the multiple re-rating from 10 times to 15 times.
David Paradice: If you can get companies that can grow with generally slow GDP growth, but reduce the volatility and the risk, it comes up with a reasonably well-performing portfolio. If you were to briefly compare some of the developed countries' multiples with some of the emerging markets' countries' multiples in similar businesses, are they quite different?
Edward Su: Yes. For example, usually when you're comparing some of our businesses such as Ali Baba and Tencent relative to some of the leading internet companies in developed markets, the valuations are probably not all that dissimilar, but the growth characteristics that are provided for in the emerging markets are usually much faster. But there is a country risk element to where EM can be more volatile. There are more things that could go wrong from a political environment, from a currency perspective, that we need to be aware of and think about. I think that's why we like to maintain a broad-based diversification over the portfolio where we're not being subjected to too much undue risk from a single security.
David Paradice: Great. I think it's a fantastic way for people to compound their money over the long term. So, thank you very much.
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