Emerging & Frontier Equities: A turn in the cycle
There is a tussle between ‘quality’ and cyclicality among the top strategies in emerging market equities. Martin Steward looks at how three portfolios are shaping up for a possible turn in risk appetite
Rarely does the investment performance survey from Mercer reveal such a stark result –
especially in such a hotly-contested asset class as emerging market equities. Our top performer over three years to Q3 2012, Vontobel Asset Management, delivered a full 210 basis points of annualised return more than the runner-up, First State Investments. But over the course of Q3 itself, Vontobel’s placing fell precipitously, leaving it 197th out of 222 strategies.
There is something clearly beta-related here – other portfolios clearly suffered a similar fate – and it is not difficult to identify: Q3 marked the beginning of a ‘risk-on’ rally and Vontobel’s portfolio is self-consciously ‘quality growth’. Its initial screen looks for companies with low debt, high return on equity, free cash flow and stable margins, and its core universe adds requirements for defensible franchises and high-quality governance standards.
While its dividend yield is respectable at 2.4%, thanks to its high level of payout, its forward P/E ratio is a fairly racy 18.5 times (versus the MSCI EM index’s 11.2 times).
“Higher quality names can trade at higher multiples, especially in emerging markets,” says portfolio manager Rajiv Jain, unapologetically.
The only time investors were able to get their hands on the quality franchises that Vontobel likes at truly low multiples was in 2001-02, after successive Asian, Russian and Latin American crises had sapped their appetite for emerging markets. At all other times they price in a good part of what Jain calls “the long tail” of growth that can be expected as companies penetrate new markets.
“Unilever Indonesia trades at 40 times earnings – but you could have bought it 15 years ago at a similar multiple,” says Jain. “It has compounded at such great rates because the tail is still long because penetration is still low. It’s something that’s not appreciated, even by dedicated emerging markets investors.”
Vontobel is willing to pay up for these ‘long-tailed’ businesses – and who could blame it when it can achieve an ROE of 31.5% through its portfolio, and five-year EPS growth of 19.2%, both well in excess of the benchmark’s?
While Jain says that some positions have recently been trimmed as valuations became stretched – he cites AmBev – he notes that other stocks that have compounded earnings at 20%-plus over the past five years, growing to major positions as dividends were re-invested, have seen their prices barely move. One, Baidu, China’s answer to Google and favoured by Vontobel for massive growth potential surrounded by considerable barriers to entry, has made money for the portfolio over the past three years, despite a 36% plunge in its stock price since April. While this is an outlier, it demonstrates the importance of total return for this strategy and explains its consistently low volatility and five-year beta of 0.80.
“We were at the bottom of the pile over three years coming into 2007,” Jain concedes. “We are generally underweight China and we are generally underweight commodities. We underperformed quite a bit in 2009. It comes with the territory.”
Despite the very different results revealed by the Mercer data, there are many similarities between Vontobel’s strategy and that of Carmignac Gestion. Both articulate their respective quality biases as an alpha contributor, and single out Brazil from the past couple of years as an example of how bottom-up stockpicking can turn an apparently toxic country overweight into a success story. Vontobel’s big exposure to Brazil finished 2011 up slightly even although the market crashed by a third.
Didier Saint-Georges, a member of Carmignac’s investment committee, points out that a purely top-down view of Brazil would have resulted in a major underweight, but that once sectors like energy, banks and utilities have been stripped out, the remaining 25% of the Bovespa looks much more promising. Echoing the ‘long tail’ philosophy at Vontobel, Saint-Georges says: “Our very strong top-down view on Brazil is that it remains very under-penetrated in terms of infrastructure – so this is an area where we will try to find stocks such as CCR, which owns private highway concessions, that we like.”
In addition, Saint-Georges confirms that Carmignac does not have “too much of a problem” with higher P/E ratios. Its portfolio exhibits volatility (15%) and beta (0.74) even lower than Vontobel’s and, like Vontobel, it carries a huge overweight in consumer staples.
“This is really characteristic of the style of the portfolio manager, Simon Pickard,” says Saint-Georges. “The fund tends to have a bias towards ‘quality’ companies that do not require external funding, and has exhibited very low beta.”
So why did the Carmignac strategy only fall to 36th place over Q3 2012, rather than 200th? There are ways in which it differs from Vontobel’s – namely its construction as a kind of barbell, with quality consumer staples at one end and some cyclical technology exporters like Samsung and TSMC and, especially, miners like Zambia’s First Quantum Minerals and Turkey’s Eldorado Gold, at the other. Describing its top holding, Mexican bottling, packaging and logistics conglomerate FEMSA, as “a key building block in our portfolio”, Saint-Georges explains: “It is the kind of position that balances our exposures to technology cyclicality in stocks like Samsung and the mining cyclicality that we have at the moment.” Carmignac’s key regional overweight – 15% in Africa versus 8% in the benchmark – perfectly exemplifies the theme, pairing its second-biggest holding, South African supermarket chain Shoprite, with its fifth-biggest, Mali’s Randgold.
The Somerset Capital strategy finds itself somewhere between Vontobel’s and Carmigac’s. While it holds the least number of stocks, it represents a more diversified balance between growth and value, quality and cyclicality, evident in a lack of the big sector bets that characterise the other two, and also the fact that both its dividend yield (2.2%) and its P/E ratio (14-times) are lower than Vontobel’s.
“We tend not to invest in companies on the promise of high growth such as those that you find in parts of China, India and Indonesia,” says lead manager Edward Robertson. “We feel that there’s growth, anyway, in emerging markets, so the key thing is how you value it.”
Like Saint-Georges, Robertson agrees that there are companies that can deliver sustainable growth and free cash flow, to which valuation multiples provide a poor guide.
And its current value-tilt, an important aspect of the rotation of the portfolio over the last 12 months, does not mean a turn from quality. It is, rather, a change of time horizon, and a turn toward cyclical quality.
“We’ve seen good-quality cyclical companies trading at low valuations, with which we are comfortable as longer-term investors,” he explains. “There might be soft earnings in the short term but, in any recovery, companies with strong competitive advantages should generate earnings growth.”
So while Somerset does have a (small) overweight in consumer staples, it also carries more marked and unusual overweights in energy and materials (even Carmignac, with its gold miners, remains underweight the latter sector).
Somerset has broad exposure to materials. Some, like cement producers Semen Gresik in Indonesia and Grasim in India, are locked into secular domestic demand. Others, like steel producers Posco in Korea and Gerdau in Brazil, are more conventionally cyclical and export-oriented. “At the moment Posco’s earnings are in the doldrums, but the company is trading at 0.7 times book value,” says Robertson.
In energy, alongside names like China’s CNOOC and Thailand’s PTT E&P, positions in Lukoil and Rosneft give the portfolio a Russia overweight that contrasts with the underweights at both Vontobel and Carmignac. Saint-Georges and especially Jain dislike what they see as political uncertainty and poor corporate governance – as well as the nexus of the two: over-reliance on political connections for corporate success. “The capital outflows from Russia are a pretty good indicator that we aren’t the only ones that feel uneasy about this kind of thing,” Jain notes.
“These concerns are not overplayed,” Roberston concedes. “But both Lukoil and Rosneft are cheap and undergoing change. Lukoil’s capital management is improving, and that could allow a re-rating.”
By contrast, Robertson worries that some consumer staples and other defensive sectors have become “very expensive”. Two positions sold during 2012 were among the priciest – India’s Sun Pharmaceutical (six times P/B) and Wal-Mart de México (5.5 times, and a top 10 holding in Vontobel’s portfolio). FEMSA is the only staples name in Somerset’s top 10.
“Again, we look for a more cyclical element to consumer-related businesses at the moment, and we are able to buy those at better valuations,” says Robertson.
This includes Somerset’s top holding, Indian car maker Maruti Suzuki (although Robertson says that since it was bought a year ago its 50% appreciation has taken it close to fair value) and names like Brazil’s Duratex, a wood panelling and furniture manufacturer that was hit by the downturn but maintained a tight balance sheet and made some synergistic acquisitions.
Like all value-tilted strategies, it includes its share of uncomfortable positions: Robertson singles out Chinese department store chain Parkson Retail, which has been trying to roll out new stores while being hit by the consumer spending slowdown more severely than Somerset expected. “The company generates a lot of cash and pays a good dividend, yielding 3.8%, but it’s in a tricky position at the moment as it struggles to regain some operational leverage,” says Robertson.
There are no such compunctions about staples valuations at Vontobel and Carmignac. The former has 42% in the sector, a whopping 34 percentage point overweight; the latter has 32%.
Such a big active weight in a sector almost necessarily leads to similar active risks elsewhere. In Vontobel’s case, it pops up as an 18-percentage-point overweight in India; its top 10 holdings includes ITC and Hindustan Unilever.
Despite some reservations about over-diversification (into the hotels and greetings cards businesses, for example), Jain likes ITC’s management and its track record in protecting its key market position – “essentially a monopoly” – in tobacco.
“Philip Morris has been trying to break into India forever, but while Marlboros are available, they are nothing like as popular as the local brands,” says Jain. “But the FMCG business, especially branded foods, is also working well and could become the next driver of growth.
For a long time we did not think that was possible because so many companies had tried and failed. Success would be big, because penetration in packaged foods is incredibly low in India.”
India simply offers many more domestic consumption opportunities than many of the other countries, Jain adds: “China would be a similar story, but not many of the larger, higher-quality names are listed – there isn’t ‘Unilever China’ or ‘Procter & Gamble China’, there’s only one beer company, and so on.”
This is an important point, as it emphasises how the consumer can be accessed through sectors other than the traditional staples and discretionaries. Even in India, Vontobel’s top 10 includes consumer-related financials such as Housing Development Finance Corp and HDFC Bank, for example.
Carmignac’s Saint-Georges makes the point explicitly. “Exposure to the theme varies from one market to the next,” he explains. “In China the focus is the part of the consumer spend that is rising as a proportion of GDP; in Brazil what’s under-penetrated is investment as a proportion of GDP, the very opposite of China. So consumer stocks are not going to be an overweight across the board.”
While Carmignac’s third-biggest holding is Want Want, China’s leading manufacturer of rice cakes and flavoured drinks, consumer-related exposure in Mexico, Peru or Indonesia, for example, is much more geared to playing the low penetration of personal credit, leading to key positions in Grupo Banorte, Credicorp and Bank Rakyat.
Similarly, Jain, who manages Vontobel’s global as well as EM portfolios, emphasises the importance of global analysis – particularly for accessing the emerging consumer via multi-nationals. The portfolio’s top two holdings, BAT and SABMiller, are both UK-listed; HSBC comes in at number seven. BAT owns about a quarter of third-largest holding ITC; Vontobel’s eighth-largest holding AmBev is controlled by Belgium-listed global brewing giant Anheuser-Busch InBev; and its tenth-largest position is WalMart de Mexico. The weighted-average market cap of the portfolio, $40bn, is close to the benchmark’s and double that of Somerset’s, indicating the tilt towards these multinationals – but Jain says that the strategy is more exposed to domestic consumption than ever before.
“BAT takes 65% of its earnings from emerging markets, HSBC is moving towards 75-80% Asia and emerging markets,” he observes. “A company like Samsung or TSMC, by contrast, sees 70% of its earnings coming from the US and Europe.”
This goes some way to explain why, unlike developed-market ‘quality’ portfolios that tend to be stuffed with tech and industrial names, Vontobel and Carmignac’s carry clear underweights. And, just as the consumer sector tilt leads to an India country-tilt for Vontobel, so this sector position leads naturally to big 13 and 11 percentage-point underweights to Korea and Taiwan, respectively. Similarly, Carmigac’s big regional bet is overweight Africa and underweight Asia, especially Taiwan, Malaysia and Korea. Robertson at Somerset puts the problem succinctly: “The trouble with emerging markets is that we don’t really have any Apples.”
The conditions that enabled Korea’s economy to produce globally competitive companies like Samsung, Posco, Hyundai and Kia are changing. Cyclically, China is slowing down; structurally, its companies compete for mid-level manufacturing on both price and technology – forcing incumbents to expend capital on untested products and businesses.
Many would argue that Samsung is losing its way relative to, say, Posco, which is focusing on high-end steel products, or LG Chemical, which is doing something similar in battery systems for hybrid cars.
This leaves industrials looking quite binary at the moment: some of the quality manufacturers are trading at high multiples but there are others that are very capital intensive, with quite stretched balance sheets.
“If you want to look for good-value ‘quality cyclical’ characteristics, as we do, there are better opportunities in other sectors,” says Robertson.
Turn to Vontobel and Carmignac, and you see the same move away from traditional commoditised manufacturing names towards industrials that have an infrastructure story (Saint-Georges mentions “bottlenecks” in India and Brazil) or a domestic-consumption tilt (Jain picks out Asian Paints, dominant in India thanks to its state-of-the-art local distribution network and strong brand).
“Is Asian Paints cheap?” Jain asks. “It’s not being given away at 30 times next year’s earnings, but we feel that you can look at names like Sherwin Williams in the US to get a sense of how successful the paint industry can be, even where the housing industry has been in bad shape for a long time.”
In tech, it seems much more difficult for these managers to find stocks they like.
“We are overweight tech in our global portfolios,” says Jain. “[But in EM] these are commodity businesses where profit margins have been declining consistently for a decade, with the exception of TSMC. Even Samsung, which had first-mover advantage in smartphones, doesn’t have a long-term edge. What IP does it have? The software is Google’s Android: if Google launches its own phones, Samsung might have an issue: it’s on 10 times earnings and it deserves to be. It addresses its growth problem by investing in healthcare – but what has that to do with the way they’ve made their money over the past decade?”
Carmignac also has a four-percentage-point underweight – but interestingly, Samsung is its seventh-biggest position, and it is there thanks to the same kind of global analysis that Vontobel emphasises in its process.
“We try to cross-fertilise our global and emerging markets analysis as far as we can – and it is particularly important in tech and energy,” says Saint-Georges. “Until the beginning of this year, our global IT portfolios had Apple as their biggest position. But pretty early on, our global tech analyst concluded that while Apple would certainly continue to do well in terms of earnings, Samsung would be the key beneficiary of the maturity of Apple’s product cycle. We will have to wait and see whether this does indeed turn into a longer-term trend.”
Here is a genuine alpha decision on the part of these two strategists. Carmignac not only likes Samsung above other tech companies in Asia (which it generally dislikes), but above Apple, the global star of the sector. Vontobel dislikes Samsung even more than it dislikes the rest of the EM tech opportunity.
It is an important position – but more as an exception to the rule than anything else. The key differentiators at the top of our emerging market equities table appear to be style-based. Looking past the Samsung position, Vontobel and Carmignac share much more in common than either does with Somerset. Carmignac’s is essentially a low-volatility, ‘quality’ portfolio like Vontobel’s – its cyclical names act more like a hedge than an outright active position. Somerset’s, by contrast, is actively rotating in preparation for outperformance by more cyclical businesses. The fact that both sets of strategies compete for places at the top of the performance table today tells us a lot about the uncertainty of the inflexion point that we seem to be experiencing, not only in Europe and the US, but globally.