Somerset Capital finds a nice selection of tomorrow's mighty oaks and quality local businesses among emerging small and mid-caps, writes Martin Steward
In 2010 Somerset Capital Management LLP, the $1.2bn (€900m) London-based emerging markets boutique, won what can only be described as a dream mandate.
About two-thirds of its AUM came from the US - mostly endowments and foundations - with much of the rest from UK wealth managers. But it wasn't merely that this new mandate came from a market-leading UK pension fund.
"They simply asked us to create what we thought would be the best product we could run," says Timothy Hay, partner and portfolio manager for the new brief.
The result was a small and mid-caps strategy to sit alongside the firm's Dividend Growth, Large Cap and Small Cap emerging market funds. Two managed accounts total around $270m (€200m), and a pooled version followed in December, seeded by two US foundations.
The small-cap fund has been building a great track record since August 2008 - but once a holding breaches a market cap of $2.5bn the fund cannot add to it, and can hold it only for another 12 months.
"Ideally, we'd like to find good companies under $1bn and then hold them long-term, hopefully all the way up to $7.5bn - the loose upper limit for the new strategy," says Hay. "We're probably not going to add much value buying Petrobras; its investor relations team outnumbers the entirety of Somerset Capital. But we do a lot of travelling - it's our second largest cost item - and that really enables us to drill down into these smaller firms."
That results in a relatively concentrated, 60-stock portfolio, but also something of a tilt to domestic over export demand: healthcare, utilities and consumer discretionary are overweights; energy and resources are significant underweights. Against the likes of Petrobras in Brazil, Hay cites Valid, which specialises in chip-and-pin and other IT systems technology for banks and government agencies, but is also applying itself to inventory management.
In Peru, he notes that the "lovely little consumer staples business", Alicorp, punches above its weight in its domestic markets for everything from cooking oil to pet food. "They squeezed Unilever out of Peru some years ago," he recalls. "That's a completely different opportunity from the commodity-based companies which tend, often with the aid of the state, to evolve into the behemoths of emerging markets."
There are big businesses in the new portfolio - relaxing size limits was part of its raison d'être - but the logic for these positions is interesting: Hay talks of the desire to gain exposure to frontier markets while avoiding the "lobster pots" - illiquid positions that can trap you when markets turn sour.
"That meant removing the market-cap limit for frontier companies," he explains. "So, we have Bancolombia at $11bn, because we have re-classified Colombia as frontier. In South Africa we have MTN Group - market-cap $30bn - on the basis that over 70% of its revenues come from Africa ex-South Africa."
The portfolio is, therefore, generally underweight the larger countries, just as a function of its diversification. Significant underweights at the moment include China, Korea, Brazil, Russia, Mexico, and Indonesia. But the reasons for this positioning are an interesting mix of top-down and bottom-up.
Hay has a research folder full of desirable Brazilian small and mid-caps, for example, but has recently become concerned about macro risks like the politicisation of the once hawkish central bank under pressure from the exports lobby, and levels of consumer debt.
Political risk informs another small underweight in a big country - South Africa. Again, it has terrific small businesses with management that is "second to none", but while Hay is encouraged to see more worker-owned trusts being established to buy stakes in companies, he still worries about the tendency of oligarchs to be the chief beneficiaries of Black Economic Empowerment, and the populist turn in politics in response to persistent youth unemployment.
"At the back of every analyst's report on a company there is a page on the political and macro risk to ensure we don't buy companies in countries where a military coup is being hatched for the week after next," Hay notes.
Of course politics does not always have to have the drama of a coup. Alongside
some of Hay's more successful defensive healthcare picks, like Taiwan's St Shine Optical and Malaysia's Top Glove, sits Pharmastandard, which is suffering from talk of a ban of over-the-counter sales of codeine as the Russian government tackles addiction issues; and Slovenia's KRKA, whose revenues have been hit by fiscal austerity. "I made the mistake of underestimating the ability and willingness of European governments to cut back on prescription subsidies," Hay admits.
And political risk can work both ways. Just as the portfolio was being constructed, Hay picked up significant value in Peru as markets balked at the imminent election of Olianta Humala (whose 2006 election campaign guest-starred Hugo Chavez), fearing a massive hike in the 2% mining royalty tax. On closer inspection, Hay's team thought he would emerge as more of a Lula than a Chavez in office - and so it proved, with the royalty tax increasing only to 4% and the appointment of a technocratic government.
In Mexico, by contrast with Brazil and South Africa, Hay is relatively happy with the macro context but faces a challenge in finding decent companies on attractive valuations. The same is true of India, a slight underweight which Hay nonetheless thinks skews the P/E of the portfolio up to about 14 times (against the MSCI EM index P/E of about 11 times). "We're not really finding the value that we'd like in India, but my colleague has just returned, having identified some interesting new ideas," he notes.
This is where Somerset Capital's combination of feet on the ground and constant screening can pay off most clearly - helping to uncover gems in difficult markets. In Mexico, Grupo Herdez, which specialises in selling Mexican foodstuffs to its domestic market as well as US-based Hispanics and non-Hispanics, suddenly popped up in Hay's weekly screen for Latin American companies trading under 12 times P/E, with operating margins at 10%-plus and an average daily trading volume of more than $1m. It hadn't come up before because it was held disproportionately by a single owner and hardly traded. But when that owner's son - who managed his wealth portfolio - died, he began to liquidate, sending Herdez's daily volumes above $1.5m. As Hay puts it: "It's one of those companies that gets picked up and you think: ‘What's this? Surely it's too good to be true?'"
Hay describes the strategy as 70% bottom-up and 30% top-down. As well as influencing country weights, the top-down element can influence the risk characteristics of the portfolio. Currently beta is relatively low, for example, partly thanks to a preponderance of good dividend payers - the payout ratio sits at 38%. That resulted from the bearish mood that accompanied portfolio construction in early 2011, which sent the team rummaging through Somerset Capital's dividend-growth watch list.
"It's a house view that dividends are a pretty good way of investing, in any case," says Hay. "Ask Indian management what their pay-out ratio is and they say: ‘What, isn't growth enough for you?' Well, I'd like to break the news - you can grow and pay a dividend. In Brazil, if you want to list you have to pay out 25% of your bottom line - and you can't say those companies haven't enjoyed phenomenal growth. Dividends discourage quick-buck strategies and align interests."
CEO Dominic Johnson, who left Lloyd George Management to found Somerset Capital in 2007, observes that the firm's Dividend Growth fund currently offers a 4% yield from growing companies. "It's a myth that all emerging market companies are five years old and fixated on breakneck growth," he says. "They are deep-rooted, often family-owned, with management that is long-termist because they think inter-generationally about their wealth."
Still, looking closer at the defensiveness of many of the portfolio's sector overweights one finds that, while there are some smaller healthcare and staples businesses, many are larger-scale utility and consumer-staples conglomerates like First Pacific (telecoms, infrastructure, foodstuffs) or Beijing Enterprises (water and gas, brewing), or straightforward energy companies like Kazmunaigas (which is sitting on $5bn of cash). The proper conclusion to draw is that it is wrong to overstate the importance of top-down or sector-based defensiveness or income in this portfolio. In fact, the best numbers during the turmoil of August 2011 were posted by two very stock-specific growth opportunities.
One was Korea's NCSoft, currently receiving warm reviews in tests of its forthcoming ‘Blade & Soul' game. The other was E Ink of Taiwan, an ePaper specialist and sole provider of the backlighting for Kindle screens. It also worth noting that, while NCSoft has been specifically targeting Chinese gamers for its new release, the Kindle is hardly a consumer-staples or emerging-consumer story. Success in these markets from one quarter to the next does not necessarily map onto easy investment themes - even if the long-term trajectory is clear enough.