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Emerging Market Equities: Buyers’ strike?

Cracks may be appearing in the great emerging consumer story. Martin Steward speaks to three managers that have scaled this edifice and offer different perspectives on whether it is time to jump off

Over the past two years the top-performing portfolio managers over three or five-year time horizons, in all markets, were almost inevitably running ‘quality growth’ strategies. This month is no exception.

Alex Homan

Alex Homan

Among the three strategies featured here, Fidelity Worldwide Investments’ is the most explicit about the orientation. As investment director in emerging market equities Alex Homan puts it: “Ultimately we are trying to protect our clients’ capital by investing in high-quality names, and also grow that capital by giving them access to what emerging markets are all about over the long-run, which is compounding attractive earnings growth.”

But at Unigestion, head of equities Alexei Jourovski makes a similar argument. Its emerging markets strategy is part of its stable of low-volatility products, evident in its exceptionally low beta of 0.70. But Jourovski emphasises that low volatility is not the be-all-and-end-all of the strategy, for two reasons.

First, asymmetric risk is important – that 0.70 average hides the fact that upside beta has historically been 0.80-0.90. “Clients who invest in emerging markets want to see performance – they are investing in growth markets, after all,” Jourovski observes.

Second, like Homan, Jourovski emphasises the focus on limiting the risk of loss, which makes Unigestion’s characteristic qualitative overlay very important for avoiding the regulatory, governance and valuation risk that historical volatility fails to pick-up.

“We are not big fans of the ‘low-volatility’ label because [in order] to reduce future volatility we need to consider many more indicators than the past volatility,” he says.

“Some part of risk can be measured by volatility or macroeconomic indicators, but another part is much more qualitative – and particularly important in these markets.”

Finally, the ‘quality’ characteristic is the clearest marker – next to a small and mid-cap bias – in the portfolio offered by Conrad Saldanha and his team at Neuberger Berman.

Something else that we have become used to is the sectoral bias in these ‘quality growth’ strategies. The ‘quality’ element tends to pull them away from highly cyclical sectors like semiconducters and autos, highly-geared sectors such as utilities, or sectors like banking and mining that exhibit both of those characteristics. The ‘growth’ element has increasingly focused on the consumer in the emerging world, leading to overweights in multinational consumer staples with significant emerging-market revenues, and a range of domestic consumer-facing names in the emerging markets themselves.

Conrad Saldanha

Conrad Saldanha

Again, this month is no exception. The low-volatility bias at Unigestion results in an overweight in utilities and an underweight in IT, but otherwise all three share a similar profile: underweight energy, materials and financials, and overweight consumer and healthcare stocks.

Reversal

But this is where the interesting questions begin. First, has the emerging-consumer story simply become too expensive to make money from? And second, is the evolving macro environment undermining the very premise of that story?

The leaders of the pack at First State Investments, whom we featured in this slot two years ago, have warned their investors to brace for a reversal of fortune. Jourovski also raises the alarm over some of the natural ‘quality growth’ biases.

“In low-volatility, quality sectors we take special care over valuation and interest rate sensitivity,” he says, detailing his portfolio’s low overlap with systematic low-volatility indices. “Many quality stocks have low volatility but many also have very speculative valuations, [which] could be harbouring future downside risk. We had some of the consumer-facing stocks, but we have started to reduce them now as we see risks appearing. Today, I wouldn’t pick them out as being representative of the portfolio.”

Saldanha insists that things are not too stretched. “The domestic story is slightly more expensive on a cash-flow multiple, but growth in both cash flow and earnings is faster,” he argues.

Still, he concedes that he has had to trim some Mexican consumer stocks as they have hit their targets, and that valuation has become an issue in some keystone positions – like Korea’s manufacturer and distributor of water and air purifiers, Coway. It has a 55% share of the domestic market based on cash-flow generating service contracts, and targets growth in other household appliances, but carries a valuation 2.5-times that of the broader market.

Saldanha says that his strategy’s small and mid-cap bias helps him maintain and even increase his staples allocation. The portfolio has almost 40% in companies smaller than $5bn, and in the emerging world these stocks have not exploded in the way they have in developed markets over the past two years.

“In small caps we are at a 5-10% discount on an absolute P/E basis versus large caps, but you can also find 3-5 percentage points of extra growth,” he explains.

But even here Saldanha concedes that there are consumer stocks long resident in the portfolio that have “seen valuations become a bit more challenging”, such as white goods manufacturer Haier Electronics, with its strong distribution network across third-tier cities in China.

As such, alongside the smaller-companies move, Neuberger Berman has been seeking

consumption-growth exposure through non-consumer sectors, especially industrials set to benefit from infrastructure spending, and healthcare names associated with over-the-counter brands.

“While the domestic consumption theme has become a bit over-played, it has been focused on consumer staples and we try to find the domestic theme across other sectors that are a play on local economic growth,” he says.

Healthcare is the strategy’s biggest sector overweight, and holdings include Jordan’s Hikma Pharmaceuticals, with a very strong MENA franchise in branded generics and injectables; South Africa’s Life Healthcare, focused on meeting local needs for low-cost nursing homes; and Mexico’s over-the-counter generics and personal care specialist Genomma Lab.

“That company distributes through its own sales channels in Mexico, where it is doing an excellent job back educating the customer about generics,” says Saldanha. “It is also looking for further acquisitions to grow its US footprint, selling mostly into the Hispanic community.”

Genomma Lab is only one stock, of course, but is this play on both emerging-market and US consumption a sign that recent macro headwinds have started to sow seeds of doubt about the emerging-consumer story? Economies are slowing, generally, and where there are current account deficits to fund, the prospect of QE ‘tapering’ suggests that external liquidity may now have to be replaced by domestic savings.

“We are underweight autos, the media names and the retailers,” says Saldanha, explaining his slight underweight in consumer discretionary stocks. “After seeing strong wage and disposable income growth over several years, the emerging consumer is now facing CPI ahead of wage growth and a slightly increasing risk of unemployment. We’ve seen a bit of tightening of discretionary spending in some markets like Brazil, India and Indonesia, where current account deficits have forced central banks to tighten.”

The same macro theme is to some extent behind the portfolio’s considerable underweight in Asia. “While we have been opportunistic in China, finding very attractive businesses that play into the policies for a cleaner environment and the focus on tier-three and tier-four cities, we have been a bit more cautious on some of the ASEAN countries because of the current account deficits and the downward pressure on currencies,” Saldanha explains.

Jourovski articulates similar concern about the top-down risk for countries with current-account deficits.

“The domestic consumption story is still good over the very long term but we have seen some investors become too optimistic, creating extra downside risk that is realised when some catalyst comes along for capital withdrawal,” he says. “If we take India [as an example of a twin-deficit country], a significant depreciation of the rupee caused the central bank to hike rates, which meant that local growth rates had to be adjusted downwards – bad news for companies sensitive to local consumption.”

By contrast, he points out, a weak currency is good for exporters with local-currency cost bases, whether it is an IT outsourcer like India’s Infosys with its US and European clients, or Taiwan’s semiconductor manufacturers TSMC and MediaTek, into which Unigestion has recently been rotating.

“These companies tend to have a lot of cash, good governance and reasonable valuations – especially relative to some consumer staples businesses in Asia,” says Jourovski.

These positions, as well as rotations into discretionary sectors like autos, point to greater cyclicality in the Unigestion portfolio as it pulls back from some of the valuations in staples and utilities. And Neuberger Berman certainly is not afraid to edge further into cyclicality, either – its top-three holdings are Samsung, Vale and TSMC.

“We’ve seen underperformance from emerging markets for a couple of years, initially driven by fading earnings from cyclicals since 2011,” says Saldanha. “We are probably approaching the end of that, and can look forward to a stronger underpinning. These more cyclical names have gone from being darlings to being ignored in the frenzy to get hold of consumer stocks, and can sometimes be found at near-distressed valuations.”

Structural

At Fidelity, Homan refuses to call time on the emerging-consumer story, insisting that the basic drivers of a young population with growing wealth and very low credit penetration remain in place.

“Do we still have an appetite for the emerging consumer?” he asks. “You bet we do. And we target the areas where we anticipate huge volume growth – which might be in consumer staples in relatively-poor Africa or cars and internet penetration in relatively middle-class China.”

While this strategy of the three has the biggest consumer-sector overweights, Homan’s statement about where volume growth lies suggests that, like Unigestion and Neuberger Berman, he seeks consumer exposure outside the traditional sectors.

Like Saldanha he goes for domestic consumer-facing healthcare (he owns a Chinese hospital operator), but also companies that play both the home and export markets (he also holds Mindray, the healthcare equipment manufacturer that competes against the US and European giants). And while the Fidelity portfolio is actually underweight telecoms, the stocks it does hold in that sector, together with an important part of its technology overweight, reveal a strong theme related to increasing mobile data use.

He agrees with Saldanha that there are many emerging mobile telecoms markets where frenzied competition for licences has destroyed margins.

“But there are certain markets – Russia being one of them – where there is less competition, rational players, and good valuations for fairly chunky dividends,” he says. “We are also starting to see average revenue-per-user from data rise because these guys don’t have fixed-line infrastructure to get online with.”

This is why companies like Baidu and Tencent (to which Fidelity has exposure through the ownership stake of its top overweight, South Africa’s Naspers) have been spending so much on their mobile platforms, Homan argues. Tencent’s WeChat social media business is starting to perform, and Q3 also saw Baidu deliver higher-than-expected mobile subscribers and monetisation. Its stock rocketed after months of underperformance.

“Baidu saw some margin compression through 2012 and a lot of investors panicked about that,” Homan says. “But it was because they had been investing in their mobile strategy – which is exactly the way to go.”

The consumer discretionary element of this – mobiles, internet access – points to the most important difference between the Fidelity portfolio and the other two. The sector is its biggest overweight – a significant 12.7 percentage points – versus a small overweight for Unigestion and an underweight for Neuberger Berman. Like the other two, this move is the flipside of profit-taking from consumer staples; unlike the other two, there is little enthusiasm for more cyclical and export-orientated names.

Its top overweights alongside Naspers are characterised by the likes of China’s private education services provider New Oriental, currently on a productivity drive that Homan likes, and Nigerian Breweries. The latter has a 70% share of the local beer retail market, which, given that neighbouring Ghanains get through four-times as much beer as Nigerians, can be expected to grow considerably. Margins should also grow as the capacity constraints of high fuel prices and poor infrastructure ease off.

How does the top-down story fit into this? Homan does not dismiss the turmoil that has erupted in current-account deficit economies, but he sees the currency depreciations, which make imported goods more expensive for local consumers and manufacturing more globally competitive, as having created a more stable environment to buy companies that he already liked at cheaper valuations.

This includes Cognizant, the IT outsourcer with its dollar and euro revenues and rupee costs – an equivalent to Unigestion’s holding in Infosys. It also includes autos, also favoured by Unigestion, like Tata Motors, which benefits from its rupee cost base. But most importantly, it means names like Brazilian fashion retailer Lojas Renner (many of its local-made brands now look very competitive next to expensive imports); and South African furniture retailer Steinhoff (which is actually picking up much of its business in Eastern Europe). The pattern is quite clear: discretionary names across emerging markets, and, in those countries that have been hit by depreciations, discretionary firms that sell domestically or internationally with very little external cost exposure.

“When fundamentally attractive stocks like these get sold down along with everything else in a market panic we are happy to add exposure and re-load our positions in them,” Homan says.

That tactic worked well in the bounce-back that emerging markets enjoyed during Q3 2013. While Fidelity managed to improve its ranking in the MercerInsight universe over three years, the other two slipped out of the top quartile. One might expect that from the low-beta Unigestion portfolio. But alongside stock-specific effects, it is tempting to conclude that Neuberger Berman’s lag in Q3 owes something to its more benchmark-neutral sector positioning and the relatively lighter weights to the consumer that that implies.

For now, the consumption story appears intact. Diversifying away from the valuations in those sectors might make sense, longer-term – but rising developed-market interest rates do not seem to threaten the thesis just yet.

“The structural drivers are still there,” Homan insists. “Sure, high level macroeconomic speculation and related currency effects probably put a dampener on the story in certain markets – but not everywhere. There are plenty of pockets across the world’s developing markets that are still delivering very healthy top-line growth.”

 

 

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