Q: What is the history of the fund?

Within OppenheimerFunds we have a large Emerging Markets Equity Strategy, managed by Justin Leverenz, with assets under management of approximately $48 billion. Our goal was to create a portfolio that was complementary to our flagship strategy and different from all the other 300+ actively managed EM funds.

Prior to joining the EM team, I spent 10 years as a global investor specialized in small- and mid-sized growth companies. I gained a reputation for identifying transformational growth in the Healthcare, Technology and Consumer Discretionary sectors. In 2013, I was hired to launch a small-and-mid-cap EM fund in partnership with Justin. I spent 18 months mapping the investment universe—spending at least half the time on the ground in EM countries with the goal of designing something different. We launched the Oppenheimer Emerging Markets Innovators Fund (EMI) on June 30, 2014. 

What is exciting about EMI is that it’s a very different portfolio, both in terms of content and style. Almost 85% of all companies in the main MSCI EM Index are large cap. There are only around 400 companies in EM with market caps above $10B, but there are over 5,000 small- and mid-sized companies in the EM universe, with market caps of $500 million to $10 billion. With EMI’s focus on investing in innovative businesses, we’re also taking advantage of a big structural shift in the EM opportunity set. The number of companies within EM in the high growth, high profit sectors of Consumer, Healthcare and Technology has tripled over the last ten years and doubled over the last five. Since the fund’s inception, those sectors have accounted for between 65-75% of invested assets. Given this concentration, we believe we are uniquely positioned to benefit from structural growth in emerging markets going forward. 

Investors see our portfolio as a diversifier. EMI’s active share is over 90%. Our overlap with the MSCI Emerging Markets Index is only 4%. As a result, we’ve taken some market share from large cap portfolios and now have around $1.2B in assets.

Q: What else differentiates you from your peers?

We seek to invest at the intersection of strong earnings growth and positive impact. We perform exhaustive due diligence to avoid companies with exploitative labor and environmental practices. Whenever possible, we align ourselves with the aspirations of EM people. These include education, financial inclusion, affordable healthcare and environmental improvement. That’s a unique element of our strategy. 

We also offer more concentrated exposure to entrepreneurial culture in developing economies and the dynamism of these fast-changing markets. Whiles many large-cap companies sell their products globally, our small and mid-cap companies are more focused on domestic or regional growth. 

Finally, we don’t invest in commodities, which is almost unique among our peers.

Q: Which emerging markets do you focus on?

We invest in 30 countries. Our largest allocation is in China. Other major exposures are South Korea, Taiwan, India, Brazil, and South Africa. About 4% of the portfolio right now is in the frontier markets. 

We have underweights in Brazil and in South Africa. We have observed an inverse correlation between natural resources and innovation, where countries with a lot of natural resources tend to spend their money on the development of those resources, while countries with no natural resources have been quicker to develop innovative industries. 

In emerging markets, country allocation has been one of the biggest determinants of relative performance over the last several years. As an example, in 2016 we underperformed in part because of the big commodity rally. But we were also heavily underweight in Brazil during the impeachment and subsequent removal of President Dilma Rousseff. We did not respond quickly enough to the change in the country’s macro environment. This mistake taught us to be more responsive to significant macro/political changes and more thoughtful about our relative country weights. 

Q: What core beliefs drive your investment philosophy?

We are growth investors looking for highly profitable companies. We believe seeking innovation allows us to identify durable competitive advantages that lead to earnings growth. We care about valuation. We use a proprietary EPS growth model with a 3- to 5-year time horizon.

Since we understand the importance of local context, we spend a lot of time on the ground in emerging markets. This has the added benefit of helping us to identify opportunities early. 

We also have a lot of imagination and can see a future that looks very different from the present. This allows us to identify transformational growth companies with the ability to rapidly take market share or create new markets. 

Q: How would you describe your investment process?

Each year we screen the entire investment universe and divide the interesting companies from those we want to avoid. We eliminate about 80% of the EM universe in that process. Our screening is both qualitative and quantitative. We use metrics like profitability, sales growth, balance sheet strength and business essence, including competitive position. We don’t invest in highly-regulated businesses like commodities, telecoms or utilities.

We use structural growth themes to help identify opportunities. Some of these themes have existed since the inception of the portfolio. Other themes are new, like industrial automation and augmented or virtual reality. We analyze companies in clusters. As an example, when looking at the education theme, we’ll examine education companies around the investible universe to identify the best ones. This approach provides context and better understanding of each business.

When meeting companies in their local markets, we aim to understand both advantage and opportunity set in order to determine how profitable the business could be.

In assigning a valuation, we assess for direction and magnitude, because we try to identify companies whose valuation could more than double over the next three years. We look to buy good companies at great prices. 

Q: Could you give us some examples that illustrate your research process?

Since the fund’s inception in 2014, we have been very interested in identifying biosimilar drug makers with compelling science. Biosimilars, which are replicas of biological drugs, require strong development capabilities and are difficult to manufacture. Over the next few years, a number of blockbuster biological drugs will be coming off patent. These drugs, which treat diseases like cancer and inflammatory diseases, generate over US$100B in revenue. For many diseases, Emerging Market companies are leading the way in biosimilar development. We seek to identify the companies with the best scientific capabilities in each of the countries where the biosimilar industry exists. 

The search for the best science led us to invest in Biocon in India, Celltrion and Samsung Biologics in South Korea, and 3SBio in China.

Biosimilars offer a good example of how companies with high earnings growth potential can also benefit local populations—in this case, by providing cutting edge drug therapies at more affordable prices. And as these drugs start to sell in the U.S. and Europe, we believe they will help solve the problem of ballooning healthcare costs worldwide. 

Q: Can you give us another example from a different industry?

We invest in K-12 education companies in Asia and Africa. Parents in Emerging Markets spend on private schools or after-school tutoring to provide higher quality education for their children. This industry is growing fast and the demand is relatively inelastic. Brand and content quality matters. In countries like China, outcomes are measurable through higher standardized test scores or entry into prestigious universities.

Our positive view on this theme has led to investment in companies such as New Oriental Education, TAL Education, Bright Scholar Education, China Maple Leaf Educational System and Four Seasons Education in China, as well as Curro Holdings and Stadio Holdings in South Africa. 

Q: What is your sell discipline?

We value stocks on a 3- to 5-year horizon and portfolio turnover is approximately 30%. Since the EM space is volatile, we have to be responsive if new information causes our investment thesis to change.

If a company becomes overvalued or the position size becomes too big, we trim it. We also trim if the company gets too large. Valuations appreciated significantly at the end of last year so we have been actively trimming to reduce our exposure to the larger companies, while investing in smaller companies and in new ideas. 

Q: What is your portfolio construction process?

Our largest position right now is 3% and our top 5 positions represent about 12% of the portfolio. We don’t run a concentrated portfolio; right now we own about 110 names. We’ve consistently invested between 65% and 75% in Healthcare, Technology and Consumer. We don’t invest in energy, metals or mining. We are unlikely to have positions in telecom and utilities. In terms of geography and country allocation, we tend to be closer to our peers and the benchmark but have an overweight in Asia vs. Africa or Latin America because we find more innovation in Asia. Our benchmark is the MSCI Emerging Markets Mid Cap Index.

Q: How do you define and manage risk?

Since its inception, the portfolio has had a low beta relative to the benchmark. Part of the reason is that benchmarks are very cyclically allocated. The large-cap focused MSCI EM Index actually has a higher beta than the MSCI EM Mid Cap Index. This is counter-intuitive. Typically, smaller cap funds are riskier than their larger counterparts, but this hasn’t been the case during EMI’s almost four-year existence. Aside from the more cyclical allocation of the MSCI EM Index, with its higher relative investments in commodities, financials and real estate, flows into passive EM funds magnified the volatility of the Index. In 2017 the flows into active emerging markets funds were $11.4 billion and into passive EM were $42 billion. Because almost all the money in passive instruments flows into funds that replicate the MSCI EM Index, the valuation and volatility of large cap index components has risen. 

We try to reduce relative exposure to political risk, by remaining cognizant of our relative country weights. 

Additionally, we think about the impact of higher interest rates on the portfolio. Our companies are net cash positive, which should create some relative margin of safety because they don’t need debt to grow and their profitability wouldn’t be impacted by rising interest rates.

Of course, as growth investors, multiple compression risk is another factor we must consider. That is why we use a PEG analysis and keep our position sizes relatively small. We try to avoid unnecessary volatility, believing that we can generate return for investors in a relatively responsible way. Our standard deviation is lower than our benchmark.