Q: What is the history of the fund?
Principal Funds launched its first international fund in 1987, and even early on, this included emerging market investments. Then, in 1995, we established our first dedicated emerging markets fund, followed by this mutual fund, which debuted in 2000. It is managed by a team of emerging market specialists.
The International Emerging Markets Fund provides core exposure to emerging market equities through rigorous research and bottom-up stock selection. Our goal is to achieve competitive risk-adjusted results. A majority of our client base consists of retirement plans, including defined benefit, defined-contribution and individual retirement accounts.
Q: What core beliefs drive your investment philosophy?
We believe that the market is slow to recognize change, especially positive change, leaving expectation gaps we can exploit. For instance, investors tend to react swiftly to negative news, but slowly and skeptically to improvements in a company’s earnings. We endeavor to take advantage of these types of mispricing. If we identify positive trends and catalysts earlier than the market consensus, we can purchase that investment at a relatively attractive price.
We are fundamental investors. We have a systematic approach leveraging proprietary technology to identify where positive change might offer relative value, whether in the profit-and-loss or the cash-flow statement, and whether it’s sustainable. That’s the key—we’re not looking for change in the short term. It has to be a fundamentally sound business whose value the market is overlooking.
We don’t find specific price targets particularly useful. To us, valuation is a moving target, relative to competition and peers, and to the market itself, and depends on the growth expectations and monetary conditions.
Q: How do you assess if a company is mispriced?
One example is a company in Brazil, called Magazine Luiza SA, a retailer of light and electronic goods with about 800 stores and a $1.2 billion market cap that has grown its Brazil footprint through acquisitions. They went through a fairly difficult period about three years ago where, operationally, they had overextended themselves and ran up losses for a year, and the market devalued their stock. But the company was moving in the right direction, entering the e-commerce business and increasing its channels of sales, adding credit business which is now about a quarter of their revenue line. It was a blip, not a sustained situation.
When things get worse, the market overextends and prices at the bottom of the cycle, and when things look good, like they do now, the market overextends and may overprice. The question then becomes less about valuation more focused on our buy and sell discipline. We want to buy when the market is pricing downward. We want to sell when the market prices upward, or if we see extended exuberant growth that looks unsustainable, or an acquisition strategy that might push them to become the largest retailer in Brazil, where too much is priced into the stock.
We are not only students of fundamental analysis but of behavioral finance. The pillars of our philosophy and process is how we align those two skill sets. We distinguish between a generally good company and one that’s undergoing positive, unrecognized change, and being disciplined in avoiding common behavioral traps that can trip up even the most experienced professional investor.
Q: What is your investment process?
Ours is strictly a bottom-up process. Our quantitative screen filters roughly 3,000 investable companies within emerging markets, looking the highest alpha opportunities, roughly the top 20%, and we single out 70 or 80 companies with the strongest potential for an expectations gap in relative value that looks sustainable.
Our 10-analyst team, which is organized by global emerging markets sector, conducts analysis on the top 20% focus list (each has roughly 200 companies to analyze, at any point in time). As industry specialists, we know many of these companies well already and understand key industry drivers, political and economic impact. We evaluate specifically where any change is coming from: earnings, cash flow, balance sheet, or management. We talk to management and conduct industry, channel, and competitive analysis along with the necessary financial statement analysis.
We model out the key earnings drivers of a company to make our case, present it, and input the case thesis into our online Portfolio Manager Workbench system, which is accessible to all team members around the globe. Within the emerging markets team, we debate whether this investment thesis is a relevant and compelling investment for the portfolios. If the thesis is accepted, we buy a position. Analysts and portfolio managers talk daily, reviewing existing and potential positions.
The daily discussion amongst the portfolio managers centers on risk and portfolio construction. We run three different buckets of strategies—global emerging markets, Asian regional, and China related funds—so for each stock we assess our conviction and risk considerations, and which strategy it’s most relevant to, by reviewing each strategy’s risk parameters and existing portfolio composition. Deciding to buy or sell a stock, and how much of it, boils down to three pillars: conviction, risk perspective, and the stock’s liquidity profile. While we are benchmark aware from a risk management perspective, we are not driven by the benchmark’s weighting as much as by those three pillars.
One of the biggest pitfalls investors fall into is the view that a good company is always a good investment. It’s not just the level of profitability but the direction of profitability that determines our success.
Q: How do you analyze the operations business?
We follow the money. We evaluate the strategy and direction of a business by how it deploys capital, by understanding what drives the business owners in terms of capital needs. A fundamental question one should always answer is who owns the company, what drives them, and what do they demand from this asset.
For example, if the owner prioritizes capital return, whether it’s the government or an individual or family, one can expect to see a capital return model, either buying back shares or paying dividends, with less emphasis on reinvestment, and their business would suffer as a result.
If the company is largely publicly owned, in which case management is focused on maximizing shareholder value, then we expect that company to invest for growth and return less capital, until it reaches a point of saturation and capital spending starts to decrease.
A business either relies on cash flow or capital deployment to grow. It’s not just about profit and loss, it’s not just the cash flow statement or balance sheet—it’s putting all of that together and following the flow of money to determine whether the company is doing what it said it would do, how well it’s doing it, and how the market values it.
Q: Can you provide some examples?
If we look at the IT sector, the market effectively values such companies as long-duration assets. Alibaba Group Holding Ltd., for example, has been increasingly investing in its balance sheet and overall investment. Alibaba’s balance sheet has grown about four-fold in the past three or four years. Half of that increase is investment, while the other half is cash and investment in their operations. The market pays a fairly high multiple for the capital the business deploys in future growth. The market isn’t paying for current earnings because the company is investing as much in its current business as it is accumulating cash. It’s investing in the future.
On the other extreme, mining companies are busy deleveraging, and their capital expenditure plans have disappeared. The market is valuing them based on how much capital they return to shareholders and how much they deleverage their balance sheet. For both those extremes the market is willing to pay a higher multiple because management is doing what the market wants.
If Alibaba started returning all of its capital to shareholders instead of deploying it for future growth, they would not have the multiple they have now. And if the mining companies did what Alibaba is doing, and started building and opening up mines and levering up versus returning capital to shareholders, their valuations would be a lot lower. One must follow both management strategy and how the market views it, and it’s done by following the money through the business itself and seeing what the business is doing.
As an organization, our ESG (environmental, social, and corporate governance) engagement is becoming a formal part of the process. Improving governance begets better valuation multiples, and vice versa, but at the same time, in emerging markets, that also speaks to the importance of focusing on trends versus levels.
Today, if we look within any industry, European-based companies tend to score better than those in the emerging markets companies, and the U.S. and Japanese companies tend to fall in between. But while some of these emerging market standards might be lower than those in Europe, companies in emerging markets have more runways for improvement, which provides another source of added value for our clients.
Q: How do you construct your portfolio?
There are just over 90 companies in the portfolio—it’s diversified, but by no means a closet hugger. Emerging markets is a very top-heavy universe, and mega cap companies are chunky weights in those benchmarks, so we are thoughtful about how we position around that.
By and large, we pursue an all-cap strategy. One of our competitive advantages has been delving more into the small and mid cap spaces than some of our peers, and, most importantly the way we look at risk from a multi-dimensional perspective. We don’t engage in active short-term market timing, and generally keep cash balances at a minimum. The overall beta profile of the portfolio is close to one (1) at all times so that stock picking drives results rather than bold calls on macro themes. By design, 80-plus percent of our relative returns are derived from stock picking, rather than country or sector allocation. Year-to-date, our stock selection comprises 95% of our outperformance.
The individual country, sector, and stock allocations depend on client needs, but the broad rules of thumb are plus or minus 5% at the country and sector levels (for larger countries and sectors we can go plus or minus 10%), and at the stock level we generally limit concentration to 2% or 3% over the benchmark weight. For segregated accounts we can tailor to higher-risk/risk-tolerant and less risk-tolerant parameters, depending on the client needs.
We avoid extreme overweights in any particular area, or forced exposures to areas that we don’t particularly like, and use more of our latitude on the underweight versus the overweight side.
Q: How do you define and manage risk?
Multiple levels of risk exist, from the stock research and selection levels down to portfolio construction.
At the portfolio construction end, we look at risk two ways: through the portfolio’s factor exposures, like momentum or earnings, and macro factors, like currency or commodity risk; and via exposures in terms of market cap, valuation, earnings growth, etc. We quantify this and update it every day, using our own internal risk model.
Another way we look at risk is to use the same quantitative model we use to find investment ideas (making this unique to us) in order to minimize the risk in the portfolio relative to our model. We assess daily if are we overweight or underweight any exposure to a level that adds too much risk of reversal.
Yet another level of risk lies at the stock level, and that’s an iterative process of the fundamental analysis, determining if our level of conviction and thesis still hold, what the market thinks of that thesis, and the fundamental analysis level to confirm whether, at the stock level itself, the investment is appropriate.
