Q: Would you give us some background information on the fund?

We’re primarily an institutional firm; we manage money for large institutions and this fund is one of our vehicles. 

I have been running the emerging market strategy with my own team since 1997. My background has been in the industry, including commercial banking in the mid 80's to the early 90's, which were the early days of emerging market debt. Then I moved to the equity side as an analyst at Principal Financial Group. In 1994, I was offered an opportunity with Lazard Freres to start the first emerging market institutional equity product as part of a team of portfolio managers. 

In 1997, I started my own firm with partners, which merged with Trilogy in 2005. Ever since 1997, the strategy has been managed in the same way, with the same team, with me being the primary decision maker. So the strategy has a track record of more than 20 years.

Q: What is the mission of the fund? How does it differ from its peers?

Our goal is to find and invest in companies with the ability to generate attractive return on capital and above average growth. We screen the companies on a sector basis and we would invest in any sector if we find the right company.

A main differentiator of our firm is the global view and understanding. We believe that even in emerging markets, the world is moving towards companies and industries competing globally against major players. Even in primarily domestic industries, such as banks, the understanding of how the industry works globally is important. 

Our process is primarily bottom-up, although the team includes people with strong track record in macro risk management and top-down views. Bill Sterling is our CIO and he founded Trilogy in 1999. He has a PHD in Economics and has worked on macroeconomic analysis his entire career.  He works closely with our bottom-up analysts to incorporate any potential macro risks into the analysis of specific companies. So, we assess the downside risk in the particular companies, which could be affected by the top-down macro views. 

Q: When investing in emerging markets, what are the main opportunities and challenges?

The main driver of opportunity is the concept of catching up with the developed economies and establishing systems and institutions. As the emerging economies catch up, the potential for higher wealth rates is created, because incomes and productivity increase as companies and markets become more efficient. In some cases, the economies become more productive because they are managed in a new way.

The other driver is rooted in the very sizable market opportunities. Some of the emerging market economies have the largest potential markets due to the size of their population. Obviously, the two markets that represent this opportunity are China and India. There are high rates of economic growth, as the economies have become more efficient and the companies have become more competitive globally. That also creates strong employment. As a result, significant part of the population has more income, and that creates opportunities.

The challenge is the lack of track record for many of the companies and the managements. In some cases, the governments are less stable. Although on a macro level they are trending towards the developed markets, they can be still volatile and with high inflation.

Sometimes leverage issues could impose a challenge. In some countries, the disclosure may not be as transparent as in the developed world. Another issue is corporate governance, because the managements don’t have experience in dealing with public shareholders and tend to prioritize the interest of the minority controlling shareholder groups. These are some of the natural challenges in the emerging markets class. 

Q: What is your investment philosophy?

The two key elements of our philosophy are growth and valuation. First, we look for companies that can sustain attractive earnings growth. Second, the valuation has to be right in terms of upside potential relative to downside risk. That’s why our philosophy can be summarized as growth at a reasonable price, or GARP.

We believe that earnings growth is a key driver of potential stock returns. In our experience, the companies able to sustain above-average earnings growth, also have the ability to deliver attractive stock returns. Our process is structured to identify such companies. 

The other GARP component, reasonable price, requires valuation and risk management. We aim to quantify risk at the individual security level, so we analyze what can go wrong and what the key risks are for each company that we own. If some of those risks materialize or turn out to be worse than expected, what would it mean for the business? What would be the impact on margins, ratings, growth, and profitability, if their competitors become more aggressive on pricing, for example?

We quantify the potential downside risk at the company level and we come up with a pessimistic case scenario and price target. So, when we select the stocks, we don’t just look for better upside potential, but we evaluate the potential upside return relative to the downside risk. 

Q: How does this philosophy translate into your investment strategy and process?

The first step of the process is to narrow down the universe of potentially thousands of companies. We use quantitative screens to look for companies that meet specific criteria to be identified as GARP. These criteria include the company’s track record in return on equity, earnings growth, relative growth, cash generation etc. We also screen for certain metrics on the valuation side.

The other approach is our day-to-day qualitative fundamental work. We have an investment team of about 20 people, including 13 bottom-up analysts, with plenty of experience in their respective industries. Each year we conduct over 1,000 meetings with company managements all over the world, because we also run a global equity fund. 

We have accumulated substantial experience in identifying and comparing companies with attractive business characteristics that are good at executing cost control, utilizing technology, etc., or companies that are poised to deliver strong earnings growth in the medium term.

So, using quantitative screening and qualitative work, we narrow down a universe of 5,000 investable companies to about 200 companies. That group of about 200 companies is the working pool of ideas for the next level, which is the due-diligence, or the fundamental analysis of the companies. 

Q: What key characteristics do you look for when screening the investable universe? Could you share some examples of your quant screens?

As a starting point, we eliminate the companies with excessive leverage on the balance sheet, or companies with more than 60% of debt-to-capital ratio. Of course, that refers to the non-financial companies, because the threshold is different for financial companies.

Leverage is important, because companies with stretched balance sheets and high leverage have more downside risk during unexpected macro shocks, which come to emerging market economies more regularly than we would like to see. There is a long list of companies that went out of business in economic downturns because of excessive leverage.

Another important screen is proven growth metrics, or a set of historical factors. We also have a set of forward-looking factors to achieve a balance between traditional and early-stage growth companies. 

For the traditional growth companies, we look for strong returns on equity relative to their peers in each sector. If we are looking at consumer discretionary, for example, we’ll examine how all the companies in that sector rank in terms of return on equity, and look for those that rank in the top 30% of the sector. 

The superior track record in generating returns on capital is an essential factor for GARP funds. The companies that sustain high returns on equity have the ability to compound value for the shareholders at a more rapid pace. That’s why return equity is one of our key metrics.

Another important metrics is the history of earnings growth. We examine the normalized earnings growth for the last five years to see how a company is ranked in the sector. Again, we look for the top-ranking 30% of the sector. We also select the ones with the lowest historical volatility of earnings, because they are able to sustain longer and higher growth.

Forward looking, we search for strong cash flow generation. The difference between reported net income and operating cash flow helps to select the companies that are better at converting reported earnings into actual cash. Growing receivables or inventories, for example, could potentially result in severe write-downs at unexpected times. 

We also look at the earnings improvement potential and we examine analyst revisions over the last 90 days to search for companies with strong revisions relative to the sector.

Overall, between the quant screens and our fundamental day-to-day work, we identify about 200 companies with GARP-like characteristics that we can take to the next level.

Q: Would you highlight the next step, the fundamental analysis?

The goal of the fundamental analysis is to understand the positioning of a company within its sector, the major competitive threats, the macro-outlook in its markets, the regulatory factors that could potentially impact the company, the quality of the management, etc.

Our analysis takes all of these factors and we come up with our own forecast on the earnings and the cash flow. We use that forecast and the historic earnings for the valuation of the company. For each company, we consider the potential profitability over the next three to five years and, based on that analysis, we come up with a price target. 

A unique feature of Trilogy is that we have been doing this work under three scenarios. The first one is the base case, or the assumptions that we consider most likely. Based on these assumptions, we come up with a base-case price target.

The second one is evaluating the downside risk. For us, a big part of risk reduction is quantifying the downside risk at the security level. This is where we try to understand the key risks for the company and to quantify them. What are things that can reasonably go wrong? If these risks materialize, what would this business look like? What would be a fair valuation based on that scenario?

Then we can compare the base-case potential return with the downside return. So, if we’re looking at two companies with similar upside potential, but we find significant difference in their downside scenario, the one with the lower downside risk will be more attractive. 

The third scenario is the optimistic case. We do this work across all sectors and for all the companies that go through the due-diligence process. The three scenarios result in three price targets that we call a return distribution. The companies with the most attractive return distributions are included in a sector buy list. 

The sector buy lists represent our best ideas for each sector and are a key tool in constructing the portfolio. In that process, we can compare companies across sectors, countries and regions based on the framework of potential upside return relative to downside return. This process steers the portfolio to the areas where we find more attractive ideas with better upside relative to the downside.

Sometimes we find more ideas in one particular sector, or in a few sectors, or in some parts of the world. Our sector and geographic distribution is a reflection of our bottom-up work. So, although we do the stock selection on a sector basis, the bottom-up process drives both sector and country exposures. 

For example, in 2007 the Chinese market had gone through a bubble and many stocks were trading at more than 40 times earnings. A year earlier, MSCI China stocks had been trading at about 13 price-to-earnings, which was in line with the emerging market universe. But during in 2006 and 2007 many stocks went up 200%, which led to the high multiples.

Our exposure to China at that time was quite low, because the stocks were becoming more expensive and we were exiting Chinese stocks. The downside risk was becoming more pronounced relative to the potential upside and, in many cases, we didn’t see much potential upside left. Our weight in China in September 2007 was close to 3%, which is very low compared to the 17% weight of the country in the MSCI EM universe at the time. 

Q: Can you provide some examples of specific holdings and their investment merits?

One of our larger positions is the internet search company Baidu. We have owned the stock for three or four years already and have been following Baidu since its initial public offering in the U.S. 

Because of our global sector view, we had already analyzed and owned similar companies in the global and emerging portfolios. In the past, we had owned Google in the U.S. and Naver, the leading search engine in Korea. The industry was very interesting as it was taking share from traditional advertising media and becoming a very cost-effective advertising vehicle. In that growth industry, once a company had established a dominant position, it was quite difficult for competitors to erode it.

As we were working on Baidu, we saw many similar characteristics with Google in the U.S. and Naver in Korea. But although we liked the business, the competitive position, and the growth story, during the IPO the valuation quickly became too high. We had to wait until 2011, when the stock became more attractive. The stock has remained relatively flat for two years, while earnings were still growing with more than 30% annually. That meant that the P/E was coming down and we started a position in early 2011. 

Q: How important is diversification in your portfolio construction process? Do you have any geographic or sector limits, and what is the maximum position size?

As I mentioned, our team has been in the industry for a long time and we were among the first to acknowledge the importance of proper diversification. Anyone can be wrong, so certain risk controls in the portfolio are necessary. On the other hand, we also understand that to outperform the benchmark, you need to have positions that can generate alpha. 

We are benchmark agnostic and we have a lot of flexibility in terms of sector and country exposures. For countries or sectors that represent more than 10% of the benchmark, we can have twice the exposure of the benchmark. If consumer discretionary has 11% weight in the benchmark, for example, we can have exposure of 22% to that sector.

For smaller sectors or countries, our risk control limits the exposure to 20% in absolute terms. For example, Mexico has weight of 3% or 4% in the benchmark. Even if we find plenty of interesting ideas in Mexico, our exposure cannot be more than 20% of the portfolio.

That strategy has given us the flexibility to work in areas that we find attractive. We also do not have any required minimum exposures by sector or country. In the case of China in 2007, when many stocks were trading at high multiples and we weren’t finding many stocks with attractive upside/downside potential, our strategy would have allowed us to have zero weight. 

At the individual security level, our risk guideline is 5% maximum position size, except for companies that constitute more than 5% of the benchmark. Right now we think Samsung Electronics is quite attractive in terms of the fundamental outlook for the business, combined with compelling valuation. Currently this position is slightly higher than 5% of the portfolio, but still below the risk controls limit for exposure.

Historically, we have held between 70 and 100 stocks. Over the years, the portfolio has been well-diversified, but it can be overweight in the areas with more interesting ideas within the guidelines that I mentioned.