Q: What differentiates this fund from other emerging markets funds?
The fund was established in 2012 as part of the BMO Financial Group, which believed in our approach to investing in emerging markets. LGM Investments, which is the sub-adviser of the fund, has over $5 billion under management, with about $2.5 billion of the assets in the Global Emerging Market fund. The strategy has about 10 different vehicles and the BMO LGM Emerging Markets Equity Fund is one of them.
A differentiating feature of the fund is that we do what we say we do. We invest in quality companies and our return metrics substantiate that statement. The return on invested capital of the companies in our portfolio is twice higher than that of the benchmark. These companies are not levered at all and that is a substantial difference.
We do not follow the benchmark. Constructing the portfolio with the sight of the benchmark has never been our ambition. For example, we don’t have any exposure to Chinese banks, Samsung or TSMC. Our set of holdings is different, because for us the main decision is not whether to overweight or underweight something, but whether we invest in a quality company. I believe that this approach distinguishes us from other managers.
Another differentiator is that our portfolios tend to behave more defensively in different market conditions. While we do not aspire to perform great in all market conditions, we tend to outperform when the markets are flat to down.
Q: What core beliefs guide your investment philosophy?
We view ourselves as business owners. We don’t just buy shares on the stock market; we buy stakes in business, because we aim to compound our clients’ capital in the long term without taking unnecessary risks. With this objective in mind, we invest in companies that can compound their intrinsic value over the long term. These companies are typically high-quality companies with dominant businesses, which have high moats and generate high returns and a lot of cash flow.
The key point is that they allocate capital in a way that allows them to continue to generate high returns. When there is extra cash, they share it with minority shareholders and that makes us fully aligned with their capital allocation. We never compromise on that factor and we also never overpay for the companies that we hold.
We also believe that it is important to recognize the company culture. That factor is often overlooked, but the distance from philosophy to outcome is reinforced by culture. I believe that our culture distinguishes us as an organization. We are driven by conviction and not by coverage. That means that we attract enormous talent that is self-motivated, bright and driven. It also means that we have disrespect for hierarchy in organization. Our structure is flat; everyone is an analyst and is empowered to bring the best ideas forward.
We have a focus on quality, but that focus is derived from our objective to compound our clients’ capital. We invest with an absolute mindset since we are not a relative-performance manager.
Q: How does your philosophy translate into your investment process?
Because we are a conviction-driven fund, we don’t need to have a view on every stock in the universe. We take a large universe of over 20,000 stocks and distill it to something that we can understand. The majority of our ideas are generated by our travels and interactions with companies. We like to see companies showing strong metrics like return on invested capital, balance sheet strength, margins, profitability, free cash flow generation, etc.
We also do some filtering of the universe based on some of the mentioned factors and we take a note if something looks interesting, like a company that is a dominant franchise that sold off for some reason. On our next trip, we include that company in our travels. We need to understand the competitive dynamics, so we talk to competitors and industry consultants; we perform channel checks and visit stores and factories. During these trips we need to achieve not only an understanding of the potential company, but we also need to form a holistic and independent view.
If we like what we see and hear on the trip, we would do further due diligence and analyze how the business generates its returns or cash flow and whether the returns are sustainable.
We build an understanding of the market and the industry and we ask ourselves where the industry would be in 10 years and what is its growth potential. We also assess the culture of the company because that’s an insight on future capital allocation. Is the management likely to use capital in a value-destroying acquisition? Is it prudent with money? If there are no projects that need financing, would they release the capital to the shareholders? That’s a big part of the qualitative analysis. Then, of course, we understand how much we are paying for the business.
Before we make an investment, there are three things that need to be done – the investment documentation, the discounted cash flow (DCF) model as a way to value the business, and the environmental, social, and governance (ESG) analysis. DCFs give us an idea of how much the business is worth. We take a long-term view of the business and aim to understand the drivers behind the ability of the company to generate a lot of cash. That process is necessary to understand how much we will be paying for the business.
The ESG analysis is integrated in our process, because corporate governance is paramount for understanding capital allocation. If we cannot trust the company in allocating capital, then we wouldn’t invest.
Q: How is the team organized and who makes the final investment decisions?
Ultimately, the portfolio managers decide what goes into the portfolio, but prior to the decision, we discuss it at the investment board. That’s the best way to make sure that we invest only in high-quality companies. In fact, if the board discusses has a positive view on a company, there are good chances that it will be included in more than one portfolio.
Although we have a small team, there are many people involved in the process. We travel together; we have follow up conference calls with the managements and discussion within the team. When the idea is presented to the investment board, it is open to all the 20 people in the company and that leads to a productive discussion. The board makes sure that the process and the selection criteria are followed. Only then we can be certain that our objective of owning high compounders is achieved.
Because we own the businesses for many years, we look for companies with a clean balance sheet. When we buy and hold a company over five to ten years, its debt on the balance sheet, particularly if it is in the wrong currency, could hurt our franchise. And the quality businesses typically don’t have any need for levered balance sheets.
Q: What is your investment universe in terms of geography and sectors?
In our view, the best companies that were able to compound their intrinsic value over the years, have a domestic focus and are located in markets where the consumer is coming off low economic base. In markets like India, Indonesia, and Vietnam, the consumers get richer every day and spend their cash on branded products. Typically, these are the businesses that we own. They may be simple businesses that support the livelihood of consumers in emerging markets.
Overall, we tend to find more quality companies among domestically oriented businesses in consumer discretionary, consumer staples and financial services. We don’t target these sectors, but we tend to favor them, because they display higher-quality characteristics and ability to generate cash and returns.
Q: Do you have specific requirements for the scope of compounding earnings?
No, we do not have a specific number of how quickly we want a company to grow or what type of compounders it should have. We make sure to find a company with a dominant business, which generates high returns and cash, and operates in an environment where it can grow. In emerging markets, that’s the environment that we want to see.
Because of their dominant position and pricing power, these companies typically have the ability to pass on inflation to the final consumer, so their margins and earnings don’t get destroyed. We keep in mind that we need to grow our investments in U.S. dollars and that’s why we focus on companies with high branding power and the ability of passing on inflationary pressure better than the competition.
Q: How do you differentiate between earnings growth and compounding earnings?
Philosophically, if a business grows at 8% or 10% every year for the next five years, that is compounding. We wouldn’t penalize a company if one year it achieves less than we expected as long as there is an explanation. It depends not only on the market and the industry, but also on the management and who is behind the business.
For example, since 2015 we have owned India-based Yes Bank, which has a compounding ability of about 25% or 26%. At the same time, the compounding ability of Hindustan Unilever is in single digits, but the stock is trading at high valuations. When we analyze the ability to compound, we take into consideration not only the sector, but also the ambition of the owners and the ability of the management to execute in the context of the market and the market growth potential.
Q: Do macroeconomic factors affect your strategy?
We are a bottom-up investment house, but we do pay attention to macroeconomic factors. Typically, we differentiate between important and not-so-important macro factors. A not-so-important macro factor would be a factor related to the U.S. monetary policy, for example. The more relevant macro factors take place inside the country, such as local monetary or fiscal policies, which have a direct impact on the investment.
Q: What is your buy and sell discipline?
We understand what the quality companies are and when these companies hit a bump on the road, we would analyze whether it is just a bump or a structural change. We are active investors; we usually know these companies, so we can make a decision rather quickly. When the price is too high, we may patiently wait for it to drop.
When it does, we can buy into the companies or use the opportunity to add to our existing positions. It’s not that we are contrarian, but due to our active travel and the ability to identify quality companies ahead of time, we know them well and we take action when opportunities present themselves.
Q: Could you illustrate your process with a few examples?
A good example would be Mr. Price Group, a South African retailer. It is a well-known brand for local consumers who don’t have the ability to buy expensive clothes. The company focuses on increasing sales densities as opposed to growing by opening new stores. That strategy has enabled it to double its margins and returns over the past 10 years. The management team is committed and focused. That’s what attracted us to Mr. Price and we were lucky to become shareholders when there was a bump on the road. We bought the stock when it was down 40% in U.S. dollars at the end of 2016 and we were rewarded as shareholders.
They hit a bump when they didn’t have the necessary inventory in terms of fashion and when the weather was not on their side. For the first time in their long history, returns dropped and the market began questioning the strength of the business model. After talking to the management and analyzing, we realized that it was a short-term problem and that the company can quickly regroup and continue to generate high returns and to give cash back to the shareholders.
It took the management some time to regroup, refocus, and fix up a brand that was underperforming. It also got the supply chain in better shape, which resulted in even better cash flow generation. That’s what we like about the management and what ensures us that this company will continue to be a high cash-flow generator. The earnings exhibit double-digit growth, despite the unexciting macro and challenging polity of South Africa. Mr. Price Group doesn’t have any leverage on its balance sheet.
Q: How do you go about building the portfolio?
We typically have a concentrated portfolio of 35 to 40 names. The exposure to undervalued high-quality companies could be anywhere from 3% to 7%. Fairly valued companies start at a modest position of 1% to 3%. We would not buy companies that are overvalued, but such companies would be on our watch list until there is an opportunity to include them in the portfolio.
Our benchmark is the MSCI Emerging Markets Index, but we don’t consider its constitution. Unlike the benchmark, we have a significant exposure to consumer names and financials, while we don’t own anything in materials or energy. We have very little in IT, because the IT companies in emerging markets are the ones that make components for Samsung and Apple. They are not the brand bearers, but OEM providers, so their margins and returns are squeezed and the cash flow is patchy.
On the country level, there is also a big deviation from the benchmark. For example, we don’t own anything in Korea, but we have a high allocation to India of about 20%. By benchmark standards, we are underweight in China. Overall, the portfolio is intuitive and bottom-up driven. The cheaper the high-quality company is, the higher weight it could get into the portfolio.
Q: How do you define and manage risk?
We have a different view on risk. Our first consideration is to know our companies. We control risk by knowing our holdings and meeting with their managers several times a year. Second, despite being a bottom-up fund, we also consider how much capital could be allocated to an individual market.
For example, we would need to think whether allocating 20% to Turkey in the context of emerging markets is a warranted decision because of the other choices we have. Then we need to consider what that allocation would mean to the U.S. dollar return that we generate in the particular market. We discuss risk at the portfolio managers meeting from the perspective of how much capital is allocated to the market.
