Exploiting Behavioral Inefficiencies in Emerging Markets
Q: What is the history and the scope of the fund?
The fund was launched on November 1, 2013, but our firm has been investing in emerging markets since 2010. I have been dealing with many of these markets for more than 10 years and became the portfolio manager on January 1, 2017.
Under the emerging markets strategy umbrella, we manage the mutual fund and separate accounts. We manage a total of about $150 million in the strategy, while in the mutual fund we manage assets of about $40 million.
Q: Which part of the emerging markets do you focus on?
A Japanese company with significant assets in China and Asia would qualify, as well as a company listed in the U.S. that generates most of its revenues from Latin America. We believe that having such investing flexibility gives us as active managers an edge over the emerging market ETFs.
Q: What are the main challenges of investing in emerging markets?
First, there are language barriers, so we need to have a strong and deep network on the ground to navigate those markets. That network includes various company contacts, industry experts and analysts.
The other challenge is related to the information flow and analyst coverage, which is much smaller than in the developed markets. For example, the average number of sell-side analysts covering a stock in the emerging markets is four, compared to 21 for stocks in the S&P 500 Index and 16 for the stocks in the developed MSCI EAFE Index.
However, these challenges create significant opportunities for active managers, who have the infrastructure and the capabilities to capture these informational inefficiencies. Emerging markets account for 85% of the world’s population, about 25% of global equity market cap and roughly 15% of the MSCI ACWI Index. They continue to grow both in terms of their economies, as well as in terms of the number of listed securities.
At the same time, the asset class is clearly underrepresented from a global perspective as U.S. investors have less than 5% of their portfolios in emerging markets. The asset class is trading at much lower multiples than the U.S. equity markets and is undervalued relative to its historical levels and to the developed market benchmarks.
Q: What core beliefs drive your investment philosophy?
We have a value-based approach and our portfolio exhibits lower earnings and book value multiples compared to the benchmark. Academic research has proven that value investing works in emerging markets, which we believe can be attributed to the behavioral biases of investors. While emerging markets grow faster than developed markets, investors tend to overpay for growth in these markets.
That dynamic allows value to work significantly over the years. Another core principle is that our alpha or additional return to benchmark comes from security selection, not from unintended currency or country bets.
Q: How do you define value?
That definition varies in the different industries. The value approach incorporates downside protection as we need to understand our potential for permanent capital loss in a bear-case scenario. We utilize a combination of factors to determine the fair value of a particular opportunity.
For example, in the financial industry, we look at price-to-book value compared to the return on equity that the company generates. In the consumer staples or discretionary space, we look at price-to-earnings using very conservative downside scenario assumptions. For industrial companies, we examine the EV/EBITDA multiple, again using fairly conservative assumptions in a down-cycle scenario. Then we compare our downside case with the upside catalysts and the steps for the companies to unlock value.
Q: Would you explain your investment process?
We are active managers and our portfolios have high active share. We incorporate quantitative tools for screening and rigorous fundamental research in our bottoms-up analysis. The fund invests across the entire market-cap spectrum within emerging markets, but we look for a minimum of $1 million trading per day, because we need to know that we can easily exit a security from a risk management standpoint should our thesis not play out according to plan.
The first part of the process is to identify our opportunity set. The universe within emerging markets is quite large, with more than 5,000 securities, so we use proprietary quantitative tools to narrow it down. Our quantitative screens incorporate a robust scoring tool that utilizes a multi-factor approach through FactSet. The goal is to determine the top 20% of companies within the universe that we believe have the highest probability to outperform over a medium term investment horizon while also meeting our strict valuation criteria.
We use that tool in conjunction with our network on the ground to source new investment ideas. The network includes sell-side analysts, specialists that we have met over the years, as well as reports and publications.
The second step of the process is downside protection. At this stage, we try to understand our risk of permanent capital loss. We examine historical data and we perform peer-valuation analysis. We extensively examine the cash flow generation abilities, because we look for businesses that generate cash flow through the cycle. We don’t buy businesses in deep turnarounds, so we need to see profitability through the cycle. Typically, we buy companies with strong balance sheets and low leverage levels.
After analyzing the balance sheet strength, we focus on corporate governance. That part is of critical importance in emerging markets, where governance standards and practices are not as high as in more developed markets.
If a company meets all the criteria in the downside protection analysis, we move to step three, which is our upside potential. We talk to the management teams to understand their strategic plans for unlocking value both operationally or through asset optimization. We evaluate the capital allocation to see if the companies maximize value. We look closely at the absolute levels of ROE and the potential for ROE improvement through better capital allocation. Another upside catalyst could be some positive change in corporate governance, which might include new members to the Board or changes in compensation structure.
The upside catalysts could also take place at the industry level. We don’t necessarily set timelines for these catalysts to be realized, but we need to be able to define what those catalysts are. We do extensive industry and competitive advantage analyses to understand if there are any potential positive changes that could help unlock value in the shares.
Once the downside protection and the upside potential analyses are quantified, we look for opportunities with upside potential that is two-to-three times higher than the bear case scenario.
Q: Could you illustrate your research process with specific examples?
A good example would be Anhui Conch Cement, the second largest cement manufacturer in China, which has market share of about 10% and is geographically diversified. We like the company, because it is the cement producer with the lowest cost of production which allows it to achieve the highest margins in the industry. We believe this will enable Anhui Conch to further expand its market share and to consolidate the industry. The company also has strong pollution controls at their plants due to significant investments in such facilities over the last couple of years.
Our investment thesis is supported by limited supply growth in the cement industry. We expect the supply to grow at CAGR of only 1% over the next three years. That should allow the industry to have much stronger pricing power than in the past. The superior pricing should lead to higher profitability on a per ton basis.
We found the company through a quantitative screen. Then we thoroughly researched the industry to understand the supply-demand dynamics. Anhui Conch stood out from our downside protection perspective, because it was undervalued. It is currently trading at 10 times earnings, six times EV-to-EBITDA, and 1.5 times book value. That’s quite low compared to the historical average of about 17 times earnings and almost nine times EV-to-EBITDA. We believe that there is mean reversion potential as the industry supply-demand dynamic improves.
In addition, the company exhibits a strong balance sheet and generates 7% free cash flow yield with low capex planned in the medium term. Price increases have started to flow through and the company has significant operating leverage. At the same time, inventory levels across the industry are quite low at about 65% below the average levels in the last five years.
Anhui Conch is slowly expanding outside of China, primarily in Southeast Asia. It has already built plants in Indonesia, Vietnam and Cambodia. In terms of asset utilization and capital allocation, we are very excited about the investment opportunities in those markets as they have low per capita consumption of cement currently.
Lastly, the dividend payout ratio is only 30%. With the company generating free cash flow of more than 7% and having a net cash balance sheet, we believe that the dividend will increase in the next couple of years.
Q: What is the reason behind the low valuation? Could you explain the supply-side constraint dynamics in the Chinese cement industry?
The multiple is below its historic average, because the market focuses too much on the long-term prospects for cement demand in China. Right now, the cement per capita demand in China is quite high relative to other countries and is expected to gradually decrease.
But we believe that the market is underestimating the supply outlook, which will lead to price increases. One of the reasons for the supply constraint is that the government wants to eliminate the smaller plants with significant emissions and poor pollution controls. We are seeing stringent government control in the commodity sector; no new plants are being approved, while demand remains strong.
Within the cement industry, about 40% of the demand comes from property, 25% from infrastructure, 25% from rural, and 15% from other areas. We think that the market is overly concerned with the 40% coming from property and that’s why valuations are low. However, demand from other areas remains strong.
Q: How do you assess the growth potential of an industry?
It is critical to understand the industry dynamics and the barriers to entry when we invest. For example, the renewable energy in China is still growing at 20% CAGR per year, but there are very low barriers to entry. The excess return just gets eaten away by new entrants and, as a result, many companies haven’t generated any return for investors.
The key element, even in growing industries, remains capital allocation and generating appropriate return for the shareholders. There is significant difference between top-line growth, earnings per share growth, and capital returns to shareholders.
For example, a state-owned enterprise may continue to grow its top line without the focus on generating returns for shareholders. In an ideal case and what we look for, is when there is alignment between a management team and a strategic investor base that aims to create value for all stakeholders. That’s the critical distinction and that’s why active managers can add value, in our view. We align ourselves with management teams who can ensure that if the industry is growing significantly, we as minority shareholders will be entitled to a piece of that growth.
Q: What is your portfolio construction process?
We typically have between 60 and 100 positions in the portfolio; right now we have approximately 80 names. We look for maximum exposure of 4% to any individual investment and 30% to any single country or sector. Although we can invest in frontier markets, we restrict that exposure to less than 20% of our investment capital. Right now, we have only one or two investments in frontier markets.
After we quantify the upside and downside potential for each investment, we use that analysis in conjunction with a portfolio optimization tool to determine the appropriate weights, while minimizing portfolio risk. Our optimization tool also helps us to make sure that we don’t take on any unintended sector, country, or factor bets. Finally, a security is bought with an absence of veto from either of the two portfolio managers.
The primary benchmark is the MSCI Emerging Markets Index, but we also compare our fund versus the MSCI Emerging Markets Value Index. Because of our value investing style, we think it is appropriate to look at both.
Q: What is your sell discipline?
If we believe that the full valuation of a particular investment has been reached and the upside potential left is limited, we will take profits and move on to the next opportunity. The second reason for selling a stock is identifying better investments. We always evaluate our opportunity set and if we see an investment with a superior risk-reward potential, we may swap a position.
We would also sell a stock if any news negatively alters our investment thesis. These could be company-specific news or changes in the macro picture and the industry environment. We constantly evaluate and revisit the underlying investment thesis to see if there are developments that would require a change in the position. Finally, we would sell if a company is acquired and we do not want to hold the acquiring company.
Q: How do you define and manage risk?
We focus on valuation risk and the price that an investor pays for an asset. We aim to minimize that risk by purchasing companies that are undervalued and with limited downside potential.
We also consider the financial distress risk by targeting companies with strong balance sheets and that generate cash flows through the cycle. We avoid companies that require access to the financial markets on a regular basis.
At the security level, we avoid business models that are at risk of obsolescence or models with binary outcomes, like biotech and early stage energy exploration companies.
At the portfolio level, risk management aims to minimize any unintended bets. That’s where the optimization tool helps to make sure that our alpha comes from bottom-up security selection. We want to allow the individual stock selection to generate the portfolio alpha’s and we seek to outperform our benchmark by 200-300 bps per year on average.
