Q: What is the background of the fund?
In the late 1980s and 1990s, investors looked to the emerging markets for the growth. As the volatility increased in emerging markets between 1994 and 2002, fund managers began to focus more on downside protection and less on the upside capture. After that period, when markets began to advance, investors aimed to outperform and became bullish on the asset class because of the earnings growth opportunity.
We launched the Lazard Developing Markets Equity Portfolio on September 29, 2008 with the emphasis on beating the relevant index in a rising market environment. Our investment philosophy drives us to pay attention to the valuation that we are asked to pay for the earnings growth experienced by the companies.
We manage a little over $4 billion within this investment strategy. The mutual fund has approximately $260 million in assets.
Q: Which part of the emerging markets do you focus on?
The strategy covers all of the emerging market countries. We start with the countries in the MSCI Emerging Markets Index, but we look for opportunities in the Frontier markets as well. We also consider companies that may be headquartered or listed in developed markets, if the majority of their assets or revenues comes from the emerging markets.
We look across all sectors to find where earnings growth is quickest or more sustainable and where valuation doesn’t reflect that earnings growth. We look for multiple patterns of growth when evaluating investment opportunities. Some of those opportunities maybe in businesses, where in our assessment growth can remain high for a number of years, or in cyclically inclined businesses on the upside, or in businesses that are growing due to investments in R&D, increasing capacity, or through acquisitions.
Each analyst looks for the earnings growth opportunity over a multi-year period. Then, the valuation that we pay for that earnings growth varies depending on the pattern of growth. Areas that are expensive and offer no growth are not really an opportunity for the strategy, however, areas that grow quickly but tend to be more expensive, are still an opportunity.
Q: What core beliefs drive your investment philosophy?
Our philosophy is based on two assumptions. First, we believe that over time stock prices follow the earnings. So, if we have strong earnings performance over a multi-year period, we should have strong stock price performance as well.
The second assumption is that valuations do matter. In our back test, we have seen that the benefit of strong positive earnings trends tend to decline once valuations become expensive. We work with a PEG ratio and our process focuses on stocks with above-average earnings growth and somewhat average valuation. That’s the sweet spot that we look for.
Q: What is your investment strategy?
We don’t start with a theme; we follow the earnings growth. Our strategy relies on a bottom-up process, which starts with a quantitative stock screen. That screen represents the intersection of stocks with average valuations and above-average earnings growth over a multi-year period.
We have an experienced team of seven people, but within Lazard there are more than 70 individuals that focus primarily on emerging markets. Our team is responsible for the day-to-day management of the portfolio, but we also work together with the larger Lazard team to get an analytical advantage.
The goal is to find companies that we believe will achieve higher earnings growth than Wall Street expects over a multi-year period. For example, our analysts may expect a company to grow by an average of 20% per year for the next several years, while Wall Street projects the same company to achieve annual growth of 15% over the same period. If we are right in that expectation, we tend to be right about the security.
Another important aspect is that our views on the risks are actually embedded into the final target price. These risks can be economic, political, diversification, environmental, social, or corporate governance risks. Based on these factors, we discount our target price. Then we use that risk-adjusted target price to determine the final stock selection and size the position within the portfolio.
Q: How do you generate ideas?
We screen the investable universe for various factors, including liquidity. But the most important factor is the average valuation and the above-average earnings growth over a multi-year period. We split the universe into quintiles based on those two factors and we focus on the intersection, adjusted for liquidity. That’s when our proprietary bottom-up research on the company starts.
Q: What are the main factors in assessing earnings growth?
A key aspect of our approach is that we examine the earnings growth over a multi-year period, not on a quarterly basis. Typically, we look for companies that may be strong in one area and are currently entering a second area of business, launching a new product line, or going to a new country. After we investigate the company’s prospect in that new area, we may reach the conclusion that the company is able to enter the new market successfully, or that their new product line is more successful than Wall Street thinks. That means that there is an earnings growth driver over a multi-year period.
In general, we examine the company’s ability to broaden its product line. If it is successful in some consumer products, then it may broaden its product line and be successful in the new ventures. We rely heavily on the talent and the knowledge base at Lazard to examine the prospects and debate theses that makes us more confident on those prospects than other investors.
Q: How do you deal with the different accounting standards in emerging markets?
The great thing about the evolution of emerging markets is that many of the countries have begun to adopt the International Financial Reporting Standards, or IFRS. When we first began investing in the asset class in the 1990s, the difference in the accounting treatments was significant. That difference has diminished over the years.
A core feature of both the strategy and Lazard is that accounting validation is a key step of the fundamental analysis. We do in-depth analysis of reported financials, read the footnotes, and do adjustments and checks to validate the information. We avoid companies that don’t pass the test. However, if a company has lower returns relative to global peers, it may turn out that it still provides an opportunity after the accounting adjustment.
The validation of the fundamental accounting is where some of the heaviest lifting occurs but, again, many countries have adopted the IFRS and fewer companies are changing their accounting policies year over year.
Q: How important are governance issues for your strategy?
Governance represents an external risk factor for us. The fundamental risk is that the company fails to execute and then the external risks come. Before making an investment, we discount for some emerging market risks, including macro, political, and governance risks. When we talk to the management and go through the footnotes, we look at the shareholder structure and the management incentives.
I don’t necessarily view the government shareholder as a negative aspect. Actually, we have found better governance in some government-controlled businesses than in some private ones. The final conclusion depends on our level of comfort with the accounting policies, the shareholder structure, or the management incentives. We work in a broad enough universe, so when we become uncomfortable with an issue, we can just move on to the next security.
We send a questionnaire on governance to every company in the strategy. We also utilize third-party vendors for their views on governance on every stock in the portfolio. If our analysts give a fairly positive rating for a company’s governance, while we suspect it might be different, we do have the ability to check that with a third party. In some cases our analysts have to lower the rating for the company’s governance. In such cases we’ll increase the discount or decide not to own that security.
Q: What is the impact of all the different currencies on your strategy?
We view currency as one of the risk factors associated with a company. We take it into account in our risk scoring and we discuss with the companies their hedges and their overseas revenue. We also have an independent risk team that provides oversight to and counsel for all of the teams at Lazard.
We’ve worked very closely with Lazard’s emerging debt team, which has been very helpful on macroeconomic issues. For example, a while back our debt team warned us that the South African rand was due to weaken. We owned one of the mining companies there, so for us that was a positive trend, because that miner would benefit from a weaker rand. On the other hand, at the time another Lazard strategy was owning South African banks and they subsequently reduced their positions. So, all of us agreed that the South African rand was vulnerable, but this vulnerability got manifested differently in sizing.
Q: Would you describe your research process?
We start with a universe of about 4,000 or 5,000 companies and the stock screen eliminates half of them. The next step is the accounting validation, which removes many companies that we are not comfortable with. At the end, we focus our bottom-up due diligence process on 200 to 250 securities.
Our seven-person team is mostly focused on coming up with the multi-year growth rate. We reach out to the other experts at Lazard for their feedback regarding our growth rate forecasts. If that rate and the model look good, if we are confident in the company, its management and its business plan, then we move on to the analysis and the incorporation of all the risks. After these four steps, we end up with a portfolio of about 60 to 90 securities.
Each of the seven people on the team is responsible for specific sectors across the asset class. That means that the technology analyst follows hardware and semi-conductors in Taiwan and Korea, e-commerce in China and Russia, or software or service companies in India. So, the analysts are looking at all the different models across the asset class. For each of those models, there are different opportunities.
For example, 10 years ago the smartphone industry was booming and there were investment opportunities in rapidly growing businesses. Now the smartphone market is mature and the story is less about taking market share in a fast growth industry and more about incremental market share. The investment opportunity has changed from a company doubling its market share to a supplier that’s doubling its component within a multi-national smartphone company, or a company adding a new feature to its own phone.
I believe networking is very important in identifying growth opportunities. Chatting with colleagues, who are investing in European and U.S. technology, attending industry conferences like the Consumer Electronics Show, reading and staying on top of industry trends, talking to the companies in the portfolio and to other players in the supply chain, is invaluable.
We are always focused on the multi-year trend, especially in terms of products transition. The ability to think through the opportunity case, to see the misconceptions about product margins and pricing is crucial. Each analyst aims to do that at the sector level and to filter the ideas, where there is acceleration or an opportunity. If, after the fundamental analysis, we think that the company can’t continue to grow at the rate we expected, we will exit the position.
Q: Who makes the final decision to include a stock in the portfolio?
The two of us have the final say, but the analysts have ownership of their ideas. It is their responsibility to bring the most attractive stocks, in terms of earnings growth versus valuation, to the table. We have a price target for every stock in the portfolio and if the new opportunity has better risk-adjusted upside, we will sell a stock to add this one. It is a very methodical process. If the upside is less than the portfolio average, we’ll keep the idea on our watch list.
Q: What is your portfolio construction process?
The size of each position depends on the risk-adjusted upside of the stock. The businesses that are more mispriced relative to their potential growth would represent a greater percentage of the portfolio. The stocks with smaller valuation/growth discount would have less weight in the portfolio. We are benchmark agnostic and we can have large positions in stocks that are not in the benchmark. The active share of the portfolio has been between 80% and 85% over time.
At the individual security level, we have limited our positions to 5% at cost and 7% at market value. In terms of country and sector parameters, our risk team determines the limits based on liquidity. We could have zero exposure to an area, where earnings growth isn’t quick enough or where valuation is too high relative to growth. The upper limit is the investable opportunity set with some liquidity constraints.
Overall, we aim to own more of the stocks with the greatest upside potential. Our minimum size position and likely entry position is 75 basis points, but we quickly move to the appropriate position based on the upside we see. While we are fairly benchmark agnostic, our benchmark is the MSCI Emerging Markets Index. Again, we don’t really make allocation based on countries or regions; we follow where earnings growth is most attractive across the asset class.
Q: How do you define and manage risk?
We view risk both from an absolute and expected performance standpoint, so we expect to outperform in rising markets. Since we are an earnings-driven, bottom-up strategy, we aim to intelligently take on earnings risk with the idea that earnings might be higher than what most other investors think. Also, we sit down with the risk team on a monthly basis to understand the risks to the portfolio at various stages in our process. Risk management is embedded within our process – throughout research, security selection, portfolio construction, and ongoing management.
