Q:  What is the history of the fund? A : Batterymarch was founded in 1969 as a US equity manager, and we’ve invested in non-US markets since 1978. Beginning in 1987, we were one of the first US-based institutional equity managers to invest in emerging markets, which gives us much more experience in this area than most managers. The Legg Mason Batterymarch Emerging Markets Trust, which was launched on May 28, 1996, is managed by our emerging markets investment team, including five portfolio managers and two analysts. The fund currently has more than $650 million in assets under management. Q:  What is the advantage of investing in an emerging markets fund? A : We believe that emerging markets have a lot to offer long-term investors. They’re fundamentally stronger than developed markets at the sovereign, corporate and even household levels, and they fared much better during the global recession. The emerging economies should continue to benefit from internal growth drivers, including major infrastructure development and rising domestic demand. On the investment side, earnings growth prospects are very strong, with earnings per share expected to continue growing by approximately 20% annualized over the next two years. Earnings expectations may soften a bit in the short term, but strong domestic economic growth and sufficient liquidity in both the domestic and global capital markets should support stock prices over the longer term. Emerging markets are still higher beta than developed markets—although they’re less risky than in the past—and we expect to see some volatility until a steady global recovery takes hold. However, market corrections can provide an excellent opportunity to buy promising stocks at very good prices. This approach has typically been rewarding for investors with a long-term focus. Regardless of short-term market fluctuations, we believe that it’s more important than ever to invest in emerging markets because of their fast-growing role in the global economy. According to recent reports, emerging markets account for 13% of float-adjusted market cap in the MSCI World Standard Index, as well as 34% of world GDP, and these numbers are quickly climbing. Investors without adequate exposure could miss out on many attractive opportunities over time. Q:  How is investing in emerging markets different today when compared to a decade or two ago? A : There are a couple of differences. When we first started investing in emerging markets in the late 1980s, we couldn’t rely on the quantitative disciplines that we use today. For example, when we started investing in Brazil, we often struggled to get a working phone line to that country. The sourcing of reliable financial data in a timely manner was a big challenge, and we weren’t able to conduct thorough quantitative analysis. However, in the early 1990s, Wall Street brokerage houses and MSCI started covering emerging market stocks, and we began getting reliable stock data that we could use within the quantitative infrastructure already in place for our developed market strategies. In terms of emerging markets companies themselves, during the early days of investing in these markets, many companies were not generating returns above their cost of capital. But over time, we have reached a point where the profitability of these companies exceeds their cost of capital. In fact, the return on equity in emerging markets has been higher than in the developed world for years, with much less leverage. We now have very well-managed companies in the emerging markets that generate consistent and sustainable returns, as opposed to companies suffering from significant earnings cycles. We’ve also seen major changes at the sovereign level. Many emerging markets underwent a financial overhaul as a result of the Asian crisis in the late 1990s—similar to what some developed markets are grappling with today. As a result, emerging markets currently have better fiscal balances than developed markets, as well as large current account surpluses. They even control most of the world’s foreign exchange reserves. Sovereign strength in emerging markets, combined with their increasing economic independence, puts them in a good position to withstand the ups and downs of the global economy. Q:  What core principles guide your investment philosophy? A : Our philosophy incorporates three key beliefs: that long-term stock returns are driven by underlying fundamentals; that the most effective way to build optimal portfolios of attractive stocks is by using dynamic quantitative models based on traditional fundamental analysis; and that every part of the investment process should be continuously measured and improved. In our view, the best way to implement our investment philosophy is through an investment process that incorporates rigorous, bottom-up stock selection, effective risk control and cost-efficient trading. This philosophy applies to all of Batterymarch’s investment products, not just on the emerging markets side. Q:  How does your investment philosophy translate into the investment strategy? A : In keeping with our belief in the importance of company fundamentals, bottom-up stock selection is the core of our investment process. We analyze stocks from a fundamental perspective, using proprietary quantitative techniques that bring order and efficiency to emerging markets stock selection. Country allocation also reflects our bottom-up orientation because these decisions rely in large part on aggregated stock-level information. We also incorporate multiple risk controls throughout the investment process. Q:  What is your research process? A : Batterymarch’s research process is a unique combination of quantitative and fundamental approaches that incorporates the best aspects of both. Our goal is to identify high-quality companies with above-average growth prospects as well as reasonable stock valuations. We rank approximately 1,750 liquid stocks every day on a relative basis across five fundamental dimensions: Cash Flow, Earnings Growth, Expectations, Value, and Technical. These are the same broad measures that fundamental investors typically use to analyze stocks. In some cases—such as stocks that are ranked as buys by our quantitative model—we also incorporate fundamental opinions, based on traditional fundamental research performed by our portfolio managers, who conduct hundreds of company visits each year. We also incorporate fundamental opinions when there is pertinent information that can’t be captured by a model, such as changes in company management. Opinion ranks are typically placed on less than 20% of the investable universe and are equal weighted with the quantitative rankings. Each of the five quantitative dimensions in our process is supported by a library of factors—measures designed to predict excess return. Our factor library includes widely used fundamental measures such as book value to price, EPS forward to price and sales momentum, along with proprietary factors that we’ve developed in-house at Batterymarch. Not all of the factors in the library work well at the same time, because the investment environment is constantly changing. By the same token, not all factors are equally effective across every market or industry group. The decision whether to use a particular factor at a particular time or in a particular market is based on monthly testing. We remeasure the effectiveness of every factor in our library—65 or so—under current market conditions and recalibrate the model as needed. One of the things that distinguishes Batterymarch from other managers is our use of multiple peer groups. With the complexity of today’s global economy, using a single investment perspective can’t provide a full understanding of a stock’s relative attractiveness. Therefore we rank stocks from multiple viewpoints, within common-sense peer groups based on country, economic sector and market cap. We rank all 1,750 stocks in our investable universe from 1 to 100, with 1 considered best and 100 considered worst. These daily rankings—the output of our research—are the basis for our buy and sell decisions. We buy stocks ranked 1-20 and sell stocks ranked 51-100. Q:  Can you give a few examples? A : One of the companies we’ve identified through our process is Pharmstandard in Russia. Pharmstandard started out as a small, generic pharmaceutical company that was essentially selling goods from other producers into the Russian marketplace. The company was ranked well by our stock selection model. We conducted fundamental research to fully understand its business model and discovered that they were shifting their focus from simply reselling to developing their own generic drugs. Our research confirmed what the model was saying about the company’s positive long-term prospects. Satyam Computer Services Limited is another example of how our process works. Satyam is a global IT business consulting services provider headquartered in India. Back in 2008, we held a relatively moderate position in the company due to its favorable quantitative ranking. As the year wore on, however, we noticed a couple of transactions that suggested that corporate governance wasn’t aligned with minority shareholder interests. As a result, we sold it out of the portfolio. A few months later, it was revealed that Satyam’s chairman had been fraudulently exaggerating corporate profits. The company actually had healthy profits, but the chairman exaggerated them to hide losses in other activities. Q:  What is your sell discipline? A : We have a strict rules-based discipline for both buys and sells, based on our daily stock rankings. We only buy stocks that are ranked in the top 20% of our investable universe, and we sell stocks whose rankings fall into the bottom half. If a stock’s valuations deteriorate, this is reflected in its daily ranking. If the ranking falls below 50, we sell the position. This approach is meant to ensure that our buy and sell decisions are made objectively. It’s one of the ways we control for risk. Q:  How do you build your portfolio? A : We’re benchmark oriented, managing the fund against the MSCI Emerging Markets Standard Index. We optimize the portfolio daily, using a multifactor risk model that weighs all the important variables, including stock rankings, country weights, market cap constraints and fund-specific guidelines. Risk control plays an important role in our portfolio construction process. For example, we don’t let portfolio weights stray far from the index,. The fund’s exposure to an individual country is capped at ±5% of its benchmark weight, and we have comparable guidelines at the stock level. The fund is also very well diversified, generally holding 200 to 250 stocks across about 20 different markets. That way no single position has too large an impact on performance. The final risk control measure in our process is a manual review of all trades by our portfolio managers before they’re released for execution. The portfolio managers can adjust a trade in case any significant new information about a company is not reflected yet in its stock ranking.