Emerging markets - worth another look
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Alva Devoy: I'm here today to talk to Alex Duffy, our Portfolio Manager for Global Emerging Markets.
Alva Devoy: 14 years is a long time in a very, very volatile sector of the market. So why? Why are you in love with investing in this area?
Alex Duffy: I think the key attraction to global emerging markets is just the breadth of the opportunity set. You are dealing with markets that are relatively nascent in many instances.
Alex Duffy: What that creates is an opportunity for good companies to deploy significant amounts of capital at accretive rates of return. And if you combine that with a long-term investment time horizon, it creates intrinsic value over 3, 5, 10 years.
Alex Duffy: That is a very unique opportunity set, and that is really what I seek to access with the fund that I manage and investing in the asset class where I've really got up close and personal with a huge number of companies on the ground in EMEA, Latin America, and now living in Asia.
Alex Duffy: I think that that's the best way we can add value to clients, is to know companies in detail, find those good businesses, and manage the volatility accordingly.
Alva Devoy: The macro is incredibly important to this region, and the macro backdrop at this point in time, more uncertainty than we've seen in previous years, so how are you approaching both analysing it, seeing it as a backdrop for your investments, and then allowing it to influence your investments?
Alex Duffy: Some of the challenges that are being presented right now result around impact of trade wars between the US and China, how that manifests itself in Chinese demand and competitiveness for China, has implications for the value of the currency.
Alex Duffy: That the importance of China to emerging markets cannot be understated. So that has pushed down effects across the rest of the asset class.
Alex Duffy: Some of the challenges that presents is that ultimately growth is slowing. We're on the back of a very, very strong period of global growth over the last few years, particularly in the US but also in China following that stimulus in '16 and '17.
Alex Duffy: We're digesting some of the implications that that stimulus has created, and so it's about how do we find opportunities to manage against that cyclical backdrop.
Alex Duffy: My base case is that actually we are going through a softer period. You have to identify good business that can manage against that, that have strong balance sheet and can consistently generate return profiles. You have to have a strong focus on valuation to provide margins of safety.
Alex Duffy: But most importantly, you have to be prepared to embrace some of the volatility, not lose sight of the long-term opportunity and actually use that to your advantage, which is really what I'm doing with the portfolio and have been doing over the last six or 12 or so.
Alva Devoy: What do you do specifically that would help investors get invested but weather the volatility?
Alex Duffy: I focus very much on the companies that I'm invested in. Understand the governance structures of the companies that you've invested in. Understand that balance sheet structures of those companies. Ensure that both of those parameters provide you with downside protection.
Alex Duffy: So you've got .... You defend against probably let's say a permanent lose of the capital and then the balance sheets and the incentive structures of management teams should enable the company to invest accretively in its business over 3, 5, 10 year time horizons, and then ensure that you don't overpay for that at the outset.
Alva Devoy: So you're selecting companies with that type of filtering so that you're selecting investments that are aligned with the end investors' needs.
Alex Duffy: Absolutely. I do think that being investors in this asset class does require something of a long-term view. It requires the ability to weather and be prepared to embrace some of the volatility that comes with the asset class. If you do that through good companies, I think that that will be a successful outcome.
Alva Devoy: Yeah.
Alex Duffy: Then at the same time as an investor managing the fund on a day-to-day basis, I'm dealing with some of these more macro and shorter term currency volatility and overlays from a sector and a country positioning to ensure that we're alive to the opportunities that are presenting themselves, but we're also helping to mitigate some of the downside risk through prudent stock selection.
Alva Devoy: Okay. Given the noise in markets, why do you think now is a good time to invest in emerging markets?
Alex Duffy: I think some of the challenges they are very real. There's no point in shying away from the fact that the challenges in China with respect to the debt position, the threats to potential weakening of the R&B as a consequence of trade wars. It is very real.
Alex Duffy: But it has to be viewed in the context of the price that you pay for the company that you're buying, that you're invested in and also the strength of that individual business model.
Alex Duffy: Now, there are some companies that have great brands, that invest in technology, who actually have weaker competitors who are unable to continue reinvesting their competitive advantages that would strengthen certain areas of the ...
Alva Devoy: Yeah, potentially.
Alex Duffy: Yeah, certain positions over multiple years. They're the companies that I want to be investing more of my capital in today. Those companies that can continually invest and take market share cycles to cycle.
Alva Devoy: How do you differentiate, if you were to pick two to three things specifically, differentiate between a really good long-term proposition versus a company that's hot right now looks good today but could be over inflated?
Alex Duffy: What's most important to me is about understanding consistency of return profiles.
Alva Devoy: Okay.
Alex Duffy: You manage downside risk by ensuring you've got a proper alignment and a governance perspective and ensuring that the balance sheet is strong and can survive the vagarious of the economic cycle as we're going through now.
Alex Duffy: Then it's about understanding consistency of return profiles, the ability of the business to consistently generate a return on capital above its cost of capital, and for that to be sustained over a multiple time horizon.
Alex Duffy: We're look at competitive intensity in an industry structure. What is it that's unique about this particular business from a brand perspective, from a technology perspective, from a geographic natural resource perspective in certain instances.
Alex Duffy: It enables it to perpetuate that return on invested capital and then how we value in that cash flow stream. Does the valuation give us a margin of safety?
Alex Duffy: Often emerging markets as an asset class can be very thematic. All right?
Alva Devoy: Okay.
Alex Duffy: What that can create is, particularly with the advance of passive investing as well and indexation, is a wall of money going into sectors or certain areas and inflating companies way beyond fair values without a true understanding of the sustainability of those return profiles.
Alex Duffy: Actually what we've seen here today particularly with US yields rising, which is a real valuation headwind for all assets not just emerging markets equities, is resulting in the de-rating of those valuation multiples for higher growth companies.
Alex Duffy: If you've got companies that are priced for delivering very, very strong returns and actually that return profile isn't sustainable, it creates a real risk of a permanent loss of capital through the multiple de-rating.
Alex Duffy: So I focus much more on consistency of returns, deliverability of returns and a margin of safety from evaluation perspective. It tends to result in a portfolio which might not exhibit the high beta that often gets associated with emerging markets. Personally I think that's a bad thing. But that is the nature of the portfolio.
Alva Devoy: How do you distil the philosophy piece and then the complexity of the opportunity set into a process that delivers ultimately quite a concentrated portfolio of stocks for investors?
Alex Duffy: So I'm basis forums around 23 other Asian portfolio managers with a huge depth of understanding and knowledge of that investment universe. That's a real sort of idea generation but also cross checking on, fact checking on businesses.
Alex Duffy: Then there's the research team. 48 emerging market analysts, industry experts covering stocks, making buy and sell recommendations to the portfolio.
Alex Duffy: Then the next point is really understanding what fits my criteria in terms of a good business. So those filters in terms of focuses on governance, focuses on balance sheets, identify businesses that consistently generate returns on invested capital, understanding the reinvestment opportunities set and then bringing that together with a margin of safety from evaluation perspective.
Alex Duffy: It does lead me away from certain pocket of the market and it leads me into other areas of the market where I find companies where I have a higher probability of being correct and actually adding value to clients.
Alex Duffy: So, I'm not afraid to avoid the areas that I don't understand. It's a very broad investment universe. The question is actually how do you distil it, not how do you broaden it.
Alex Duffy: With that in mind, I tend not to invest in state-owned companies simply because of the fact that I don't necessarily believe that those businesses are managed with the interest of minority shareholders in the first instance. Then secondly, I don't embrace balance sheets that have foreign currency debt funding local currency assets.
Alva Devoy: There's a misalignment right there.
Alex Duffy: So where you have those mismatches, it just creates instability in a balance sheet structure, in a company's return profile and it introduces the risk of a permanent loss of capital because you can get disconnects when currencies move.
Alex Duffy: We focus more on the areas where we can add value through the research team. So what is the competitive advantage of BTA, an Indonesian bank that's got a very strong deposit taking franchise, it enables it to raise deposits at a very low cost versus its peer group.
Alex Duffy: That is a sustainable, competitive advantage for that business. It's a meaningful position in the portfolio and it's a stock where we can add value through the research process.
Alex Duffy: Really that's how I narrow this investment universe down to the subset of stocks that meet my criteria. Then going through that subset diligently and patiently to build a portfolio of 35 to 45 stocks, high conviction ideas that can meaningfully add to the output of the fund over a three, five year investment time horizon.
Alva Devoy: If we were to look at the portfolio today and think about themes and stock stories, what would you highlight today?
Alex Duffy: If you look at the fund today, there is a focus or there's dominance of financial companies within the portfolio. So around 30% of the fund is invested in financials.
Alex Duffy: The common theme amongst all of those financials is that they tend to be in their own market a very strong deposit taking retail facing banking entity for the most part.
Alva Devoy: So you get the demographic place for that?
Alex Duffy: Absolutely, 100% correct. So you've got very under-penetrated consumer financing in a lot of these markets. More importantly than that deposit taking tends to be under-penetrated.
Alex Duffy: So it's all very well lending money, you need to raise deposits to fund that as well. So having a strong deposit franchise provides stability to the balance sheet and it ensures if you've got a low cost deposits in the case of BTA, which I mentioned earlier, that gives you a competitive advantage in both loan pricing as well as funding risk.
Alex Duffy: So, those banks tend to be very interesting and they have HDFC Bank, very strong franchise in India, under-penetrated market and ability to deploy huge amounts of capital at attractive 20% rates of return.
Alva Devoy: Right.
Alex Duffy: That drives value over 5, 10 year time horizon.
Alva Devoy: We're not generating that in Australia.
Alex Duffy: No. So they're some of the opportunities. I also think you've got areas of the consumer market in China which look interesting. There is a cyclical slow down going on.
Alex Duffy: That is creating a draw down in terms of equity prices but valuations are compelling for certain businesses that are actually gaining market share.
Alex Duffy: Stocks like Midea, which is cyclical, it sells air conditioning units so the end market is cyclical and it has had a very strong up cycle over the last 24 months or so.
Alex Duffy: I do think the way that that company is investing in its distribution base to improve incentive structures for its sales people which will prevent inventory build in the end channels, prevents discounting, delivers more stability of margins and profitability. Those are companies which are creating value.
Alex Duffy: In these market environments, I tend to buy more of the good businesses.
Alva Devoy: Of what you've got.
Alex Duffy: So there's been a concentration of the fund as well over the last three, six months.
Alva Devoy: Your country weightings, or your country exposure falls out of those stock selection decisions.
Alex Duffy: Yeah, absolutely. I take a very absolute approach to building this portfolio. So to me, risk is a probability of a permanent loss of capital. The biggest risk we face is we put 100 in, we don't get 100 back.
Alex Duffy: I don't think too much about relative risk or country exposures from that perspective. I look very much at the bottom out stocks, I grade them according to my five key criteria of governance, balance sheets, returns, reinvestment and valuation. That determines the capital that the stocks get within the portfolio.
Alex Duffy: But then I do pay close attention to absolute correlation within the fund. So by doing so, by thinking about what new stock ideas bring to the portfolio that isn't already there, how can I increase diversification and broaden the portfolio. You tend to find more sector and country exposure as a consequence of that.
Alex Duffy: I then look at the intra-fund correlation and whilst that I still run a relatively concentrated portfolio under 40 stocks. I'm able to get breadth to the fund and ensure that the fund has got higher diversification ratios than the 900 stock index.
Alva Devoy: That layering of diversification inside the portfolio is another protection mechanism in a volatile asset case.
Alex Duffy: Yeah, absolutely it is. So how do you deal with risk? You really deal with risk by ensuring you know the business you're invested in.
Alex Duffy: The fund shouldn't be a play on any particular theme or country because it's not that vehicle. It is a diversified global emerging market strategy in a concentrated fashion.
Alex Duffy: So that focus on diversification and bringing it together to ensure we got breadth in the fund is the second way that I manage the correlation risk in addition to the stock risk which I'm managing on a daily basis.
Alva Devoy: Okay. Inside the thematic of demographics, which I like because demographics is really predictable.
Alex Duffy: Yes.
Alva Devoy: Which areas are of most interest at the moment to you?
Alex Duffy: I think the ... The consumer market is clearly an area where you've got under penetration of various consumer products, all the way from housing and bank accounts down to end consumption of basic products.
Alex Duffy: So whether ... There's an opportunity to grow brands and to increase penetration levels there. That's an area where demographics clearly play a role and over ...
Alex Duffy: Education, medical care, et cetera, et cetera, these are very large markets in the developed world that are under represented within the emerging markets as well because of the base at which we're starting from. Over time they are going to develop. As you said, that generally tends to be inevitable.
Alex Duffy: I think that using technology to enhance adoption of consumption of financial products, it's actually something which we're witnessing right now.
Alex Duffy: So if you look at bancarization within emerging markets, India is an interesting case study. Technological adoption is fast tracking the rate at which the market bancarization increases, the rate at which financial penetration increases.
Alex Duffy: So, I think that often technology gets looked at in isolation, but actually technology is being embedded as an enabler within multiple businesses and that ...
Alex Duffy: And actually maybe we should move away from the technology sector and think more about actually how technology is being used by individual companies and the value that that creates at maybe some other areas of the market. So be that financials, be that consumer, they're some of the areas which we're interested in.
Alex Duffy: I do think the financial sector from a penetration perspective, from breadth of products whether it's insurance products, health care products, et cetera, et cetera, I think those areas on a thematic over the next 5, 10, 15 years are going to be areas to focus on and watch.
Alva Devoy: Long-term growths opportunity.
Alex Duffy: Yeah. But the final point I would make on demographics is that thematic investing whilst being valuable and incredibly relevant is also dangerous if you don't couple it with an understanding of the return profiles.
Alva Devoy: Okay.
Alex Duffy: So the housing example is a great one. Now remember housing in Brazil in 2009, 201, so post-GFC, there was a big thematic around the need and the shortage of housing. The shortage of housing existed.
Alex Duffy: So a lot of investors were buying home builders to play that theme. The home builders were being forced to buy land at increasing values. They were raising capital to do that.
Alex Duffy: Ultimately competition was increasing in that house building market because so much capital was being thrown at the theme.
Alex Duffy: Actually the share count grew as fast as the homes that they were building, and that led to dilution for the minority shareholder despite the theme being delivered.
Alva Devoy: The right one, yeah.
Alex Duffy: So you have to, whilst the thematic is important and is a very important structural driver of returns, you have to combine it with financial discipline to ensure that as shareholders you get paid to execute the theme. That is a slight nuance to the approach of thematic investing.
Alex Duffy: 100% agree that's exactly what we do through active management of the portfolio, but also through that research structure and through leveraging portfolio management and the research teams.
Alex Duffy: We know a lot of these companies. We have a very deep institutional knowledge of these businesses and that helps to identify the good guys from the bad guys in terms of return profiles.
Alva Devoy: We definitely want to get a view on what your thinking is and your positioning for 2019. How is that year going to unfold because I think we're finally coming around to the knowledge and the view it's going to be a more volatile environment for investing.
Alex Duffy: Yeah. So the point I would make initially is that going into 2019 there's a huge amount of economic uncertainty. We've had sizeable declines in equity markets this year already.
Alva Devoy: Yes.
Alex Duffy: So equity markets is moving ahead of economic fundamentals. There is an opportunity today to buy very good companies in emerging markets, more attractive valuations that we've seen in the last two, three years.
Alex Duffy: So I think that for the asset class generally, we should be looking to identify those key opportunities within EM. I do think that certain pockets of the market will remain vulnerable to volatility in currencies and particularly the industry environment.
Alex Duffy: So, I like the technology sector. I like the way that technology is enabling multiple other industries to grow and develop.
Alex Duffy: I do think there's areas of technology that are relatively highly bid in terms of valuations and maybe there are some regulatory headwinds. That would be one thing to keep in mind.
Alex Duffy: I also think that within emerging markets over the last few years and as a consequence of technology actually, we've become very fixated with Asia and growth in Asia and it's important to keep in mind the breadth that global EM offers you.
Alex Duffy: There are good businesses throughout emerging Europe, Middle East, Africa, throughout Latin America that are not as correlated with some of these challenges that we've talked through.
Alex Duffy: There are some potentially signs of improvement maybe from a political perspective. There's also low inflation in these markets. That creates a relatively more stable backdrop for investing and valuations of compress.
Alex Duffy: Names like Itaú Unibanco in Brazil I definitely think are interesting. I also think names like [lohas frahena 00:19:21] in Brazil, which is a consumer business, fashion retailer, very good management team, great execution, limited competition. Those areas of the market remain interesting to me.
Alex Duffy: Equally, a couple of names in South Africa. AVI, which is being held in the portfolio for a very long period of time keeps generating returns paying strong dividends.
Alex Duffy: I think they're areas of opportunity and it's important to use volatility to your advantage and that's what we're seeking to do today with the portfolio.
Alva Devoy: Very good. No shortage of opportunities is what I'm hearing, which is great. On that note, we have worked with you.
Alex Duffy: Yes.
Alva Devoy: Added to your workload actually to launch our first active ETF.
Alex Duffy: Absolutely.
Alva Devoy: Here in Australia. So from our point of view, we have chosen emerging markets as our first product as an active ETF because we're in a fantastic period where post a period of volatility but also slow in growth now after strong growth in other regions.
Alva Devoy: The hunt for growth is going to be incredibly important. The hunt for investor returns based on growth in emerging markets I think becomes central in 2019.
Alex Duffy: I think the great thing about the act of ETF is its simplicity.
Alva Devoy: That's it.
Alex Duffy: The ability to transact very easily, seamlessly in what is actually a complex asset class and then as you said to have that pricing alongside your bank shares or your mining shares, whatever it might be, within a broader portfolio is a unique trait to the product.
Alex Duffy: I think it's something that really serves the interests of our clients in terms of helping them achieve their own financial goals which is ultimately all that we're charged with, we're trying to achieve.
Alva Devoy: I would just like to say thank you for your time today, Alex. It's been terrific having the opportunity to sit here and discuss emerging markets with you.
Alex Duffy: No, you're most welcome. Thanks for your time.
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