The ‘free lunch’ is over. It’s time to get active in emerging markets.
Nick Price, Portfolio Manager of Fidelity’s Global Emerging Markets Equity Strategy, discusses the changing outlook of emerging markets.
After several years of poor performance from emerging market (EM) equities, they have enjoyed a strong start to 2016, are we witnessing an inflection point?
As you well pointed out, emerging market equities have attracted investor attention during 2016; outperforming developed markets and recording the best month for EM equities since October 2011.
As the year started, Brazil was amongst the best performers at country level, as we witnessed a renewed appetite for Latin America’s largest market, as the process to impeach President Dilma Rousseff progressed. Brazilian political developments are important, relevant and not to be dismissed. It seems likely that we will see a more market friendly government, but there are major structural changes to be made. Additionally, newsflows from Chinese policymakers during the first few months of the year indicated that there was room to stabilise the domestic economy, which had a positive impact on investor sentiment. During this period, we questioned the sustainability of certain aspects of the upward move, given the sudden increase in risk appetite, with little regard for fundamentals. This was evident when we examined the extreme share price moves amongst highly politicised names, where the underlying quality of the business was questionable. In addition, commodity price moves – in some cases underpinned by newsflow from China and bolstered by a weaker US dollar were notable. Many of the stronger moves happened in spite of the relative unattractiveness of many of the companies available to us as investors in equity markets, so in this regard it is hard to believe that their strong performance can be maintained on a sustainable basis.
That said a stronger oil price, the decreasing likelihood of a hiking cycle in the US, and compelling valuations do provide support for emerging markets, and following a number of disappointing years, I certainly believe that the asset class can perform just as well as developed markets.
To comment on very recent events, the impact of Brexit is negative for financial assets globally. Having said that we are seeing relative outperformance of EM assets today versus UK and European assets, which is unusual during typical risk-off periods, but reflects the fact that the major impact is expected to be in the UK. Forglobal emerging markets investors under exposure to the UK should limit the impact of the vote. When I consider the implications for the portfolio I manage; holdings such as Tata Motors, where around 80% of the value of the company comes from its 100% ownership of Jaguar Land Rover may be subject to scrutiny in the short-term. However, in theory, the cost base in sterling terms should reduce, but it will take time for the fullimpact to become apparent.
What are the key threats facing EM at present?
For example subdued global growth and US dollar strength. There are always risks (and opportunities) associated with investing in the developing world. It’s for this reason that prudence is critical.
When I consider the risks in emerging markets, I would argue that selectivity is critical; an argument that is easily exemplified when I consider the risks associated with investing in China. Essentially China is a two speed economy – one with a buoyant consumer sector, but also a failing heavy industrials sector.
The Chinese government has been focusing its efforts to move the Chinese economy onto a more sustainable footing, where future economic growth places greater emphasis on sustainable domestic consumption, with less reliance on one-off capital expenditure on fixed asset investment. This has negative ramifications for areas of the market exposed to excessive capital formation in the past, including heavy industrial sectors, and the banks who ultimately provided the credit for the over build, and who are now exposed to a rise in the level of non-performing loans sitting on bank balance sheets.
How are the fortunes of EM tied to those of China?
China is a significant emerging market caught in the difficult situation of trying to wean itself off economic growth fuelled by credit-funded infrastructure and fixed asset investment, at the same time as trying to navigate towards a more self-reliant and sustainable economy based on domestic consumption. The construction sector is likely to be the primary area impacted by a potential deceleration of the Chinese economy. It would put pressure on domestic construction firms as well as equipment/raw material producers (such as cement makers). Beyond China’s borders, this would put further pressure on commodity producers such as iron ore producers in Brazil, and copper exporters, primarily Chile and Peru. In the particular case of Latin America, the region benefited strongly from the commodity-intensive investment boom that propelled China’s economy between 2004 and 2012. Not only did the exports to China surge but also the impact that Chinese demand had on global prices for commodities. However, as China’s propensity to invest in fixed assets and construction activity cannot be sustained long term, its demand for commodities has cooled, putting downward pressure on prices already weakened by incremental supply. This has had a negative impact on Latin America’s (LATAM) global commodity exports and increased pressure on already extended budgets, pushing the region further out of investors’ favour.
Due to EM being a homogenous term and not a homogenous region, should investors be favouring specific regions within EM such as LATAM; Europe, Middle East and Africa (EMEA) or Asia?
It is incredibly hard to predict how emerging markets will perform over a short-term time horizon. Who knows what will present itself from a macro-political perspective.
I prefer not just to focus on the asset class, or to form a regional view, as our process is not one of regional asset allocation, instead it is all about individual stocks that can deliver attractive total returns. It’s also fair to say that very often there are big differences between the fabric of the economy and a country’s stock market. When we look at a market such as South Africa, we discover that many of the largest companies are more exposed to global rather than local dynamics – demonstrated in the chart opposite.
In a universe full of very divergent situations, adopting a selective approach to what you choose to own – and importantly what to avoid – is likely to be a key determinant of returns looking forward. Investing in EM still presents a plethora of opportunities thanks to the huge diversity of situations at every level within EM, but maximising returns is likely to be as much influenced by avoiding the weaker performers as it will be by owning those businesses that are able to compound attractive returns for their shareholders over time.
What are the key characteristics you look for in a company?
I focus on companies that demonstrate both quality and capital growth potential, while trading at attractive valuation multiples. I have a preference for under-appreciated companies that have the potential to deliver solid and sustainable returns on equity, while commanding a dominant competitive position in their industry.
Furthermore, I seek stocks able to finance their growth from internal cashflow, and where risk of equity dilution is low. This quality growth approach is seeking to compound total shareholder returns over time. Before investing in a company, I ask myself if it is the type of business I would invest the whole pension assets of my family into. I want to be very sure that this is a business which will at least remain stable. This level of prudence does not always give you the most upside in immediacy, but I want to invest in the best companies in the developing world, capable of delivering sustainable returns.
How did you become a fund manager?
I have always been interested in markets and investments. I started investing my own money when I was in university. I find the role of a fund manager extremely exciting as it offers you a variety be very enriching.
What is your career highlight?
There have been many. However, I would probably highlight leading the development of Fidelity’s successful Emerging Markets Team and strategy. I feel very proud and pleased to be able to help preserve our investors’ capital through good and difficult times. I hope to be able to grow their investments looking forward by only owning the very best businesses on their behalf.
What is your greatest achievement?
My family and children. They are the ones who help keep me sane.
Ambition or talent: what matters more to success?
Ambition. Success requires ambition and the ability to be resilient, to adapt and bounce back when things don’t go as planned. The only way you can have a successful career is to deal with challenges, and challenges automatically invoke the risk of failure. I think you need a good bit of ambition and drive to keep going and thrive.
This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.