Emerging Markets equities – Long term growth opportunities abound
What are the drivers and opportunities in Emerging Market equities?
Emerging market have complicated governance structures, evolving macroeconomics and immature institutions, which leads them to be dynamic, complex and their stocks volatile. Emerging Markets specialist Ashmore Investment Management, a PAN-Tribal Asset Management investment partner, examines the benefits of exposure to emerging market equities.
The complexities exhibited by Emerging Markets (EM) creates significant market inefficiencies and strong potential for meaningful alpha generation. The important skill is being able to discern between the good companies – those that can sustain strong, positive returns – and the rest.
To achieve this, an EM manager must have a consistent singular focus on identifying certain attributes within investments. They must then have a rigorous process in order to systemise their approach and assess the risk-reward of an investment, such as:
- High quality companies: ‘best of breed’ companies that have sustainable competitive advantages and can navigate economic and market drawdowns.
- Sustainable growth: growth is most attractive when combined with quality as this enables a virtuous cycle whereby free cash flow can be re-invested at high rates of return.
- Attractive valuation: systematically assessing the risk/reward opportunity with position sizing changing to reflect upside creates high competition for capital in the portfolio and drives sustainably strong alpha generation.
The EM opportunity
As EM countries, their economies, policies and market structures continue to develop and reform, increased confidence is built among investors, which buoys returns. In turn, this drives market liberalisation and improves market depth, or liquidity, which drives more investment.
Emerging markets are highly inefficient. Complicated governance structures, evolving macroeconomics and immature institutions result in elevated stock price volatility. This creates significant alpha generation opportunities, as well as challenges, for active investors. High quality companies delivering attractive growth are best placed to benefit from EM secular growth drivers, as well as to navigate economic and market drawdowns.
Furthermore, the opportunities to generate alpha are amplified by the fact that EM companies are poorly researched, in particular for their medium term fundamentals. This underpins the case for active management in EM equities.
This lack of research results in high quality businesses that are often undervalued and trade at prices that fail to reflect their ability to sustain high returns over the long term. This is demonstrated empirically by a performance comparison between higher and lower quality EM stocks. Based on analysis from 1 January 1995 to 30 May 2019[1]:
- High quality outperformed low quality stocks by 5.6% per annum
- High quality outperformed MSCI EM by 4.3% per annum
The characteristics of quality companies
According to EM investment specialist Ashmore Investment Management, the key to a successful EM strategy is to focus on identifying quality companies, which typically share four important characteristics:
High and sustainable return on capital
- Superior returns can be eroded by competition over time. Only a small number of companies have structural competitive advantages that can sustain high returns on capital.
- High returns can arise for a short-term period during industry or macro upturns. Successful investing is to identify the few companies that can sustain their strong returns through the cycle.
Strong predictable cash flow generation
- This provides the foundation for a company to be able to make the correct investment decisions over a cycle.
- Reported earnings can be subject to accounting presentation while cash generation rarely lies and ultimately determines the value of a business.
Robust balance sheet
- This enables a company to improve its competitive position during a macro downturn. For example, they are able to invest in their brands, technology, distribution and growth while others are retrenching.
- Leverage has potential for large negative outcomes for equity investors and can destroy even the best business models.
Skillful management and good governance
- Capital allocation provides the link between business value and shareholder value. It enables a company to expand its competitive advantage.
- Skilled management are able to continue to reinvest cash at high rates of return and grow the underlying earnings power of a business.
Finding companies with something special – a network effect or ecosystem to sustain the competitive advantage, a sustainable runway of growth or a competitive advantage – can be the difference between a profitable EM investment and a disappointment.
The company must also balance sheet strength to be resilient during tough domestic times and be able to re-emerge stronger than their weaker peers. ESG assessment should also form a key part of identifying quality, as it steers investors towards high quality management teams that are aware of all the significant business risks and opportunities in their market/s.
The importance of a sustainable competitive advantage
Identifying enduring quality attributes requires an understanding of how a company achieves its attractive economic characteristics to ensure they are sustainable. Companies with high historic returns on capital (ROIC) can be identified though quantitative screens. However, one of the key determinants for future returns is a qualitative assessment of whether competitive advantages can be sustained or even improved upon.
Competitive advantages are distinct characteristics that are difficult to replicate and therefore enable super normal returns to be sustained. Source of structural advantages usually comprise one of the following:
- intangible assets: intellectual property, licenses and brands
- cost advantages: driven by a proprietary process, superior scale or niche positioning
- network effects: a system’s value increases as the number of users expand such as a social network or marketplace
- switching costs: products with high benefit/cost ratios where the risk of changing provider is high.
If a company’s management team allocates capital correctly, the company’s competitive advantage can expand as the company grows, which leads to the potential for strong returns. This positive effect is amplified for companies at an earlier stage of developing a competitive advantage. Consequently, researching small and mid-capitalised stocks can often be well rewarded.
Sustainable growth characteristics
By investing in companies with different growth profiles, the risk/reward opportunities are better diversified and sustain alpha generation. Ashmore believes there are multiple factors that investors need to consider when targeting companies with sustainable growth characteristics:
Sustainable growth over high growth
While many companies are predicted to generate high growth, only a select few actually deliver. Consequently, identifying realistic and sustainable growth drivers is key, as is being selective.
Compounding growth through reinvestment
Growth is most attractive when combined with quality, as this enables a virtuous cycle whereby free cash flow can be re-invested at high rates of return. Taken in combination with a long runway for high return investment opportunities, this enables capital to be compounded over many years.
The power of compounding earnings is not perceptible in the short term. Instead, the majority of shareholder returns are reflected via changes in earnings multiples. However, over the longer term, it is growth and compounding of cash flows and earnings that can lead to extraordinary returns.
Preference for diversified growth drivers
Growth drivers can include price increases, entering new markets, new product development, cost reduction and operating leverage.
Cyclical growth that is driven predominantly by economic expansion and external factors cannot be relied upon. It is uncontrolled by management and can quickly disappear so requires additional analysis.
Growth driven by market share gains, product innovation and other initiatives is more sustainable as it is independent of the economic climate and is inherently more controllable.
The perils of low growth
Beyond a lack of compounding, limited growth opportunities can often be value destructive. It can lead management teams under pressure from shareholders to allocate outside their core competency.
Timeframe and forecast error
While long term profitability attributes are targeted, Ashmore’s experience has been that the value of financial forecasting and its accuracy starts to diminish after a five year time horizon, especially during periods of heightened technology disruption.
A disciplined approach to valuation
A disciplined approach to valuation of EM equities is important, otherwise investors could be paying for the next 3-5 years of shareholder returns upfront, which meaningfully limits the total returns they are likely to make.
EM companies with high quality attributes over the near term often trade at a premium to the broader market, which is a reflection of some expectation of short-term operational outperformance. However, over the longer run, high quality businesses are typically able to exceed expectations by maintaining high levels of profitability.
However, prices often do not reflect fundamentals, particularly in relation to the strong future profitability of mid or smaller size companies that are poorly researched. Stock prices generally discount high rates of return being competed away and thus systematically undervalue quality companies. The highest quality businesses with sustainable growth prospects can be held over the long run, unless market expectations become excessive.
Risk often gets priced more quickly in perceived risk assets such as EM. Eventually the mispricing is recognised, and assets are revalued. Active management enables Ashmore to systematically take advantage of such opportunities.
Emerging Markets today are the world’s primary drivers of global growth and wealth accumulation. They cover a dominant share of the world’s population and natural resources and are called home by the world’s largest group of future consumers.
Despite these incredibly attractive features, investors’ perception of these markets has not changed much over the last two decades and many miss opportunity because of the perceived risk. This gap between dated perceptions and today’s reality leads to a structural mispricing of EM assets and can provide investors with attractive investment opportunities.
EM equities are often used as a ‘satellite’ holding in a diversified international equities portfolio for investors seeking greater exposure to growth assets. An EM exposure can enhance growth and provide diversification to an investment portfolio and can complement an investor’s broader international equities exposure.
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