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Fifteen years in emerging markets
Stewart Investors Global Emerging Markets Sustainability strategy launched fifteen years ago in 2009. Portfolio Manager Jack Nelson reflects on fifteen years investing in emerging markets
At the end of 2009, emerging markets were riding high. The MSCI Emerging Markets Index soared 73% that year.1 With western economies mired in recession following the financial crisis, developing countries seemed to offer a beacon of economic hope.
Plenty of authors and commentators projected that China, India, Russia and Brazil would grow rapidly into economic powerhouses, and that equity investors in those countries would be rewarded commensurately.
This point in time marked the peak for such wide-eyed optimism. At year end in 2009, the MSCI Emerging Markets closed at 989. As of early 2024, it stands at 1025 – a return of just 0.2% per year.1
After a lost decade and a half, many asset owners understandably now ask “what is the point of allocating capital to emerging markets?”
Our answer would be that the top-down narrative was always deeply flawed – but that the bottom-up case for emerging markets has never been stronger.
"...top-down narrative was always deeply flawed – but that the bottom-up case for emerging markets has never been stronger."
The original thesis for emerging markets investing was that large developing economies converging on developed world income levels, would power outsized equity market returns. The last fifteen years have confirmed that this idea was flawed in two ways.
Firstly, a lower initial income per head is no guarantee of rapid growth. While some emerging markets, particularly in Asia, have seen income levels converging on rich countries, many others have fallen further behind.
Secondly, economic growth alone is not a sufficient condition for rewarding stock market returns. Often, government intervention, geopolitics and poor corporate governance has intervened to disappoint investors even in rapidly growing economies.
Our rationale for running emerging markets equity products was never about top-down acronyms like ‘BRICs’ (Brazil, Russia, India China), which we didn’t feel made a lot of sense. Instead, our rationale was rooted in the bottom-up: we believed that the emerging markets (EM) universe contained sufficient numbers of underappreciated, high-quality companies that we could deliver attractive long-term returns to clients.
And in contrast to the top-down narrative, this has proven correct: there have been more than enough great companies in emerging markets to deliver attractive absolute returns to long-term investors, even over a fifteen year period in which the EM benchmark return has been disappointing.
Given the huge gap in quality between the best and the worst companies in EM, it has been essential to take a highly selective approach to the opportunity set. Reflecting on our best and worst investments over the last fifteen years gives us a number of insights into what has worked and what hasn’t in terms of our stock selection.
Long-term quality
First and most importantly, quality has been the largest determinant of outcomes over the last fifteen years. Our best returns have come from those companies like HDFC Corp (India, Financials), TSMC (Taiwan, Technology) and Raia Drogasil (Brazil, Healthcare) that boasted a strong business getting stronger under the stewardship of excellent management teams. Over extended periods of time, management decision-making and culture is the single most important aspect of quality, since all other aspects of quality, from balance sheet to brand, arise from decisions made by those managers and owners.
Our greatest mistakes have been times when we have either neglected a critical aspect of franchise weakness, like Idea Cellular (India, Telecoms) or Sonda (Chile, Technology), or where we have overlooked flaws in the people in charge that we should not have, such as Choppies (Botswana, Consumer Staples)*.
It is all too easy for investors to become anchored to existing ideas and holdings, even when things have evidently started to go wrong. Cheap valuations are then used as a last-ditch rationale for continuing to own a company whose challenges are becoming self-evident to the market. We are of course guilty of these behavioural mistakes. We spent far too long continuing to own the likes of Tiger Brands (South Africa; Consumer Staples), a franchise with ebbing pricing power, a shrinking share of consumer wallet and an accident-prone management team. With deteriorating businesses, it would have been more prudent to have moved on sooner rather than we did.
In many such cases, the lesson has been that ostensibly ‘cheap’ valuations are no substitute for quality. Whatever price you pay for equity in a company, the downside risk is always -100%. It broadly has been worth paying up a little for the best companies.
The importance of patience
Secondly, and adjoined to this critical point on quality is the importance of patience. For many investments, we should have been less rather than more active.
With most of the best companies, there have been times when we have tried to be too precise on valuation, not owned some of the strategy’s best companies, and missed out on returns as a consequence. We did the hard work of identifying the best investments, but sometimes tried to be too smart in terms of the price we paid.
Great companies compound capital over time, but it is very hard to predict the undulations of their return profiles in advance. We have owned electric motor manufacturer WEG (Brazil; Industrials) for almost the entire duration of the strategy’s existence. Over that period, the total return in local currency has been 25% per year. Yet if you missed out on the 3 best years in that 15-year period, the annual return would fall to 10%.1 That’s a tremendously worse outcome. $100 compounded at 25% for fifteen years becomes just over $3000; when it compounds at 10%, it’s just $423. An investor trying to time in advance trading in and out of WEG would undoubtedly have made mistakes in the attempt, and very likely have ended up with an inferior return than a buy and hold approach.
The lesson is to retain humility in our ability to value companies precisely, to remain actively patient and to ensure with top quality companies we focus on letting clients’ capital compound rather than interrupting it, unless there is very good reason to do so.
Ability to grow
The third major lesson is that the best returns have come from companies that have delivered consistently strong earnings growth, which requires an ability to grow into large addressable markets. This is a systemic challenge for many emerging markets, since almost by definition the size of the market in Hungary, Chile or Qatar is quite small. Domestic companies in these sorts of countries are unlikely to ever become large market capitalizations.
Our approach has been to own companies which get around this challenge in two ways.
The first is to invest in companies that are addressing large domestic markets, like the Indian financial sector in the case of HDFC Bank (India, Financials) or Latin American e-commerce in the case of Mercadolibre (Argentina, Technology). These companies have room to grow by consolidating a very large fragmented market, taking market share from inferior incumbents, or driving penetration of a previously unused technology.
The second is to own companies whose products and services are globally competitive and therefore able to tap into worldwide demand. Examples in our portfolios would be the likes of Tata Consultancy Services (India, Technology) whose technical expertise is demanded by corporates not just in India but across America and Europe, and Advantech (Taiwan, Technology) whose industrial automation systems are sold around the world. These sorts of companies have circumvented the challenge of small addressable markets in EM, and been able to deliver outsized returns over time.
Don't forget the context
The fourth lesson is that companies don’t operate in a vacuum. Even as bottom-up stock pickers, we cannot ignore the context. In particular capital should not be allocated based on top-down macro ideas, but the riskiness of emerging markets politics and currencies give us good reason to sometimes be extremely wary.
We have learned this lesson the hard way, with investments in countries like Nigeria and Egypt proving to be extremely difficult: it has been perfectly plausible to pick great companies in these countries and end up with a poor outcome. Our favourite bank in Egypt, for instance, has delivered a 27% compound return in Egyptian pounds over the last fifteen years; once converted into US$, this drops to 10%.1 A great company whose management team has delivered for shareholders handsomely has proven to be a difficult place to make superb returns for foreign investors, due to top-down factors beyond management’s control.
Top-down factors cannot make an investment case, but they can break one.
Looking forward and on a bottom-up basis, the case for investing in emerging markets has never been stronger because the universe contains more great companies than ever before.
Fifteen years ago, emerging markets investing was synonymous with resources, banks and telecoms. The most important companies were state-owned giants like Vale, Gazprom, and China Mobile. There were relatively few genuinely innovative or globally competitive companies outside of materials extraction.
There has been a tremendous change in this regard. Emerging markets are now home to a raft of the world’s leading companies in fields as diverse as semiconductors, renewable energy technologies, software as a service, healthcare supplies, fintech and e-commerce. There are more opportunities to invest in companies whose development is driven by adoption of new technologies rather than GDP growth.
Moreover, as the domestic savings pools of these large economies are financialized, we are seeing greater access to these opportunities as foreign investors. Mumbai and Shanghai have become global centres for new company listings. And with the opening up of the A-share market, we now have access to an additional 5,000 Chinese companies, which are largely excluded from benchmark indices under current methodologies.4
Emerging markets are now home to a raft of the world’s leading companies in fields as diverse as semiconductors, renewable energy technologies, software as a service, healthcare supplies, fintech and e-commerce.
This has given the strategy the chance to invest in exciting new ideas like IndiaMart (India; Technology), the dominant online B2B marketplace in India, allowing suppliers and customers to find each other in industries as diverse as textiles, medical equipment and electronics. With 7.8 million sellers and 187 million buyers on the platform5, IndiaMart’s scale and network effects will be hard to disrupt. We believe IndiaMart has a bright future as India industrialises and its SMEs go online. Companies combining such high-quality fundamentals and such attractive growth prospects were certainly rarer in 2009.
Emerging markets as an asset class has had a difficult fifteen years. However, the strategy’s performance over that time demonstrates that with a high conviction yet highly patient approach to capital allocation, attractive returns have been possible.
Especially today, at a point when emerging markets are broadly unpopular and have faced significant headwinds in the form of rising global interest rates, we find it easy to be optimistic about prospects for returns going forward. Over the long-term, the improved universe of quality companies makes us very excited for what the next fifteen years can deliver in emerging markets.
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