Global Emerging Markets Strategy Update - March 2020
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- Global Emerging Markets Strategy Update - March 2020
It seems that an awful lot has changed since our 2019 year-end letter came out in January. Some of our casual predictions have turned out to be about right – most obviously that the Crown Prince of Saudi Arabia may not run Aramco in the manner suggested prior to its stock market listing, and also that Brasilian equities were especially over-exuberant.
We noted that after a decade of ultra-loose monetary policy, our strategy portfolios were positioned conservatively with an emphasis on steady cash generators with pricing power, and that we owned a number of companies which we are confident are of the highest quality especially as regards to management integrity but which we wish were somewhat more reasonably valued. We noted too that we find the Chinese market difficult to invest clients’ monies in and therefore had extremely low exposure – there are few companies where we can evidence governance of sufficiently high levels to be confident in investing. Those companies on the watchlist often have difficulties with working capital, levels of debt, or sometimes just of optimistic valuation.
In such a context we might have expected that a significant market crash would have been kinder to our strategies, especially if the original centre of the health crisis appears to have been China. Although usually pessimists about much of the world we remain optimistic about our portfolios’ ability to weather difficult times and prosper in their aftermath. There are a few reasons we believe this has not happened yet which we should like to try to explain.
The biggest market puzzle is the continued outperformance of the Chinese stock market this year. Whereas emerging markets (MSCI Emerging Markets Index) and global markets (MSCI AC World index) are both down 32% in US dollar terms (21% in GBP) year to date to 23 March, the Chinese stock market has fallen roughly half this amount (the MSCI China Index is down 18% in USD and down 5% in GBP)1. This could be because China is perceived to have stopped COVID-19 in its tracks in (primarily) only one province, or it could be because of overwhelming state support of stock markets. Perhaps a bit of both. One element of the long term ‘buy case’ for Chinese equities is the country becoming ever more interwoven
with the global economy. Yet as the rest of the world briefly worried about a shortage of various widgets normally “Made in China”, Chinese stock markets and the Chinese currency appear not to worry that nearly all the customers of the world’s largest exporter of goods are likely to fall into severe recession.
As we have written before, any economic wobble in China is dangerous given exceptionally high levels of debt in the economy and an autocratic system which recently demonstrated the disastrous consequences of bad news failing to reach the top in a timely manner. A wobble in China could be especially dangerous for foreign investors given that corporate rule-of-law in China is untested in times of stress. Renminbi denominated Chinese government debt is the latest feeding trough for yield hungry (now yield-starved) investors who escaped from US or European high-yield funds this time around (or who presumably escaped in time from sub-prime mortgage-backed-securities last time around). Hiding in local currency bonds issued by one of the world’s most indebted countries is another sign of the times.
The second market puzzle is likely to iron itself out quite soon – which is simply that in the dash for the exits, many companies we would have considered to be high quality have been sold off just as heavily as some of those of lower quality. Whilst there will certainly be some companies where we have ourselves over-rated their qualities, the Indian IT companies feel a good example of companies that have performed poorly yet should as businesses have a fairly resilient few years. For sure, not all of their customers will have their best years, but by and large the contracts that the Indian companies work on have reasonably assured revenue and pay in hard currency vs. wage costs substantially in Indian Rupee. All the Indian IT companies we own are net cash and have high standards of governance.
The modest gold exposure of the portfolios has initially been affected by the fairly indiscriminate sell-off. In 2008/09 it took a moment or two after the deluge of quantitative easing began for questions to be asked as to the value of cash in a zero interest world. A moment or two after the current crisis began the taps have been turned on fully and, writing from the UK, the amount of money that will need to be printed to underwrite salaries in a world of sharply reduced government tax revenue is frightening. Short of forcing banks, pension funds and insurers to hoover it up (a “raid” when it happens in emerging markets) we are puzzled where it all goes. More broadly, it may be that the world continues to hide only in the US dollar (and equities or bonds listed in and backed by a Communist state) but in most past crises going back some centuries gold has also been a store of value.
On the positive side, our preference for genuine consumer staples such as the food products of Unilever and well-run consumer businesses in India will have looked after us better than some of the brands found in the luxury boutiques of airport duty free shops or some of the highly indebted global consumer behemoths.
The final negative contributor is, as ever, hindsight. As long-term investors we are reluctant to consign investments here too soon but there are one or two examples which have cost clients and us. One company where we have crystallised a steep loss is an oil company. London-listed Tullow Oil is the only energy company we owned at the turn of the year and is one of only two energy companies the strategies have owned since we sold Lukoil in 2010
(ConocoPhillips sold out which for us removed any likelihood of protection for minorities should it be required in a Yukos event2). We admired the company because we believed the management team were running an oil company in a manner that truly appreciated how a licence to operate could be earned and lost. We sold the company because despite all of its good work in Ghana, the debt that it had accumulated bringing the project to fruition meant
it was increasingly not in control of its destiny. Management may well have over-promised and if we were to take a lesson here it would be that the mere presence of debt changes the conversation that management teams have with equity holders – you are no longer their only financial ‘stakeholder’ to use modern jargon. We should like to think the lesson is well observed in most of the strategies (a low weighting in banks and a long list of net cash and very lightly geared companies) but that is not to say it has not made us reflect.
On a hopeful though penultimate note, we are finding many good companies now trading at their most attractive valuations in some times – some we own already and are happy buying more (Indian IT companies), some we sold a year or two ago and are happy to reconsider (our favourite Brasilian bank now trades below 1x book value). There are good companies with strong historic cashflows and net cash in excess of a third and sometimes a half of their market capitalisation, and there are banks which survived 2008/09 trading at price-to-book ratings suggesting bankruptcy. We are, as ever, looking hard at what we do own for clients and are aiming always to look forward as far as we can – there will be holdings which may not have looked after us these past months which are still worth exchanging for better five or ten year opportunities.
And finally. Although this has been a severe market correction, it has been unusually ‘clean’ by emerging market standards or by 2008/09 standards – almost suspiciously so. At time of writing (from home, of course), no investment banks have gone belly up and the list of stock exchanges to have closed or had “technical difficulties” is so far short and fairly minor in terms of overall size: the Philippines and Sri Lanka for a couple of days; Bangladesh for a couple of weeks; Turkey banned short-selling earlier in the year. Similarly, capital controls of significance have not appeared yet. Although most emerging market currencies have taken a hit, it has been easier for investors to extract their money from small-cap companies in the smaller markets of Latin America than it has been from multi-billion commercial property funds in the UK.
24 March 2020
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1 These figures refer to the past. Past performance is not a reliable indicator of future results. For investors based in countries with currencies other than those shown, the return may increase or decrease as a result of currency fluctuations.
Source: Lipper IM/Stewart Investors. Benchmark income reinvested net of tax.
Yield: is the income return of an investment.
Net cash: a company’s total cash minus total liabilities when discussing financial statements.
Quantitative easing: an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
Book value: the value of an asset according to its stated value on the balance sheet of a company.
Market capitalisation: the value of a company traded on the stock market.
Price-to-book rating: (Price-to-book ratio) the ratio of a company’s market value to its book value where the book value shows the company’s assets expressed on the balance sheet. A lower ratio could mean that the company is undervalued.
Short-selling: Short selling is an investment or trading strategy that speculates on the decline in a stock or other securities price.
Additional index performance
These figures refer to the past. Past performance including simulated past performance is not a reliable indicator of future results.
For investors based in countries with currencies other than those shown above, the return may increase or decrease as a result of currency fluctuations.
Source: Lipper IM/Stewart Investors. Benchmark income reinvested net of tax.