Global Emerging Markets Letter - July 2017

This document contains information which is no longer up to date. As such, it is maintained solely for information purposes to provide historical information. This document should not be relied upon, including for the purposes of making an investment decision. Reference to the names of each company mentioned in this communication is merely for explaining the investment strategy and Stewart Investors does not necessarily maintain positions in such companies.

Risk Factors

In the UK, EEA and Switzerland, this document is a financial promotion for the St Andrews Partners Global Emerging Markets strategies intended for retail and professional clients in the UK and professional clients in Switzerland and the EEA only and professional clients elsewhere where lawful.

Investing involves certain risks including:

> The value of investments and any income from them may go down as well as up and are not guaranteed. Investors may get back significantly less than the original amount invested.

> Emerging Market risk: Emerging markets tend to be more sensitive to economic and political conditions than developed markets. Other factors include greater liquidity risk, restrictions on investment or transfer of assets, failed/delayed settlement and difficulties valuing securities.

> Currency risk: the strategies invest in assets which are denominated in other currencies; changes in exchange rates will affect the value of the strategies and could create losses. Currency control decisions made by governments could affect the value of the strategies investments and could cause the strategies to defer or suspend redemptions of its shares.

Reference to specific securities (if any) is included for the purpose of illustration only and should not be construed as a recommendation to buy or sell. Reference to the names of any company is merely to explain the investment strategy and should not be construed as investment advice or a recommendation to invest in any of those companies.

If you are in any doubt as to the suitability of our strategies for your investment needs, please seek investment advice.

Quality stocks, the perennial “outperformance of quality”, and weaknesses of some tech companies that are exceptionally fashionable right now

Because we have employed the same investment philosophy for almost thirty years, we believe our definition of “quality” has been consistent and has revolved around the ownership, management and culture of an organisation.

We prefer cash generative and predictable franchises to cyclical beasts; we prefer conservative balance sheets to heavy borrowers, but the integrity of the decision makers within a company has primacy.

From time to time our definition of “quality” has mirrored the view of “the market”, and from time to time it has not.

In 2007, “quality” in a Global Emerging Markets context referred to the chemical purity of Brazilian iron ore company’s mineral resources vs. peers, or perhaps to the complexity of an Indian industrial company’s oil refinery. In other words, commodity stocks did very well. For the next couple of years after that, “quality” meant “anything other than resources and especially anything other than Russian resources”, before the market narrowed its definition to “consumer companies with growth” – an area of the universe which is a more natural hunting ground for us.

Brief moments when “the market” agrees with you are usually as much of a curse as a blessing as they lead to the over-valuation of companies one is actually happy owning for clients.

Perhaps inevitably, the probable bubble now affecting Asian internet and technology companies means that “quality” has now been stretched to cover this part of the universe, although it would take a deep cynic to believe that quality has only ever been defined by the market as “that which has recently outperformed”.

These internet and tech businesses have, by definition, high returns on tangible assets and the auditors signed many of them off as net cash which helps quantitatively buttress the rationales for owning them. And if we were mostly franchise-focussed investors then the monopolistic nature of many of the businesses would be further evidence of “quality”.

Problems that we have identified with many of the in vogue tech-related stocks at present include:

  • Clear instances of minority shareholder abuse, including what some might class as the extrication of a significant business division before the company’s 2014 New York IPO (to the detriment of then existing minority shareholders). The stripped-out business is now mooted for its own $60bn IPO.
  • Complexity, for instance, an unusually high number of operating subsidiaries for an apparently simple sounding business.
  • Unusual business structure yet to be tested – for instance where foreign ownership of certain business types is restricted, whole franchises rest on a side-deal between operational management within the People’s Republic of China (PRC), and a tax-haven structure outside.
  • Acquisition sprees. In the developed world, it seems that the response to Amazon’s bid for Whole Foods has been “those poor supermarkets”. This may well be the correct view but a hindsight view could one day be “$13bn is a lot whoever you are, and trying to integrate that must have been a nightmare”. Asian tech and internet companies are also writing multiple large cheques – a Finnish developer of mobile ‘phone games was one recipient of a colossal cheque. Where governance is murky, it is harder to be confident that the less noticed acquisitions don’t also have a “friends and family” angle.
  • Other “diworsification” (diversifying into worse areas). The beauty of tech businesses is that the boundaries of their competence are yet to be established. Financial technology “Fintech” has existed for millennia (the UK decimalising the currency in 1971 is one example). But the confluence of expanding tech companies and finance is irresistible – a couple of notable Asian tech companies are accepting pseudo-deposits yet aim to produce returns on capital to investors far in excess of that which a bank with the benefit of deposit guarantees could ever make.
  • Political intrigue. Following in his father’s footsteps, the vice-chairman of a large South Korean technology company was recently arrested for alleged corruption as part of the investigation into scandals that led to the fall of the President. Only in South Korea (perhaps?) would the share price go up (coincidentally or as a result of, we will never really know).
  • Political intrigue Mark II. It doesn’t take much of a conspiracy theorist to imagine (perhaps to hope) that Western intelligence services have a back door into social media websites, search engines and so forth. Quite how this alters the risks of these franchises and their high-profile founding management in the West is up for debate, save that it appears less of a risky potential conflict in a democracy than an autocracy.

There is no doubt some other faults too (in addition to the bright spots), but we are keen that clients are well aware that a stewardship flaw that we identified in a particular company which made it uninvestable at a market capitalisation of perhaps $50bn remains. Corporate governance still continues to rule that company out for us at a market cap of $300bn and beyond.

Portfolio positioning and outlook

Very little has changed. Valuations are fair or full for many of the companies we admire. We were relieved that the largest holding in many strategy portfolios was not acquired by KraftHeinz and the 3G consortium.

Relieved not only because finding a company of similar quality would be a challenge, but also because it may have represented a small push back against debt-fuelled acquisitions and narrow definitions of shareholder value creation. We look now at the 3G controlled brewer ABI-SAB and wonder how long profits can hold up within a business model and capital structure that is forced to prioritise shorter term cashflows, and which therefore struggles to grow volumes.

Areas of comparatively better value, especially with quality in mind, include Indian IT outsourcing companies and some domestic-focused South African companies. Some areas of the universe which provided a brief opportunity to build positions – Mexico towards the end of 2016 for example – are once again more fully valued.

Tom Prew
July 2017


Source for company information: Stewart Investors investment team and company data. For illustrative purposes only. Reference to any companies mentioned in this communication is merely for explaining the investment strategy, and should not be construed as investment advice or investment recommendation of those companies. Companies mentioned herein may or may not form part of the holdings of Stewart Investors.

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