Peter Lampert is Portfolio Manager, Emerging Markets, International Equity, Mawer Investment Management Ltd.
Signal, not noise
Emerging markets are in the spotlight as they’ve been showing increasing signs of stress. First, it was Argentina’s depreciating currency earlier this year, then Turkey with the lira falling 25 per cent in a single week. Now we are seeing a pullback across emerging markets in currencies and equities from China to South Africa to Brazil. Such events are consistent with our base case view that we are likely to witness more cracks emerge as we move later in the cycle with tightening global liquidity conditions.
It’s one of our roles at Mawer as bottom-up, long-term investors to differentiate between signal and noise, and it seems that what we’re seeing is signal as emerging markets are now approaching bear market territory. For nearly a decade, we have enjoyed a bull market, with low interest rates leading to rising asset prices that had investors reaching for yield in riskier asset classes. As this trend is now reversing with a strengthening U.S. dollar and rising interest rates, it’s not surprising to see emerging markets get hit first with falling valuations and currency sell-offs as capital flows back out of the asset class.
While some investors like to move in and out of emerging markets, we believe successfully—and consistently—timing the market is virtually impossible. In contrast, Mawer’s approach is to build a resilient portfolio of strong companies that can survive the downturns and thrive over the long-term. After a strong rally in 2017, emerging markets stocks peaked this year on January 26 and have since retreated. During the pullback so far, the Mawer Emerging Markets Equity fund has outperformed the MSCI Emerging Markets Index by 3.85 percentage points (-8.76 per cent vs -12.61 per cent in Canadian dollar terms).
Opportunities over time
It is probably not surprising that one of the most frequent questions we’ve been asked recently is what our fund’s exposure is to Turkey. The answer is zero, although we previously held Turkish software company Logo but sold it in January due to company-specific concerns in combination with a deteriorating economic outlook in Turkey.
An even better question is: where are we finding resilient investments in the current environment? For the most part, our assessment is that valuations of riskier companies with higher growth prospects are not adequately reflecting current risk levels. Instead, we favour the more stable, boring businesses with strong competitive advantages that generate reliable cash flows.
Two beer companies make our list in terms of resilience: Heineken Malaysia and CCU in Chile. Both have very dominant market shares in their respective regions, are highly profitable, and generate strong cash flows. And as they are both subsidiaries of Heineken, investors acquire emerging markets exposure while having confidence that a well-managed multinational corporation is ultimately overseeing operations.
HDFC Bank in India and Itaú Unibanco in Brazil are two banks that fit our criteria. Although other banks are often riskier and more cyclical, these two are very well-run and have demonstrated their ability to not only weather past downturns but to also gain market share from weakened competitors.
We also find opportunities among small caps, which tend to be more overlooked, particularly in South Korea and Taiwan, which are two of the more economically stable countries within emerging markets. Two such examples are S-1 Corporation, the leading alarm security system operator in South Korea, and Tehmag Foods, the leading distributor of food ingredients to bakeries in Taiwan. Both have strong competitive positions in their niches, resulting in stable cash flows and favourable long-term prospects.
Inevitably, investors will face shocks and downturns throughout market cycles, and these often first appear in emerging markets. Over the long-term, emerging markets may be attractive for investors who can take a sensible approach and stomach heightened volatility.