Sustainable Equities Boutique

How industry leaders help to unlock value in emerging markets

Viewpoint
Emerging Markets Sustainable Investing
merz_roger

Roger Merz

Head of mtx Portfolio Management, Senior Portfolio Manager

EM investors face a plethora of labels. Among the most prominent ones today is “BAT” representing the Chinese internet giants Baidu, Alibaba and Tencent. It all started in 2001 when Goldman Sachs grouped the four fast-growing economies of Brazil, Russia, India and China and coined the term “BRIC”. Since then, new acronyms have mushroomed, from “BRICS” (BRICs plus South Africa) to “MIST” (Mexico, Indonesia, South Korea and Turkey). As popular as these labels may be, they don’t tell the whole story and are certainly no guide for investing in these broad and diverse markets.

In this Viewpoints, Roger Merz and Thomas Schaffner reveal why the vast opportunities across EM are best captured at the stock level to consistently generate value for clients.

Companies within the same emerging market are different
EM represent a heterogeneous group of countries. Not only are they spread across various continents with geological, social and political differences, their economic paths and where they are in the current cycle is equally diverse. Therefore, when it comes to investing, many investors approach them from the top-down. They first conduct a country analysis and in a second step analyze the companies they have filtered. The problem is that they potentially miss out on opportunities as you may find high quality firms in countries with a poor macro environment and lower quality ones in thriving economies. This is particularly relevant for EM because dispersion of company profits and equity returns is greater than in developed markets.

Exploiting inefficiencies in emerging markets
EM are also rich with inefficiencies so from an equity market perspective, it’s all about identifying the biggest inefficiency at the lowest possible price. Finding these opportunities is challenging since often they don’t occur for obvious, analytical reasons. Rather, they’re created by short-term market thinking, misunderstanding of a situation and a mismatch between market perception and reality.

A strong framework is needed to distinguish leaders from laggards
So given the great dispersion of company profits and equity returns within countries as well as pronounced market inefficiencies, investors may want to approach EM from the bottom-up, using a combination of systematic screens and fundamental research. But how exactly can they distinguish leaders from laggards? It’s obvious that size in terms of market capitalization or revenues does not explain a global leadership. Many EM companies are large simply because of the size of the addressable market, protectionism or even geology. For example, nearly 90 percent of global oil reserves are located in this region and 80 percent of the world population lives there. Furthermore, EM harbor the majority of the arable land for food production and global reserves of fresh water. Therefore, the number of companies that are exposed to sustainability risks is much higher in emerging than in developed markets.

We would like to highlight the following key criteria for identifying attractively valued industry leaders (4-pillar approach):

  1. Consistently high and improving return on invested capital (ROIC),
  2. Strong competitive industry position,
  3. Attractive valuation and
  4. The company effectively addresses environmental, social and governance (ESG) issues.

The importance of ROIC is widely recognized in the corporate world and in 2016, The Wall Street Journal even declared ROIC “The Hottest Metric in Finance.” So why does ROIC matter  so much and what’s the picture like in EM?

ROIC – The link to value creation and outperformance
Generally speaking, the share price of a company tends to follow the ROIC. This is based on empirical evidence which suggests that the relative level of profitability matters for the returns of stocks, i.e. companies with a high level of ROIC outperform those with a low level of returns through the market cycle.

When taking a closer look at EM, competitiveness and profitability has clearly improved over the past ten years. In fact, the number of EM companies with a ROIC in the global first quintile has grown from 518 to 704 (Source: Vontobel AM, HOLT). What we also find is that ROIC is stable over time. In other words, leaders tend to stay leaders and laggards tend to stay laggards.

Example: Taiwan Semiconductor Manufacturing Company (TSMC)
TSMC has constantly reinvested its ROIC over the years which has led to a strong research and development (R&D) pipeline. As shown in chart 1, this has enabled TSMC to innovate i.e. produce ever smaller chips with a higher capacity that should allow the company to take further market share from its competitors (see chart 2).

2018-11-09_vp_st_how-industry-leaders_chart1_en
   
2018-11-09_vp_st_how-industry-leaders_chart2_en


Interestingly, the market tends to underestimate EM companies’ ability to sustain their profitability and thus future cash flow growth which ultimately drives equity out-performance through the market cycle.

Bottom line
EM offer a wide range of opportunities and potentially attractive returns given their superior growth profile driven by long-term structural drivers.
However, dispersion of company profits and equity returns is also greater than in developed markets. So to fully capitalize on the vast opportunity-set, it’s important that EM investors cast a wide net and embrace all companies in the universe before carefully conducting their research to identify the most attractive ones.

Therefore, EM investors may want to consider a fundamental, systematic and rules-based approach focused on leading companies to help them along their journey. With a disciplined focus on higher quality, yet inexpensive stocks, they can achieve portfolio stability in an asset class that offers an attractive long-term risk-return profile but also faces the inevitable bouts of market volatility.

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