Macroeconomic issues have undoubtedly influenced investor sentiment lately. In light of concerns about slowing economic growth, for instance, cyclical stocks have generally been overlooked and we are seeing many attractively priced, economically sensitive opportunities appearing. We have been recycling capital from defensive areas into more cyclical sectors such as materials and financials, in particular banks.
Valuation extremes are evident at the country level too as investors have flocked to smaller markets like Mexico, Indonesia and Thailand. We consider valuations in these markets to be excessive and have reduced our exposure recently. On the other hand, there is negative sentiment towards larger markets such as China, Korea and Brazil, but we believe investors’ concerns have been over-discounted.
We have seen this situation before. A few years ago, Thailand was out of favour, trading at a major discount to other emerging markets as the country was beset with rioting and violence. And yet today it trades at a significant premium. Back then, we increased our exposure when Thailand was ‘unloved’ and trimmed it when sentiment changed.
In the current environment, we believe there are great returns to be had by taking a long-term view based on fundamentals. There are plenty of risks in the bigger emerging markets at present, such as the slowdown in Brazil and China. However, these factors have been more than discounted and we think there are attractive opportunities for long-term investors.
Brazil has undeniably been affected by concerns about slowing economic growth and government meddling in its two largest companies, Vale and Petrobras. But investors cannot ignore the fact that valuations have fallen dramatically. We think this makes Brazil worth exploring. In our view, there are plenty of well-run Brazilian companies, with good business models and attractive growth prospects.
We have recently invested in Banco Bradesco, one of the country’s largest private sector banks, and Brasil Insurance, an insurance broker that is engaged in consolidation of the market. In our opinion, it has a straightforward and profitable business model as it takes commission for every insurance contract, without handling client cash.
In Mexico, there are some great companies, but at current valuations, to us, they are not necessarily great investments. A few years ago the news was full of drug violence. Today, everyone is excited about the government’s reforms. The prospects of Mexico are well known.
The market has seen a notable shift toward ‘quality stocks’. Consumer staples stocks have seen a marked increase in their valuations in the past few years. They used to trade roughly at a 50 per cent premium to the index, but now it is around 150 per cent. Three years ago we had an above-index position in the sector, but are currently about 4 per cent underweight because we feel it is so expensive. Investors have very high expectations for the growth prospects and returns of these stocks. Until recently we held FEMSA, a Mexican drinks-bottling firm. We think it is probably one of the best managed companies in the emerging markets, but we could not justify the valuation given the level of future returns that were priced in.
The capitalist model implies that competition will cause a company’s high returns to fade over time. The current valuations of consumer-related businesses suggest they have a competitive advantage which means their returns would not fall. In my view, these valuations can only be justified if these firms never experience any competition. In emerging markets today, companies are at an early stage in building brands and everyone is competing for market share. I am concerned about investors’ expectations given the huge amount of competition and because I do not believe many firms yet have the competitive advantage to sustain high returns.
As an outlook for the asset class, on the whole, I think many emerging market companies look very attractively priced, particularly relative to developed markets. In my view, the wide dispersion of valuations between countries and sectors also presents numerous opportunities for discerning, active investors to identify firms whose long-term potential is under-appreciated.
One headwind that emerging market companies are facing is the direction of return on equity. Emerging market firms have done a great job of improving their profitability in the past decade. More recently, however, the level of returns has fallen. One of the biggest challenges for companies today is how to stem this decline in returns. We believe this can be achieved through investment in research and development, innovation, brand creation, outsourcing and introducing modern management practices. The old advantages of cheap labour have arguably gone and firms are going to have to work harder to generate returns.
In this environment, the onus is on management teams to act. When searching for potential investments, we want to back management teams that are doing the right things to create value. We try to find companies which are focused on their returns on capital and are taking steps to improve them. This might involve restructuring or shrinking their businesses to enhance performance.
In our opinion, emerging market companies could also increase asset utilisation; many firms are over-capitalised. We would like them to use their balance sheets more efficiently or return the capital to shareholders. For instance, Korea’s Samsung Electronics only pays about 5 per cent of its earnings as dividends despite having plenty of cash on its balance sheet. We think Samsung could raise its dividend, but it is worried about being perceived as ‘ex-growth’.
In the future, we expect Samsung and other emerging market companies to start acting more for their shareholders. When engaging with management teams, we encourage them to act in the best interests of all their investors and move away from a focus on growth to increasing their returns and creating value for shareholders.
Matthew Vaight is manager of the M&G Global Emerging Markets fund