Emerging market equities have experienced an extended period of lower returns compared to other asset classes. Despite this, the team at LGM believes that there is a strong long-term case for the asset class but argues that a selective approach is required.
SELECTIVE THINKING
The case for investing in the emerging markets (EM) remains strong but a broad-brush approach could see you miss out on the most attractive opportunities.
Most listed EM companies operate in capital-intensive industries with little pricing power. So, by simply allocating to an EM benchmark, you are likely to gain sub-par EM exposure.
SEEKING DIAMONDS IN THE ROUGH
At LGM we invest with a long-term horizon, looking for quality companies with defensive characteristics such as robust balance sheets, high returns on invested capital and a stable and growing stream of free cash flows. The average emerging market company may not possess these qualities, which is why we believe that an active approach is essential – our bottom-up stock-picking approach has helped us to build a portfolio of attractively valued, high-quality stocks.
WHERE WE FIND OPERATIONAL EXCELLENCE
We find a higher proportion of quality companies in domestic sectors in the less developed parts of the world. These markets often have a high level of informality, which raises entry barriers and results in benign competitive environments that allow dominant companies (with a strong brand, distribution and/or scale advantage) to generate high margins and high returns and, as a result, strong free cash flow.
This approach has led to operational outperformance by our holdings compared to the broader market. Revenues have grown at 11.8% compound annual growth rate (CAGR) in US dollar terms over the past 5 years, outpacing the MSCI Emerging Market Index’s equivalent growth of 7.6% (CAGR) while operating profit has grown at 15.5% in US dollar terms; substantially higher than the corresponding 6.2% for the index. This demonstrates the strength of the underlying quality in our portfolio of companies and their long-term free cash flow growth potential.
A KEY DIFFERENTIATOR
The ‘active share’ of our portfolio is notable – on average, the strategy’s active share is above 90%, which is notably higher than comparable portfolios in the sector. We use proprietary research to build portfolios with only our highest conviction, best ideas that we believe will benefit from the secular demand trends in the region.
A GROWING WORKFORCE…
Over the next 15 years the United Nations expects that the working age populations in emerging markets ex China will amount to approx. 700 million people. In addition, Boston Consulting Group estimates that between 2010 and 2030, the population in EM cities will expand by 1.3 billion people.
…COUPLED WITH A GROWING CONSUMER POOL
In the Philippines, the per capita consumption of sweet and savoury snacks stands at 1.6kg per annum, which is at least three times lower than developed markets, providing a strong demand backdrop for our Philippine consumer holding URC, which dominates that category. Turning to banking in Indonesia, current credit penetration is 30% and less than 20% of the population has access to a banking account, which supports the long-term investment case for our two Indonesian financials, Bank Mandiri and Bank Rakyat. And in Mexico, despite having c.53% market share of the formalised market, Walmart de Mexico continues to have ample growth opportunities as the informal retail market still makes up 45-50% and will continue to lose out to the formal segment which has economies of scale working to its advantage.These companies benefit from secular trends, but more importantly, they have established strong ‘moats’ that allow them to generate high margins and high returns. It’s the continued strength and dominance of these business models which we believe is the strategic reason to invest in emerging markets over the long term.
A STRONG CASE FOR EM – IF YOU ARE SELECTIVE
We believe the investment case is attractive for our holdings: temporary headwinds will eventually stabilise and irrespective of slowing global growth, consumers will continue to purchase basic goods.
We believe the investment case is attractive for our holdings: temporary headwinds will eventually stabilise and irrespective of slowing global growth, consumers will continue to purchase basic goods. We continue to believe there are ample opportunities for long-term bottom-up investors to find high-quality companies at attractive valuations – an approach that, in our view, is much more sensible than adding emerging market exposure in a less selective manner.
LGM is one of the five specialist investment boutiques operating within BMO Global Asset Management. They specialise in Asian, global emerging and frontier market equities.
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