Notes from the road: United States investor roadshow

In his hit song “Walls”, Tom Petty sang, "Some days are diamonds, some days are rocks." Although he wasn't singing about emerging markets, this unwittingly sums up the asset class - inherently cyclical in nature. Over the past few months, emerging markets have been a case of all risk and no return. My recent trip to visit with US investors confirms that this view is on the minds of allocators and consultants from coast to coast. Being back on US soil following a COVID-induced hiatus was a pleasure, to meet with colleagues and clients in person and importantly to debate and discuss views on markets. The following is a summary of the key topics that were discussed during my meetings.

Top questions asked by investors and consultants:

1. What impact is deglobalization and higher inflation having on emerging markets?

Globalization has been a dominant theme over the past four decades and a key driver of corporate earnings and returns. It has led to companies a. adopting asset-light business models, favoring just-in-time inventory management (which has boosted asset turns), b. outsourcing business processes (which has boosted profit margins), and c. increasing leverage to buy back shares (which has boosted earnings per share). However, three supply shocks over the past four years - US/China trade war, COVID, Russia/Ukraine - have exposed the frailties in these integrated supply chains. In fact, companies are now shifting focus to just-in-case inventory management, localization, and vertical integration to shore up supply – essentially, deglobalization. For example, China power-tool company Techtronics Industries* recently declared that 25% of production will shift to the US by 2024. The culmination of these acute supply shocks and the trend towards deglobalization is ultimately inflationary. It is also likely to mean that higher costs are here to stay for longer. We think that operating in a deglobalizing world requires a nuanced, flexible approach to generating alpha in EM.

These nuances are expressed in our portfolios through three broad buckets:

• Supply tightness beneficiaries, such as Anglo Platinum* and Zijin Mining* (~40% of global supply of palladium comes from Russia), Mosaic Company* (~35% of global potash supply comes from Russia/Belarus), and Qatar National Bank* (given Qatar's significant buildout of LNG infrastructure)
• Infinity machines i.e., businesses with long growth runways and strong execution track records, such as China Longyuan Power*, CATL* and ENN Energy* (all critical in helping China push towards their net zero ambitions), HDFC Bank* and Reliance Industries* (with the informal retail sector contributing a whopping ~80% of total retail market share in India)
• Pricing power, such as retailer Carrefour Brasil*, semiconductor behemoth TSMC*, Saudi mortgage leader Saudi National Bank*, and power tools manufacturer Techtronics Industries*

2. Is China investible?

China’s risks can broadly be summarized as:

• Financial risks, including slowing GDP growth, a struggling property sector, multiple lockdowns
• Regulatory risks - increasingly stringent regulation across all sectors
• Geopolitical risks, both the US from the threat of delisting Chinese ADRs, and Taiwan from the threat of potential invasion

While these risks are tangible and cannot be underplayed, we would counter that the steer from China's Vice Premier Liu He on March 14, 2022, is incrementally positive. Acknowledging that the economy is under pressure, he expressed the importance of using monetary policy to stimulate the economy, that any further regulation would be balanced by introducing market-friendly policies to support businesses, and finally that China would be willing to take the first step in revealing the financial accounts of US-listed Chinese firms to the SEC. It is also our view that given the events around Russia's invasion and the severe repercussions, the risk of China stepping outside of its borders has decreased at the current moment (although not disappeared).

3. What does an Emerging Markets excluding-China opportunity set look like?

EM ex-China is an asset class that has attracted more attention in recent years. Investing in China has polarized opinions, which has led to some China bulls to opt for a discrete China allocation versus some China bears who wish to strip China out of the equation. This phenomenon has supported the viability of the EM ex-China asset class.

Importantly, we feel that the quality of the opportunity set is not compromised by removing China. Compared to emerging markets, Asia and Consumer Discretionary are down-weighted vs. Latin America and Information Technology that are up-weighted. Key markets such as Taiwan, Korea and India are up-weighted, which is a fertile hunting ground for consumer technology businesses, whereas the likes of Brazil and Mexico provide access to some of the world’s leading commodities companies. For more detail on the investable universe and our portfolio, read our latest update here.

4. Are emerging markets finally due for outperformance?

The asset class is trading at a ~40% discount compared to developed markets, not far off from 20-year lows. With the asset class broadly under-owned, investor sentiment at the point of “Is China investible?”, and a prolonged period of relative underperformance, we believe the asset class provides an attractive long-term opportunity for investors.

Conclusion

Notably, the asset class has come on in leaps and bounds over the past decade. One only needs to look at the top 20 benchmark names to evidence this. An index previously dominated by clunky state-owned companies has given way to enterprising, founder-led businesses with stronger governance norms. We believe that this a function of a distinct change in attitudes in emerging markets over the years that celebrates and promotes entrepreneurship. Using the blueprint of successful Western entrepreneurs, emerging markets have their own breed of game-changing founders, such as Chinese EV battery manufacturer CATL's Robin Zeng, Indian conglomerate Reliance Industries' Mukesh Ambani, and Internet giant Tencent’s Pony Ma, to name a few.

To summarize emerging markets in a nutshell: a more attractive opportunity set, a long growth runway, a supportive environment for entrepreneurs, and bargain basement valuations that appear to be pricing in a lot of the risks.

I look forward to more conversations on emerging markets…but for now, “I’m leaving on a jet plane…” and do look forward to being back again.

Best wishes,
Varun
Portfolio Manager, EME ex-China, 4Factor

*This stock is held in 4Factor portfolios.