Rasmus Nemmoe, a portfolio manager at FSSA Investment Managers, talks about why now is a good time for emerging markets – and how he spots “growth traps”.
The last five years have been an interesting time for emerging markets – we have witnessed the tragic war unfold in Ukraine, increased geopolitical tensions between the US and China, panic over the election of leftist governments in Latin America, nationwide lockdowns in response to Covid-19, and a brief period during 2020/2021 where we began to question the sanity of markets.
But we have also seen plenty of opportunity. As bottom-up investors, we focus on company management teams and franchises with sustainable growth, not politicians or macroeconomic forecasts. Short-term macro forecasts or political events are outside our control, and we do not think we have any significant ability to predict such events. Therefore, we are sceptical about any investment case predicated purely on a supportive macroeconomic environment or a favourable political outcome, and we factor in the potential for an adverse environment when considering new investments.
Being bottom-up investors doesn’t mean ignoring macro completelyIn some rare instances, external macroeconomic issues can completely swamp even the best-run company. The Argentine bank Grupo Financiero Galicia is one example. In 2017, the firm had demonstrated a strong culture and franchise – and had averaged 37% return on equity (ROE) for the previous five-year period, with performance underpinned by a good deposits franchise.
With the election of a new leader, President Mauricio Macri, it seemed Argentina would regain its former glory, and hyperinflation would finally be controlled. However, politics in the country took a dramatic U-turn, and the economy, which had been improving, was destabilised yet again. These developments, along with intense currency headwinds, dramatically affected the investment case for the company.
This example demonstrates the importance of limiting portfolio exposure to so-called “high-risk” economies (simplistically defined as those with adverse macroeconomic conditions).
Conviction comes from thinking long termThe Covid-19 pandemic has dominated most aspects of life and business for nearly three years now, with places like China still battling the spread of the virus. Many companies were also significantly challenged as the unprecedented lockdowns took a toll on their businesses.
For instance, the Mexican Starbucks operator, Alsea, had never experienced same-store sales declines of more than 4% before the pandemic, but during the second quarter of 2020, sales declined by 60-70%. For some travel-related companies, like Mexican airport operator Grupo ASUR, or Latin America’s leading online travel agent Despegar, the year-on-year sales decline was even greater, at 95%.
At this point, we re-evaluated the businesses of certain market-leading companies. This gave us greater conviction because we realised that their competitors would be even worse off if they were struggling. It became increasingly clear that these companies should have an even higher market share and face less competition when the lockdowns eventually ended.
Even though the early stages of the pandemic were particularly challenging, we tried to look beyond the immediate situation – and found some very attractive bargains.
Avoiding growth trapsDuring late 2020 and throughout 2021, there was a frenzy of initial public offerings (IPOs), most of which had dubious business models and sketchy financials. Meanwhile, valuations lost all relation with fundamentals as companies that were beneficiaries of Covid-induced work-from-home strictures were bid up to stratospheric levels.
Most of the “stars” of this time were firms we call “growth traps”, characterised by a business model where a constant supply of capital is needed to fuel growth despite mounting operating losses. There is no evidence yet of such companies being able to capture the profit pool they have destroyed in their quest for scale.
In the last few years, most emerging market IPOs are now languishing below the listing price, and there were many examples of flawed business models that promise a “path to profitability”. In these phases, staying disciplined and not being enticed into overpaying for stocks is important.
Why look at global emerging markets now?Despite the challenging conditions of recent years, many long-term secular trends offer growth potential. Valuations are now quite attractive (particularly in China and compared to the US), and quality businesses with proven management teams and competitive advantages will be able to capitalise on the long-term secular trends in emerging markets.
And there are plenty of growth opportunities, such as the formalisation of the Indian economy, the continued financialisation of the South African population or the growing adoption of enterprise resource planning software in Brazil. Yet, these kinds of businesses are often not well represented in broader indices, so we believe a bottom-up active investment approach has much value to add.
*Rasmus Nemmoe is a portfolio manager at FSSA Investment Managers, part of First Sentier Investors.
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