Should Emerging-Markets Stocks Stand Alone in Your Portfolio?

On this episode of The Long View, Jack Nelson, the lead manager of the Stewart Investors Global Emerging Markets Leaders Sustainability strategy, breaks down the role of emerging-markets equities in your portfolio, the bottom-up case for these equities, and how sustainability factors into investing in emerging markets.

Here are a few highlights from Nelson’s conversation with Morningstar’s Christine Benz and Dan Lefkovitz.

Why Emerging-Markets Equities Seem to Have a Persistent Justifiable Discount

Christine Benz: You mentioned that there’s a weak correlation between economic growth and returns. How about valuations? Because valuations for emerging markets are far lower than they are for developed equities, especially US developed equities. So why haven’t lower valuations been a catalyst for emerging markets? And to what extent is a persistent discount justified?

Jack Nelson: I think we’ve seen more and more justifiable reasons for that discount. Obviously, geopolitics has played a huge role here, whether that’s in China, Russia, or elsewhere in the asset class. And so, I think it’s easy for you to rationalize the discount. I get the sense as well, speaking to clients, that people just feel like they’ve heard this story before. They’ve heard this argument about the valuation discount between the US in particular and emerging-markets assets for 10 years now. And it’s been wrong repeatedly for a long time. So, I think people are becoming more and more immune to that argument over time.

And particularly for US-based investors, every country has its home-country bias. But when I travel to the US and meet with consultants and clients, I get this distinct impression that for American investors, there’s a sense the rest of the world looks quite scary from where we’re sitting; given what’s going on in the rest of the world, the best corporates are here, why bother. I think maybe making the argument in valuation terms is partly doing the asset class an injustice because yes, valuation discounts are at a very high level compared with history. But ultimately, in the long run, it’s actually earnings growth that’s going to drive returns. We all know that over longer periods of time, it’s compounding of earnings per share that’s going to drive individual stock returns and indeed the whole asset class.

So, I’d rather argue for all emerging markets as an allocation and as an asset class, less so on the valuation discount, which is relevant but a smaller part of it. But based on the fact that within the very diverse set of companies that make up emerging markets, there are some fantastic companies, and there are plenty of opportunities within that tens of thousands of listed corporates to find brilliant companies that can deliver exceptional compounding of earnings per share. It’s just that the index has not been a particularly good way of investing in that and getting that opportunity.

And I’m talking my own book, of course, as an active manager, but I’d argue that because in emerging markets you do have a really huge diversity in quality from the very worst companies in the world through to the very best, in my opinion, a passive approach will inevitably come up short in terms of trying to distinguish and make some judgments around that. And if you look at the top 10 constituents of the index historically over the period of underperformance that we’re talking about—we are talking about Petrobras, Gazprom, China Mobile, Vale, ICBC—big Chinese state-owned, the Russian state-owned companies, which understandably haven’t been exceptional performers. But if you were to look at that from a bottom-up perspective, at any period, you would have perhaps thought that would have been something which you might have expected—you might have thought that perhaps state-owned Chinese companies would not have foreign shareholders’ equity returns as their number-one priority. So, it has been possible to deliver good returns by being much more bottom-up and looking at individual corporates and treating the asset class as a collection of very diverse corporates rather than a monolithic block in a macroeconomic concept.

Should Emerging-Markets Equities Be a Stand-Alone Allocation in Your Portfolio?

Dan Lefkovitz: Why do you think that emerging-markets equities should be a stand-alone allocation as opposed to part of a broad global equities portfolio, or from a US perspective, international equities ex-US?

Nelson: We have seen the rise of this phenomenon, not just because of the relative performance, but also because of the success of particularly American, but also European and Japanese corporates in growing their businesses in emerging markets. And as we do also run global equity products, we certainly spend a lot of time thinking about this phenomenon in that context.

I would probably argue, though, that emerging markets justify their existence simply because of the peculiarities of investing bottom-up in the asset class. Even though, as I said, the macro concept is slightly tenuous and the asset class is much more diverse than perhaps people might at first glance realize from that perspective, there are commonalities to emerging markets bottom-up. So, for instance, I would argue that in a developed-markets context, the key corporate governance question is often around alignment. It’s often around how do we incentivize these executives to put shareholders’ interests first? And whenever we read US annual reports and go through the remuneration section, it often blows us away how complex and convoluted and well-thought-through in some regards, but also overly engineered, the remuneration packages that these corporates often put in place are in order to try and tackle this governance challenge, which is that they’re not run by people who otherwise have skin in the game.

In emerging markets, we’re in a different position. A lot of the companies we look at are controlled or owned by someone or something. So, with the aforementioned companies where it’s state-owned businesses that have been large constituents of the index, the key question has not been around incentivizing private individuals who are here for their options package and will be gone in a few years. It’s around what does the government want from this state-owned company over time? Equally, if you’re investing with families in emerging markets, which make up quite a large portion of our asset class because those founding families often have held on to their shares a long time, haven’t moved away from the business over generations, as has been the case in developed markets, you end up spending a lot of time thinking about what are the right approaches to family companies’ corporate governance. And those nuances I think aren’t necessarily replicated throughout global equities to the same extent. And so, you do have some degree of a particular approach, which works, I think, in emerging markets, which perhaps your global-investing mindset might not quite capture if you were looking at this purely through the lens of whether you gain sufficient access through Visa V or Microsoft MSFT.

Why Top-Down Factors Can’t Make an Investment Case

Benz: You’ve written that top-down factors cannot make an investment case, but they can break one. What do you mean by that? And perhaps you can share an example or two to illustrate.

Nelson: Absolutely. So, I think this just comes back to this idea that investing in emerging markets should primarily be about analyzing individual businesses rather than currencies, politics, or exchange rates. Of course, that’s important. Of course, it needs to be considered. But in our view, it’s probably the last thing you consider.

There are tens of thousands of listed companies in emerging markets, and our view would be that probably 90%-plus are not worthy of investment or consideration for investment because of flaws in quality, usually relating to people and ownership, but also the balance sheet, the business model, the positioning with regard to sustainable development, which we think is very important over the long run. And so, in that context, when you’re trying to focus on the best companies, first and foremost, it would be a very inefficient use of time to spend the first, second, and third steps of your investment case trying to find macroeconomic reasons to own an individual stock. That is an important backdrop consideration. But I think first and foremost, we need to think about whether the corporate we’re looking at in particular does have the capability to deliver compound earnings growth, which is going to be able to deliver excess returns. We then need to consider, of course alongside valuation, the macroeconomics and the politics.

What that means for us is that we never sit down and say, “Hey, we think that the South African rand is going to do x, y, and z. Let’s go and find a company that is going to benefit from it.” That’s a very risky approach. I think it’s very dangerous because you start to spend a lot of time trying to analyze things, which are almost impossible to analyze, not just because they are very complicated, but also because they depend on the whims of individuals. This raises its head, particularly in more autocratic countries. And so, a good example of this would be Turkey. We’ve not had anything invested in Turkey for quite a number of years now because we go there, we meet companies. I was there in April this year in Istanbul. There are some fantastic corporates in Istanbul and Turkey managed very well. But when you come away from that, the final piece of the investment case jigsaw puzzle is, what is the interest rate going to be? What’s the currency going to be in five years when we’re looking to sell this stock to realize the hopeful gain? And you have no real idea of how to calculate that number. Well, that’s where I guess the investment case can fall down.

Instead of trying to ascertain with certainty a position and work from that, I’d say it’s much easier for us to analyze individual businesses. As business analysts, that’s a bit more tangible. We can get our hands around that. And then when we feel that there’s a sufficient degree of uncertainty with regard to politics or macro, we can simply move away. We can say, “OK, look, this one’s too hard” and stick to companies where we feel there is a degree of predictability and resilience in the backdrop, which allows us to make that investment on behalf of clients. And there are enough fantastic companies in emerging markets that we can afford to do that and still retain a good number with which to invest.