1Q24 Letter: Global Emerging Markets versus Country/Regional Focus
Dear Investors and Friends,
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We’d like to use this letter to provide our thoughts on this long running debate and explain why, with our own money, we prefer to invest in a Global EM strategy rather than with a narrower EM country or regional focus.
But first, why EM at all? We’re obviously cognisant that the last decade has been weak, even if the very long-term returns have been good. Succinctly, Emerging Markets are far less efficient, and good investors can generate sustainably superior returns. Additionally, the valuation starting point today, even for some great companies, is attractive.
The relative advantages of Global EM include a larger opportunity set, and therefore degrees of freedom in security selection and the potential to add value through country allocation. The potential disadvantages of country and regional funds include bias arising from business necessity as local managers are nearly always bullish on their country, as well as the complexity placed on clients to oversee and manage numerous narrow allocations. EM ex-China, which recently is in vogue, has its own numerous shortcomings.
Why EM and not simply EM as part of Global? Our perspective is that EM investing requires a particular set of three skills: First, we need to be sophisticated about investing in a less developed institutional context. The range of management quality and corporate governance is much wider than in Developed Markets. Legal protections may be weaker. Dipping your toe in is risky; experience and local understanding are critical. Second, language is an important tool in fundamental research in EM, unlike developed markets which, by MSCI index weightings, are dominated by English speaking countries. For example, in China’s A-share market, which is a significant part of the opportunity set, corporate disclosure is all in Chinese. And third, assessing Emerging Market macroeconomic risk, including the risks from exchange rate fluctuations, is a specialised skill set. There are numerous cautionary tales of Developed Market funds venturing into Emerging Market stocks, sensing incredible opportunity, only to suffer staggering losses. As Buffett says, “if you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.” The Variis partners have been doing this for decades, and we know what’s up.
Degrees of freedom in security selection
At Variis our process is based on a Focus List. We have compiled an evolving list of what we think are the roughly 100 highest quality Emerging Market businesses. From the Focus List, we then populate the portfolio with a diversified selection of the cheapest 20-30. This approach, which we think is eminently sensible, works much better in a Global EM context than it would if applied at a country or regional level in large part because there are obviously more high-quality businesses in Global EM than there are in any one constituent country. The result of applying the same process at a country level would simply be a lower quality Focus List.
MSCI EM has 1,440 constituents, while MSCI China, India and Latam have 765, 131, and 90 constituents each. Of course, we are not limited to EM stocks in the MSCI EM Index, and many of our holdings are off-benchmark, but in terms of magnitude the index constituent numbers are instructive. If we assume that “quality” represents the top 5% of companies in any index, we might expect to find 38, 7 and 5 high quality stocks in China, India and Latam, respectively. It’s clear how excessively narrowing opportunity sets leads to restricted choice, and potentially forces managers to sacrifice quality to achieve adequate diversification.
Active investors often struggle to manage portfolios versus concentrated indices, and the Global EM Index is less concentrated versus the country sub-indices. Concentrated benchmarks introduce unhelpful incentives in that large single stock omissions, where the manager may not have a conviction view, may often determine relative performance (think Magnificent Seven in Developed Markets). While good investors wait for fat pitches, concentrated indices introduce an incentive to take a swing regardless. At Variis we very much take a principled stance that we will not risk-manage relative performance by managing to single stock active weights, but in a highly concentrated index that incentive would be stronger. Even for India, which is among the least concentrated EM markets, this incentive effect is about half again as large as it is for the broad MSCI EM Index. Indeed, MSCI US is about a quarter again as concentrated as MSCI EM.
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It's possible to vastly out-perform in EM through good security selection. While the MSCI EM Index returned only 12% cumulatively over the last 5 years, an equal weighted portfolio of the best performing 30 stocks from our Focus List would have returned 306%--or 123% for the whole focus list.
Country allocation
At Variis we expect to generate alpha through specific insights on business franchises. While our focus is not on macro-economics or geopolitics, it’s simply not possible to invest in Emerging Markets without considering these things. We rank the macro and geopolitical riskiness of all Emerging Market geographies, and then use these rankings to manage the aggregate riskiness of our strategy. Our rankings are also informed by externally sourced risk indices.
Our strategy seeks, in the context of generating good returns, to manage appropriately macro-economic and political risk. We are very selective about making investments in places where risks are elevated, and, if we can find compelling ideas, prefer safer locations. Hungary is a twin deficit economy with high public sector debt and relatively rapid credit growth. This is of course a negative. That said, Variis’ investment in Hungary, in the bank OTP, is safer in the sense that the banks’ operations are spread across multiple countries, including Bulgaria and other lower risk geographies. Bulgaria is among the least macro-risky EMs.
Emerging Markets have high cross-sectional returns dispersion relative to Developed Markets, and this applies to at both the country and security levels. Put another way, sometimes certain country markets and individual securities get either extremely cheap or wildly expensive. At Variis we respond to this by either hoovering up the mispriced but wonderful securities on our Focus List or avoiding the overpriced glamourous ones. Over time, we expect this rational investment behaviour to generate excellent returns for clients.
In today’s diverse EM opportunity set, and in our Focus List, there are both cheap and expensive extremes. China’s macro and geopolitical challenges have left equities there very cheap. While we’re highly selective on quality and especially stakeholder alignment, we have been able to identify several investments including Yuhong, Mindray, Centre Testing, H World and Trip.com. Indian mid-cap and Taiwan AI-themed technology stocks seem to us two of the most expensive areas in EM today. While our Focus List contains several great Indian mid-cap business franchises, like Avenue Supermarkets and Max Healthcare, we see valuations as more than fully discounting future growth. Similarly in Taiwan, while we are fascinated by the opportunities for businesses such as Elite Material, the AI-themed stock price run-up has lowered the probability of these being sensible investments from here. The FT recently carried a story about Taiwanese Ferrari sales doubling—we think this captures the zeitgeist.
We also want the ability to avoid certain markets. We don’t presently have investments in Saudi, UAE, Kuwait, or Qatar. Valuations are demanding and there is a paucity of great business franchises. We also don’t have investments in the macro-risky countries of Egypt, Turkey, Nigeria and Argentina. We hope that in the future the macro-economies of these countries improve and we are able to invest in some of the great local businesses.
Country funds’ incentives and the challenges facing allocators
Charlie Munger said “Show me the incentive and I will show you the outcome.” At Variis we are similarly convinced about the power of incentives. We organised our partnership to be the most client-aligned investment organisation we could imagine: through ownership, significant co-investment, reasonable fees, capacity limits and focused investment strategy. We hope clients and allocators will think carefully about alignment.
Our clients make the decision to allocate to EM, and within that opportunity set we look for a diversified collection of 20-30 great long-term investments. When India mid-caps or Taiwanese AI-themed tech businesses are over-valued, we’re happy to say so and avoid those investments. When the geo-politics between China and US is threatening the sustainability of certain businesses models, as it is today with cross-border bio-tech outsourcing, we will avoid those sensitive areas. We are aligned in protecting and growing your capital with ours; the broad diversity of global EM means there will always be 20-30 compelling ideas.
Individual EM country or regional fund managers are in a far different position. They are trapped in a less heterogenous pool. Business necessity encourages consistent bullishness. This is simply a set-up where manager incentives are less aligned with clients.
Allocators have a tough job on their hands. The conversations we’ve had with allocators reveal the difficulty they face in assessing where the best opportunities lie within the diverse EM universe, and then adjusting allocations to capture those opportunities. These decisions are complex, and require significant resource, expertise, and the right governance structure to facilitate efficient decision-making. A high conviction Global EM manager, free from benchmark index constraints and “in the weeds” everyday is better placed to take advantage of the wide and diverse opportunity set.
EM ex-China
Given the geo-political competition between China and the West, and a heightened perception of risk around investing in China, EM ex-China strategies are in vogue. We are sceptical and believe that the assumptions underlying EM ex-China strategies don’t stack up on further examination.
The first key assumption is that investing in China is “different” and that this is best managed separately. But, in fact, the whole opportunity set is heterogeneous. The main uniting factors in EM are less efficient markets, less developed institutions, legal and regulatory frameworks and an expectation that per capita income growth can be faster. Take China out, and you unhelpfully reduce the diversity of the opportunity set.
The second key assumption is that the West is economically dis-engaging with China and so an investment product that dis-engages is sensible. But the reality is that we live in a world that continues to be highly globalised and China is deeply integrated in that system. China’s manufactured goods surplus has never been higher, at almost 2% of global GDP.
The third assumption is that China may, like Russia previously, become uninvestable, a “zero” for Western investors, perhaps because of an attack on Taiwan. French Prime Minister George Clemenceau is reported to have said that “Generals always prepare to fight the last war.” Similarly, having experienced a near total write-off of the Russian equity market following the Ukraine invasion, some commentators are wondering the same about China and Taiwan. We think this likelihood is very low. Indeed, the market is not reflecting much risk of this happening: Taiwanese 10y bonds yield 1.2%, less than a third of US bonds—no evidence of any risk premium being demanded.
The partners of Variis have a lot of our wealth invested in our strategy and wouldn’t want to manage an EM ex-China strategy. First, this would be a more concentrated index, with TSMC nearly 12%, and Taiwan, India and South Korea two-thirds of the opportunity set. Second, an investor would still have to do all the same work on China, since Taiwanese businesses are generally heavily integrated with the mainland, or have key competitors there. Third, China would still be a critical driver for commodity producing EM including much of Africa and Latam, as, for example, China is the world’s largest oil importer.
Thank you for your ongoing interest and support!
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Leila, Eko, Rufus and Jamie
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Disclaimer
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FOR PROFESSIONAL INVESTORS AND ADVISORS ONLY
The contents of this document are communicated by, and the property of, Variis Partners LLP. The information and opinions contained in this document are subject to updating and verification and may be subject to amendment. No representation, warranty, or undertaking, express or limited, is given as to the accuracy or completeness of the information or opinions contained in this document by Variis Partners LLP or its directors. No liability is accepted by such persons for the accuracy or completeness of any information or opinions. As such, no reliance may be placed for any purpose on the information and opinions contained in this document. The information contained in this document is strictly confidential. The value of investments and any income generated may go down as well as up and is not guaranteed.
