Emerging Markets – Volatility and Value
Emerging markets have seen significant volatility and drawdowns in recent months. Clearly, the possibility of a trade war with the United States is weighing heavily on investor minds. In this Q&A, Anindya Chatterjee, Lead Portfolio Manager of the Emerging Markets Select strategy, discusses recent market developments and how his team is navigating volatility and identifying value.
- Recent developments
- Tariff review outcome
- Foreign producers competition
- Sector impact from tariffs
- Near-term outlook
- Value Sectors
- Consumer discretionary versus staples
- Opportunities in the Healthcare sector
- Change in MSCI EM Index
1. Are you changing your portfolio or approach at all to address these recent developments?
You know the boring thing about our portfolio is that you won’t see dramatic changes because our investments are made with a long-term perspective so our turnover is very low. We continue to look at the fundamentals of companies and we fine tune our exposures based on our fundamental perspective. We continue to monitor all holdings, doing deep dives on each of the companies that we have invested in and our broader universe, doing several calls daily with management, meeting with management. Decisions on portfolio changes will be based on the fundamentals of the companies. Of course, we have to be cognizant of the macro developments- global trade, tariff war issues, and geopolitics. We are taking stock of all of that in our search for value, but with a long-term perspective. We don’t believe the pains are going to continue forever, but we don’t know how long this volatility can continue. Some of these companies have fallen as if they are going out of business and many of them are fundamentally just as strong as before. We view this market correction as a rising opportunity. We believe you have to take a long-term perspective and base your decision on fundamentals. That is our recipe to win.
2. You recently undertook an exercise where you examined the portfolio to identify any holdings exposed to the new tariffs – what was the outcome of that review?
It is crucial to understand that there are both direct and indirect impacts from the trade war. First of all, we took a very close look at the direct exposure of exports and imports – the companies that either import their components or their products get exported to the US. This is hard to estimate because for many companies, although their products may not on paper get directly exported to the US, they may end up in the US after a stop or two. We are still fine tuning our estimates, but found that less than 10% of our portfolio is directly impacted by the tariffs. Although 90% of our portfolio holdings do not significantly import from or export to the US, they have been impacted by the broader sentiment nonetheless.
There are also companies that neither export nor import but still compete with US products. Or rather, I should say that the general perception is that they compete.
3. Can you give us some examples of how competition from foreign producers does or does not manifest in emerging markets?
I’ll give you two examples. The first is within the Chinese auto industry, which is being pressured by this idea that the U.S. auto industry will have an increasing presence with the lower tariff scope. The Chinese automakers are not exporting to US and they’re not importing parts from the U.S., but they would be competing. But most of the Chinese automakers, their average selling prices are $10,000 to $15,000 per unit when the U.S. auto manufacturers have a selling price of about $30,000 per unit in China. They are catering to different market segments. If you do not have this domain knowledge, you might jump to the conclusion that the Chinese auto industry will be severely impacted by “increased competition” if China goes to zero duty for U.S. cars and gives wide access. I think that there are segments of the market that are taking broad decisions selling off the stocks that are not even going to be impacted.
Our strategy’s primary focus is on domestic players in the domestic market, not U.S. trade linked companies. Recently, we have invested increased positions in some of the Chinese local retail consumer discretionary players like white goods manufacturers. There is a massive price differential on the ground in this space between foreign products and the local manufactured products – to the tune of 150%. If China complies with U.S. demands to open the market and reduce tariffs, the products from U.S. manufacturers may get cheaper by 10-20%. They’ll be catering to a completely different market segment and the Chinese local manufacturers are significantly cheaper and selling in different markets. They’re selling in cities where the foreign manufacturers are not even present. With the sphere of increased competition and tariff war, all the stocks have fallen 25-30% in the last three to four months, but the fundamentals have not altered significantly. Their sales growth remains in high teens and some of them are experiencing 20% YOY growth. We see clear opportunity there.
4. So you’re saying that because of the tariffs the total sector got hit?
I don’t want to make this analysis so simplistic that the trade impact would be nothing to companies that are not directly linked to US trade. Trade impact would be something because if there is an actual tariff war and if the companies that are exporting to the U.S. suffer there would be, at the margins, some job losses. There would be some shaving of growth and slow down at the margin across emerging markets.
Many people who lose their jobs won’t buy that local product that they might have otherwise. So, if there is a broader slowdown and if there are some companies that were to go out of business, then those companies that have nothing to do with trade may still have some impact in sales. Maybe their sales growth won’t be 22%, but will be 15%.
We’re not taking such a simplistic view, we’re not saying that these companies won’t suffer at all. We are taking a bear case scenario, we are building in all the negatives, and then we are seeing if there’s deep value and then we are buying.
5. What is your near-term outlook for the market?
I do want to highlight that we are going to see earnings unfolding in the coming weeks. This is a crucial juncture. For those companies which are priced down with the market, but retain fundamental strength, we expect earnings releases to provoke price actions that better reflect the fundamentals.
Much of the volatility in the market is driven by very short-term players. The local funds in Hong Kong China can have 300-1,200% turnover so they churn their entire portfolios within a month. And then of course you have retail investors compounding any trends. As earnings come out and things look better for the short term they would all emerge as buyers, so I see increased volatility in the coming weeks with the earnings season coming into play. So the buying opportunity in the very near term may be lower but post earnings volatility the pessimism may again set in.
6. What sectors do you see value in currently?
It’s very crucial for people to understand we are taking into consideration the ripple effect of all the macro factors and then seeing where value still lies.
We are looking for protected spaces – domestic companies not impacted by this trade war but mispriced at this point as people think they’ll collapse because of increased competition.
7. Along those lines, if you look at the overweight to consumer discretionary versus staples, are you thinking of rotating more into staples?
Staples is always interesting and many of the staples companies have done well. Staples is a space which is very rich in valuation because it is viewed as a safe haven. In emerging markets it is very hard to find consumer staples companies that are pricing at anything less than 25 times earnings, and people are happy to pay that 25 times earnings for 10-11% earnings growth.
If there is a further bout of corrections, because these are very richly valued, there is a good risk of a correction in this space. So, we want to be very judicious on consumer staples. If they meet our qualifications: reasonable valuation, reasonable growth, reasonable degree of earnings visibility, we are open to adding into our staples position.
8. Do you see more opportunities in the Healthcare sector and in China specifically with the trend towards a healthier lifestyle?
Absolutely, there are multiple aspects to it. One is the trend toward a healthier lifestyle – and we have seen data indicating people are going for more regular checkups. There is a massive initiative of universal health coverage from the government and on the other hand, there are impacts from pollution and incidentally lifestyle and middle age – because much of China is aging – so there is an explosive growth in certain health ailments and resulting opportunities in the sector. Cancer and diabetes are some of the top of the list concerns in China. There are clearly opportunities in Healthcare and, at this point, it would appear we’re underweight. That’s for the whole index though, because Healthcare in the rest of Asia is richly valued.
It’s a very expensive sector but we see more opportunity in China. The Chinese healthcare space is very complicated. You must have access to the essential drug list and you need distribution reach, as there are 100,000+ hospitals in mainland China. Additionally, pricing of drugs is very crucial because many people in China do not have insurance coverage and newer pharma drugs produced locally could be 60-70% cheaper than the competitors from the U.S. and Europe. This is another example where I see protection and insulation from this increased competition.
9. Another big development in EM recently was the change in the MSCI EM Index and inclusion of A shares. Does that increase your coverage universe or have you always paid attention to that segment of the market?
We always paid attention to that segment of the market, so this did not increase the universe for us. China has always been a focus and we never paid attention to the index. We identified this as an opportunity at the inception of the investment strategy and have been investing in China A shares for multiple years.
In terms of opportunity, the expectation is that the weight of China A-shares in the index will increase over time from the current token inclusion. Several estimates indicate that in 2-3 years it could be as much as 5% of the MSCI EM Index. We believe it is important to take the full scope of the China Asia opportunity and we have exposed our underlying investors judiciously.
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