Identifier: Emerging Markets

Cityscape of Guiyang at night, Jiaxiu Pavilion on the Nanming River. Located in Guiyang City, Guizhou Province, China.

Summary

  • EM equities were weak through April as the global economic backdrop continues to deteriorate.
  • Negative global excess money continues to feed a slowdown globally, along with falling inflation.
  • The global liquidity backdrop should become less negative as yields peak and industrial output begins to bottom. This should increasingly favour quality growth, tech and defensive (excluding energy) names.
  • China’s economy continues to buck the trend, enjoying a modest reopening bounce. However, this recovery may not be enough to offset weakness elsewhere in the world.
  • Chinese equities were down through the month and are flat for the year. Leading names in China this year have typically been SOEs boosted by government reform initiatives, banks and some energy names. Our favoured quality growth names have underperformed despite benefiting from the reopening and continue to trade at compelling valuations.
  • General elections in Thailand approach, with pro-democratic opposition parties poised to oust the military-linked conservative coalition.
  • Turkey is also set to hold presidential and parliamentary elections in May. President Erdogan is likely to face a stiff test from opposition coalition leader Kemal Kilicdaroglu, who has pledged to restore economic orthodoxy to address a deepening economic crisis. Political risk is high, with a return to Erdogan likely to court a currency crisis and add further pressure to the country’s strained banking system. 

Mixed signals from China’s reopening

The modest recovery in consumer spending and industrial activity this year has fallen short of investor expectations, with Chinese equities flat for the year. We agree recovery signals have been mixed, which aligns with our previous commentary flagging that authorities in China have been content with a gradual pick up as opposed to the V-shape boom that we saw in the West. Beijing is clearly wary of pouring excessive fiscal and monetary stimulus on the recovery lest it spark an outbreak of inflation.

The government has done little other than offer rhetorical support for business. The Politburo met in late April, with President Xi noting weak economic momentum and subdued demand. Policymakers kept their options open with respect to fiscal and monetary support, pledging a “forceful and effective” approach while reiterating that curbing speculation in property and taming local government debt remained high priorities. Following on from the two sessions last month where new Premier Li Qiang touted the party’s support of business, the Politburo provided another forum to pledge to restore business confidence through the “[elimination of] any legal, regulatory or hidden barriers preventing the fair competition and common development of enterprises of all ownership forms.” 

While the policy restraint may frustrate some China bulls, data from China’s Labour Day holiday at the end of April into early May suggests that Chinese consumers are back travelling and dining with a vengeance.

  • China Daily reported that on Friday, April 28, the day before the holiday started, train tickets departing Shanghai Hongqiao station to destinations nationwide were sold out.
  • Over the first three days of the holiday, approximately 160 million people travelled by air, road or waterway, an increase of over 162% versus the same period in 2022 (China Daily).
  • More than 240 million people were estimated to have travelled over the full five-day break, double the pre-COVID level in 2019 (Jefferies).
  • Domestic flights during the period are over 4x above 2022 levels (Jefferies).
  • Sales growth over the holiday period across catering, apparel, jewellery and tobacco were up 21.4%, 20.9%, 17.4% and 16.8%, respectively, versus 2022 (Jefferies).

NS Partners analyst Michael Zhang is currently travelling in China and sent us some photos of what he calls “revenge travel” over the holiday break.

The trend is positive but fragile – consumers are getting out but overall spending is still relatively weak – and monetary data remains supportive with additional scope for further easing should deflation risk emerge and external headwinds build.

Chile’s president looks to cash in on battery boom through lithium nationalisation

Chile’s government announced that it would seek to capitalise on the global battery boom by nationalising its lithium industry. The stocks of the two main Chilean lithium players, SQM and Albemarle, were hit by the news, with some investors fearing a repeat of the nationalisation of Chilean copper mines in 1971 by the socialist Allende government, where assets were seized from foreign miners without negotiation. The move was a disaster, as foreign engineers and investors left Chile, and just as a global recession in 1973 was about to precipitate a collapse in copper prices. Allende was ultimately ousted in a CIA-backed coup, and replaced by right-wing despot Augusto Pinochet.

This proposal illustrates the importance of factoring political risk and institutional quality into our process. While Boric risks kicking an own goal here, our analysis makes us relatively sanguine about prospects for the Chilean miners SQM and Albemarle, as the president must ultimately pass the law through a centre-right leaning Congress. The legislature is a key check on the ambitions of the president, illustrated by the rejection of a tax reform proposal in March and failure to implement a progressive constitutional reform in a plebiscite last year, with opposition led by right-wing congressional figures.

If the nationalisation plans were to pass through Congress, the government has committed to honouring existing contracts (SQM’s runs to 2030 and Albemarle’s to 2043), while encouraging the miners to negotiate state participation before expiry. It is likely that the miners will engage in and drag out negotiations on state participation as much as possible, while they generate supernormal profits at these elevated lithium prices.

While the market reaction on the news was an overshoot, we were not tempted to add to our exposure. Lithium price strength will ultimately incentivise significant new supply to come online across South America and Australia in the coming years. Additionally, we are happy to maintain an underweight to commodities broadly, based on our outlook that weak global liquidity will feed an economic hard landing that drags on commodities.

Night View of Dubai Architecture Complex.

The strategy generated a net return of 6.0% for the quarter ending March 2023, outperforming the benchmark with net excess returns of 6.5% (see below for detailed since-inception performance figures).

Gulf equity markets underperformed their emerging market peers (as measured by the MSCI Emerging Markets Index) for the second consecutive quarter. This weaker market performance can be attributed to some of the same factors we highlighted in the Q4 2022 Manager Letter namely, higher interest rates and lower oil prices. These factors present a headwind to earnings growth for the banking, energy, and materials sectors, which together constitute 69% of the S&P Pan Arab Composite Index. Banks have been a particularly sore area for the market, with profitability ratios starting to crack under the pressure of higher rates and concerns about capital allocation and corporate governance at two large banks in Saudi Arabia and the UAE. The news of indirect exposure to Adani Group companies and a potential acquisition of Standard Charter Group at First Abu Dhabi Bank, combined with the write-down of the unfortunate Credit Suisse investment at Saudi National Bank, provided further reasons for the sector’s underperformance this quarter.   

However, if we look beyond the Index’s major sector constituents, the overall market sentiment is clearly bullish. For example, in Saudi Arabia, out of the 229 stocks comprising the Tadawul All-Share Index, 174 stocks generated positive returns in the quarter. In the UAE, IPO activity has been robust and share prices of recent entrants such as Salik Co., Emirates Central Cooling Systems Corp. and ADNOC Gas are well above their offer prices. While the performance divergence between the broader market and the Index is easy to attribute, the magnitude of the divergence (in favour of the former) is noteworthy. It is evident that investors are increasingly reducing their exposure to banks and materials while increasing their exposure to other sectors, such as consumer, healthcare, and technology, where liquidity is relatively less accommodative and therefore prone to larger stock price moves.    

The context is important in partially explaining the strategy’s outperformance in the quarter. The aforementioned dynamics led to meaningful valuation multiples expansion for the strategy’s key portfolio companies. However, we also anticipate a robust earnings growth outlook for many of our core portfolio companies. For example, National Co. for Learning and Education (NCLE), a prominent Saudi K-12 school operator, reported year-on-year revenue and net income growth of 48% and 50%, respectively, in its last quarterly reporting period. Our team spent a day touring various NCLE-operated schools with the CEO in Riyadh and we were thoroughly impressed with the quality of the staff, facilities, and unique culture preserved by management dating back to NCLE’s roots as a family-run enterprise. 

The strategy’s returns also benefited from a sizeable position we have been building in Saudi Telecom Co. (STC), Saudi Arabia’s leading telecommunications provider. Our thesis on STC has been largely driven by valuation, which has been developing since the Public Investment Fund (PIF) offloaded a 6% stake in STC in December 2021. This event stoked fears of future sell-downs in the stock from the PIF, which currently owns 64% of the company. While we cannot be sure that the PIF will not sell more shares of STC in the future, we found that valuations were becoming increasingly attractive for such a dominant business, with free cash flow yields exceeding 10% for 2023. Our thesis received a strong boost from STC collecting nearly $4bn of outstanding receivables from government clients in the fourth quarter of 2022, which represented 8% of its market capitalisation at the time. We met with STC’s management at an investment conference in Dubai and were encouraged by their efforts to improve disclosure and transparency for the investor community.  

As mentioned earlier in the letter, banks have lagged Gulf equity markets. This is a phenomenon that also played out in the strategy, with five of the eight negative return stocks in the quarter coming from the sector. While we have a significant underweight in banks, the strategy’s absolute returns experienced a drag from Saudi and Qatari banks, where pressures on profitability are building up as cost of funds increases at a higher rate than yields on assets.   

The strategy also experienced underperformance in its North African portfolio, and particularly in Egypt, where severe macroeconomic headwinds have overwhelmed USD equity returns. We have been reducing the strategy’s exposure to Egypt over the last year but opted to keep a level of investment in our highest conviction portfolio companies there. 

Looking ahead, we continue to see favourable opportunities for the strategy. The macroeconomic backdrop remains supportive, with healthy FX reserves and balance of payments positions across most of the Gulf. While still early days, the Saudi-Iranian reproachment is a key event that warrants our attention, as any progress there can lead to a lower geopolitical risk premium on regional assets. OPEC+ is committed to maintaining high oil prices to support government spending plans, which could benefit equity markets. We also note that positioning from global emerging market funds remains light and governments in the region are intent on growing their share in the emerging market capitalisation, which we believe will end up manifesting itself in a quasi-short squeeze on those funds.  

The environment is highly dynamic in the region, and as active managers, we are willing to make bold decisions to ensure that the strategy continues to provide investors with attractive opportunities in the MENA region.

Vergent MENA Opportunities Composite – Performance Track Record:

  ReturnsQTDYTD1 yearAnnualized ITD
  Composite net6.0%6.0%0.5%8.0%
  Benchmark-1.5%-1.5%-20.3%7.0%
  Added value7.5%7.5%20.8%1.0%

Vergent Asset Management LLP

PETRONAS Twin Towers in Kuala Lumpur, Malaysia.

The strategy generated a net return of -1.2% in the quarter ending March 2023 (see below for detailed since-inception performance figures).  

The strategy saw strong contributions from holdings in ASEAN (Indonesia, Malaysia, and the Philippines) and the Middle East in the quarter. However, this was more than offset by losses in the Africa portfolio. As we have written in previous letters, we have been actively reducing the strategy’s exposure to Africa (specifically Egypt and Kenya) and increasing it in ASEAN and the Middle East (Saudi Arabia and the United Arab Emirates). African economies are undergoing severe macroeconomic headwinds that have overwhelmed equity returns and exerted pressure on earnings. Conversely, ASEAN and Middle Eastern economies have been performing reasonably well, allowing us to harvest healthy USD equity returns through earnings growth and multiples expansion.

Continuing with the above theme, we decided to fully tender out the strategy’s shares in East African Breweries Ltd. (EABL) to Diageo PLC at a price of KES 192/share (compared to the KES 170/share price as of the date of this letter). While Diageo paid a premium of 35% versus the one-year average (at the time of the “intention to acquire” announcement in October 2022), the deal multiples were highly favourable to Diageo at ~14x 2023 earnings, a substantial discount to emerging and frontier market brewers. We tendered out at these low multiples because of two factors: first, there are limited incremental buyers for EABL given the macroeconomic environment and stock market illiquidity in Kenya; second, the Diageo bid presented a relatively lucrative way for us to reduce exposure to Africa, in line with our strategy. Following the deal, EABL will remain listed on the Nairobi Stock Exchange with Diageo’s ownership now up to 65%, from just over 50% pre-tender. We will continue to monitor EABL and potentially re-enter the stock once the economic environment in Kenya settles.

The strategy was very active during the quarter in both ASEAN and the Middle East. In ASEAN, we invested in CTOS, Malaysia’s leading private credit reporting agency, which holds over 70% of the country’s credit reporting market. Due to the high barriers to entry in this industry, market leaders like CTOS are likely to sustain their position as they continue to compound their data sets and create new use cases for their customers. Malaysia is a particularly underpenetrated market for credit reporting, as financial institutions still rely heavily on their internal data and the public credit bureau in their loan underwriting process. Malaysia is interesting because financial inclusion is high at around 95%, yet 65% of the population still does not have a regulated credit account. As financial sophistication grows and credit compliance requirements tighten, demand for CTOS’s services should increase significantly. CTOS’ scale and technology underpins operating income margins of ~40% while compounding operating income growth at ~20%. We have followed CTOS since it listed on the Bursa Malaysia in July 2021, but had reservations on its valuation and the previous management team, who we thought were brought on just to list the company rather than the focus on generating long-term value. When the previous CEO left the company, we went to Kuala Lumpur to meet with the new CEO, Erik Hamburger, a former executive at Experian, who articulated a growth strategy around product development, digital investments, and sales strategy that we thought, if well executed, would unlock tremendous value for shareholders. With a positive view on the company and management, it was a case of waiting for a valuation opportunity to open, which finally happened in this quarter.

The strategy also invested in Al Ansari Financial Services (AFS), a UAE-based remittance and currency exchange house. AFS is a leader in the second-largest market remittance market globally (after the U.S.). The company generates revenues from facilitating the remittance of money flow from the UAE to countries in Asia (example: Philippines), Sub-continent (India and Pakistan), and the Middle East and North Africa (Jordan and Egypt). AFS focuses primarily on small ticket remittance, a market that banks are strategically not interested in, and that fintechs have found difficult to penetrate. For context, the company reports that 67% of the remittances it facilitates are less than $400 per transaction. AFS has a robust offline network in 226 carefully selected locations across the UAE, which captures monthly remittance flows from blue-collar and underbanked white-collar workers. This offline network is supported by a strong online presence, where it has a top ranked app that processes 41% of personal digital outward remittances among exchange houses. AFS’ management have executed well, deepening the company’s competitive advantage, and translating that to operating margins of ~50%, on healthy mid-teens top line growth.  

Despite the softer performance during the first quarter, we remain constructive on the strategy’s outlook. We believe the current environment is ripe for stock pickers, with valuations as attractive as they’ve been since we launched the strategy in 2018. Moreover, the economic environment is expected to deepen the competitive edge of portfolio companies in their respective markets.

As we have done in previous letters, we sign off by reminding our investors that our objective is to deliver differentiated returns that are attributed to investing skill (alpha) rather than market directionality (beta). We believe there are abundant alpha opportunities in frontier and emerging markets, which we choose to express through a concentrated but geographically diverse portfolio of companies with idiosyncratic earnings drivers and share-price catalysts. Naturally, this should result in significant deviations from global and emerging market indices in certain periods, but hopefully provide a superior risk-adjusted return profile to investors in the long term.

  ReturnsQTDYTD1 yearAnnualized ITD
  Composite net-1.2%-1.2%-14.9%-3.7%

Vergent Asset Management LLP

Bamboo forest in Kyoto, Japan.

At Global Alpha we are macro aware but don’t make macro calls. Being macro aware helps us evaluate investment opportunities through the lens of a country’s economic indicators, politics and regulatory landscape. It can also be an important risk management tool, especially in emerging markets.

Macro awareness also comes from understanding a country’s policy choices on its path to success or failure. An exceptionally interesting book called “How Asia Works” by Joe Studwell, provides unique insights into why North Asian countries (Japan, Korea, Taiwan and China) have managed to achieve sustained economic growth while South Asian countries (Thailand, Malaysia, Indonesia and the Philippines) seem to have stalled on their way to economic success. The book answers several questions including:

  • Why successful industrial brands like Haier, TSMC and Hyundai emerged from North Asia and not South Asia.
  • How the Philippines went from being twice as rich as Korea to 11 times poorer in half a century.
  • Lessons that other emerging markets can learn from ones that have experienced growth and success.

The last point is particularly useful to our investment process. If there was a common thread (or formula for success) across North Asian economies, it would be the following.

Step 1 – Small gardens beat large ranches (Land reforms)

This is the crucial initial step, yet also the stage at which most countries falter. Achieving sustained economic growth of 7% to 10% over a significant period requires making tough political decisions, such as redistributing land in a peaceful manner. Following WWII, many North Asian economies were poor and had a surplus of labour in rural areas. However, land ownership was concentrated in the hands of a few wealthy and connected landlords.

The key to unlocking growth in this situation was to peacefully redistribute land from these connected landlords to small rural farmers and peasants. This approach is counterintuitive to what neo-classical economists might recommend, which is to establish massive, mechanized farms to maximize profit per acre. Instead, an intensive gardening approach on a small plot can deliver maximum crop yield.

The effect of this type of reform is that it fully employs the abundant labour available in rural areas. Increased agricultural output leads to sharp increases in purchasing power, waves of consumption and the resources to pay for basic manufacturing technology. Another significant effect of this reform was the social and economic mobility that it enabled, which in turn led to the emergence of a new middle class and a new cohort of entrepreneurs. For instance, the founder of Hyundai (Chung Ju Yung) in Korea and the founder of Formosa Plastics (Wang Yung Ching) in Taiwan were both sons of farmers.

Step 2 – Export or die (Carrot and stick approach to manufacturing)

As agriculture begins to create a new generation of entrepreneurs, returns from agricultural reforms start to taper off after a decade. The challenge then lies in redirecting entrepreneurial energy towards export-oriented manufacturing instead of services. Manufacturing is preferable to services because significant productivity gains can be achieved with low-skilled workers, and manufactured goods are more freely traded across the world.

Where policy differs from the consensus neo-classical approach is in offering protection to domestic manufacturers in the early stages of a country’s development, in the form of subsidies, while keeping international competition out of the domestic market with high tariffs. In exchange for this protection, domestic firms are required to maintain strict “export discipline.” This means that the more a domestic business exports and competes in the international market, the more subsidies and financing it receives.

A positive side effect of this policy is that businesses in North Asia were compelled to rapidly climb the technology learning curve to produce high-quality products. Those that failed to be export competitive were cut off from cheap credit and subsidies and were forced by the government to shut down or merge with successful companies. Instead of picking winners, the government weeded out the losers.

For example, Korea’s government encouraged a dozen conglomerates, including Samsung, Daewoo and Shinjin, to master car manufacturing in a market that was just 30,000 units in size. Vehicle imports were prohibited until 1988 and the import of Japanese cars until 1998, allowing domestic manufacturers to compete for survival. As a result of this policy, a single world-beating colossus in the form of Hyundai-Kia remains.

In contrast, Malaysia decided to master car manufacturing with a single state-owned enterprise (Proton) instead of encouraging private enterprise. With no export discipline or internal development of technology, Proton has mostly found success in the domestic market. In 2022, Proton sold approximately 141,000 cars, while Hyundai Kia sold over 6.8 million.

Step 3 – Targeted finance (Saying no to short-term profits)

The final step is to ensure that domestic financial institutions are fully aligned with the agricultural and industrial policy goals outlined above. Banks are kept under government control via the central bank and “directed” to lend to industrial and agricultural projects that may not necessarily yield the highest short-term returns but have the potential to earn long-term profits by nurturing infant industries. Capital controls are implemented to ensure that citizens’ savings remain in the country to finance national development projects.

The key is to avoid premature deregulation of the financial sector as with what led to the 1997 Asian financial crisis. Deregulation and capital market development as promoted by the World Bank and International Monetary Fund came much later in the industrialization process in Taiwan and Korea. In South Asia, premature deregulation of the financial system led to the issuance of new bank licenses to a cozy group of entrepreneurs who financed their own business activities and short-term speculative investments, like luxury real estate, instead of projects of national importance.

This historic review of North Asian success may seem both contrarian and counterintuitive due to its prescription of financial repression, tariffs and political intervention. However, it helps us at Global Alpha identify countries or sectors that might be on an unconventional path to success. For example, when we were in Vietnam late last year, we couldn’t help but wonder if its combination of an export-driven model and capital controls resembles the Korea or Taiwan of 1970s and 1980s.

Similarly, when Korea announced in 2022 its plans to develop its carbon composite industry as its second steel industry, we saw parallels with how it mastered the art of steelmaking with POSCO, now one of the world’s most efficient steelmakers. In fact, we have exposure to the advanced materials space in Korea through Hansol Chemical (014680 KS), which plans to invest ₩85 billion in silicon anode production as a solution to increasing the energy density of EV batteries while reducing charging time. If history is any guide, we can expect plenty of support from the Korean government to nurture this industry of the future.

Macro awareness can help you succeed

The success of emerging markets isn’t just about individual companies, but also about the broader economic and political context in which they operate. Being macro aware and having a solid understanding of the broader context can help investors make better informed decisions, mitigate potential risks and maximize their returns.

A green and yellow motorized rickshaw zips through the streets of Delhi, India

Since the World Bank’s International Finance Corporation first coined the term emerging markets in 1981, the characteristics and composition of the markets have evolved significantly. Past concerns regarding the resilience of emerging markets during a crisis led some investors to struggle with the merits of including a direct allocation. However, with the rise of China and its leadership of global economic growth, investors are increasingly considering a dedicated allocation to emerging markets. This article reviews the evolution and the general case for investing in emerging markets.

The key attributes supporting the case for global emerging markets have been evident for some time and include:

Greater growth In the latest Global Economic Prospects report by The World Bank Group, emerging and developing economies are forecast to grow more than double that of advanced economies in 2023 and 2024.
Drivers of Innovation Many emerging markets companies have become leaders of innovation in important sectors such as internet-related technologies, electric vehicle battery manufacturing, and computer chip manufacturing.
Household names Many emerging market companies are household names such as Samsung and Hyundai, while other less recognized companies have acquired well-known global brands.
Rising returns As emerging markets shift from manufacturing to more value-added industries, there is an expectation for the ability to generate superior returns to rise.
Alpha opportunities Emerging markets are less researched by the analyst community compared with large cap developed equity markets, which creates opportunities for excess returns from independent research by active managers.

 

 Background

Emerging markets are characterized as countries with growing economies and a growing middle-class population. Many of these markets continue to have high rates of poverty, and often they are still experiencing significant social and political change. But despite such headwinds, the growth prospects of emerging markets can provide a strong base for investors to be rewarded.

The market capitalization of emerging markets was US$ 90,456 billion as of December 31, 2022, representing a little over 11% of the world equity capitalization. Yet many institutional investors have no direct exposure to emerging markets. Instead, investors often rely on their international and global equity managers to selectively invest in emerging markets, which can result in the allocation falling well short of its representation of the world equity market capitalization. With emerging markets representing the highest growth area of global stock markets, there is a case for investors to benefit from at least a market representation.

The MSCI Emerging Markets Index is comprised of over 1,300 stocks in 24 countries. Countries are normally grouped into three regions, Emerging Markets Asia, Emerging Markets Latin America and Emerging Markets Europe, Middle East and Africa, with the Asian region representing almost 80% of the market index.

Evolution

For the longest time emerging markets were considered similar to the Canadian equity market, with a heavy bias to commodities. Today, the combined weighting in energy and materials for emerging markets is less than 13% of the index market capitalization, compared to 30% of the Canadian equity market. Instead, emerging markets have evolved to offer opportunities different to the Canadian equity market. For example, emerging markets have experienced a steady rise in the information technology and health care sector allocations, which together represent over 20% of the market index (Figure 1). Not only that, but within the information technology sector there has also been a radical change in its composition with large and successful companies, such as Alibaba and Tencent making up an important component of the sector.

Figure 1: Index Sector Allocations

Global Industry Classification (GIC) Sector MSCI Emerging Markets (%) S&P/TSX Composite (%)
Energy 5.0 18.1
Materials 7.6 12.0
Industrials 19.4 13.3
Consumer Discretionary 12.5 3.7
Consumer Staples 4.7 4.2
Health Care 10.7 0.4
Financials 14.3 30.8
Information Technology 10.8 5.7
Communication Services 2.8 4.9
Utilities 3.2 4.4
Real Estate 8.9 2.6

 

Source: Thomson Reuters Datastream. Data as of December 31, 2022. Due to rounding, column percentages may not total 100%.

The financial sector represents around 14% of the index and offers a further differentiation versus developed markets, where the loan-to-deposit ratios in emerging market companies are generally lower.

However, the biggest change to the emerging market index has been with respect to country allocation, and the growing dominance of China in the index. It was not long ago that large cap China A shares represented less than 1% of the MSCI Emerging Markets Index. At the end of 2022, China accounted for over 32% of the index (Figure 2).

Figure 2: Region and Larger Country Allocations

Region and Country MSCI Emerging Markets Index (%)
Emerging Markets Asia 78.3
China 32.3
India 14.4
Taiwan 13.8
Republic of Korea 11.3
Emerging Markets Europe, Middle East & Africa 13.2
Saudi Arabia 4.1
United Arab Emirates 1.4
Qatar 1.0
Kuwait 0.9
South Africa 3.7
Emerging Markets Latin America 8.5
Brazil 5.3
Mexico 2.3

 

Understanding the Risks

It is important to appreciate risks associated with investing in emerging markets. While active managers can mitigate some of these risks through research and careful selection of individual stocks, investors should recognize the following.

  • Political and social risk: Political and social changes taking place in emerging market countries can lead to uncertainty due to corruption, regulations not always being rigorously enforced, or governments exhibiting an unwanted influence. The uncertainty contributes to market volatility. For example, Beijing’s actions to limit the influence of Hong Kong-listed technology companies, combined with a real estate sector crisis and the zero-COVID policies that witnessed longer strict pandemic controls relative to most other governments, contributed to a tough and volatile 2021-2022 for emerging market equities.
  • Information and liquidity risk: Although the quality of data has vastly improved, obtaining good, complete and timely information can still be challenging in emerging markets. Currency controls remaining in a small number of markets also may create liquidity concerns.

Recognizing the potential benefits

While the countries are classified as emerging, nearly all the companies in the MSCI Emerging Markets Index have a market capitalization greater than US$ 1 billion, which compares to 209 Canadian companies with a market value above US$ 1 billion. Increasingly, emerging market companies are becoming household names, whether on their own merits, or through acquisition of global branded companies, such as Samsung, Hyundai Motor and the Indian conglomerate, Tata, which is the owner of brands such as Jaguar, Land Rover and Tetley Tea.

The key benefits offered by emerging markets include:

  • Growth opportunity: The drivers of growth are wide ranging and include demographics, economic development, technology, innovation, infrastructure development, and capital market developments. While global growth is expected to moderate from 2021 levels, emerging and developing countries are expected to account for a significant component of world gross domestic product (GDP). The World Bank forecasts emerging and developing markets to grow at an average annual rate of 3.4% in 2023 and 4.1% in 2024, compared to expansion of only 0.5% and 1.6%, respectively for advanced (developed) economies.1 A significant proportion of developed market company earnings are also linked to emerging market growth, further underlining its importance.
  • Drivers of innovation: Innovation in emerging markets has contributed to its evolution, as well as China becoming an important component of the market. Innovation has allowed several emerging market countries to leapfrog the developed world in terms of business models. For example, while many farmers in India have no access to computers and landlines, smart phones have created an information and business environment that allows buyers and sellers to interact, as well as enabling e-payments.
  • Rerating opportunity: Ordinarily, high-growth assets are priced at a premium. Emerging market stocks have traditionally traded at a discount to developed world valuations, but the economic fundamentals for emerging markets as a whole have improved.
  • Improving returns: Many emerging market companies are shifting away from manufacturing for Western companies and looking to develop their own identity and growth success. To achieve this they are tapping into higher value-added areas using brands and technology, recognizing that branded firms with loyal followers can achieve more than double the margins of non-brand firms. Return on invested capital (ROIC) should rise for emerging market companies as they develop world-class brands.
  • Growing universe of opportunities: The growth of China in the emerging market index has also witnessed a growth in the universe of investment opportunities. Today, there are as many China A shares that meet the typical liquidity and market capitalization criteria as there are in the United States (US) equity market. Similarly, the number of opportunities for emerging markets excluding China is not too different from the number of opportunities for the global developed market, excluding the US.
  • Style offset opportunity: The growing opportunity set has witnessed a growth in systematic (quantitative) fund offerings, where the managers use technology to gain a breadth of understanding on a large universe of companies, compared to the depth of understanding associated with fundamental managers focused on selecting a smaller portfolio of companies. As for other equity markets, investors who can accommodate multiple managers in an asset class can benefit from the complementary approaches of systematic and fundamental styles.
  • Alpha opportunity: The external analyst community generally undertakes less research of emerging market companies compared to global developed companies. Active managers have been able to benefit from independent research with over 86% of managers in the emerging market equity universe outperforming the MSCI Emerging Market Index over the 10 years ended December 31, 2021 (based on the eVestment database).

Environmental, Social and Governance Considerations (ESG)

Despite the political and social challenges associated with emerging market countries, companies are increasingly recognizing the importance of ESG considerations. Helping this cause has been the expansion of ESG coverage of emerging markets companies by third-party providers. The importance of each ESG component varies from one country, industry or company to another. However, like the developed world, corporate governance tends to be the most material issue, followed by the steps being taken to manage the environmental impact of companies in the emerging markets.

The Case for Emerging Markets

Many investors are underweight emerging markets relative to its representation in world equity markets, yet global growth is expected to be led by emerging and other developing markets.

Canadian investors have historically shied away from emerging markets, partly due to the historical commodity bias. Today, emerging markets offer a very different opportunity set due to innovation that has seen a transformation in the type of companies and opportunities, including a significant growth in the information technology sector.

As emerging market companies shift from manufacturing to higher value-added interests using brands and technology, the number of emerging market household names will increase, and help to grow margins and ultimately the return potential from emerging markets.

1 Source: World Bank Global Economic Prospects, January 2023

Man looking ahead at the Shanghai skyline.

Summary

  • Emerging market equities notched a positive month despite the fears over cracks appearing in developed market banking systems with the failure of Signature Bank, Silicon Valley Bank and the UBS takeover of Credit Suisse.
  • Chinese equities steadied in March, slightly up as the two sessions (China’s equivalent of parliament) rubber stamped Xi’s unprecedented third term as leader, and Li Qiang’s ascent to the role of Premier. Li was keen to tout China’s business-friendly credentials in his first remarks as premier.
  • This was followed later in the month by Jack Ma’s return to Hangzhou, China, the home of Alibaba HQ. This was followed shortly after by an announcement by the company that it would be split into six units. According to Alibaba CEO Daniel Zhang, the units will be able to “pursue independent fundraising and IPOs when they are ready.”
  • This provided a major boost to large cap Chinese tech stocks, with investors interpreting the announcement as further confirmation that regulatory headwinds for the sector were easing.
  • Portfolio names Alibaba, Tencent and Netease all rallied sharply.
  • Stocks in Taiwan and South Korea were stronger, in part due to some optimism that the deep downcycle across the semiconductor industry is starting to bottom.
  • Brazil underperformed wider emerging markets. Despite falling inflation and scope for the central bank to consider rate cuts, political risks continue to curb investor enthusiasm. President Lula’s scepticism of central bank independence and a free spending fiscal agenda are key concerns which muddle a potentially compelling opportunity for investors.
  • Gulf markets were weak, as headwinds build for energy prices and other commodities given the deteriorating global economic outlook.

Navigating booms and busts in China

Given the wide dispersion of country returns in emerging market equities each year, we know that outperformance hinges on finding the right stock in the right country. As the below chart illustrates, great stock fundamentals can be wiped out by poor macro.

Dispersion of EM country returns

Chart 1: Emerging market returns by country from 2004 to 2022.
Source: Thomson Datastream.

The opportunity to gain exposure to high-quality companies operating in an economy delivering structural outperformance – such as India at present – is a key attraction of emerging market equities. However, experience teaches us that it is through avoiding big negative macro shocks in EM that we can sustainably tilt the odds in our favour.

Our approach to country analysis centres on two elements: 1) hard data inputs with monetary aggregates at the heart of this; and 2) qualitative macro analysis incorporating an assessment of shorter-term factors such as political risk and longer-term structural factors like institutional quality.

This piece will focus on the quantitative element, and specifically the role that the Liquidity Theory of Asset Prices plays in country selection.

Emerging markets and the Liquidity Theory of Asset Prices

Analysis of monetary (or liquidity) data is a key input in our process for determining country weightings. This is based on the insight that, while we know that monetary trends lead the economy, “excess” money – the difference between the growth of real money supply and industrial output – moves markets even earlier. Broadly speaking, when narrow money is growing above industrial production, you are probably in a bull market somewhere as money not put to use in the real economy finds its way into bonds, stocks, property and other assets. The reverse also applies, with current weakness in financial markets reflecting a deteriorating liquidity picture as hot inflation and tight monetary policy suck money out of markets.

G7 + E7 industrial output & real narrow money (% 6m)

Chart 2: Graph showing G7 and E7 industrial output relative to real narrow money from 2000 to 2022.
Source: Thomson Datastream.

Applying Liquidity Theory in EM equities

We have found this to be a powerful leading indicator and tool for assessing the optimal country exposure through economic and market cycles. In emerging markets this works particularly well as we analyse liquidity country by country in a wide and diverse opportunity set.

Over the decades our team has compiled data on the sensitivity of individual countries in EM to varying liquidity environments. This helps us gauge whether the tide is coming out or in for a country’s financial markets. While this data provides signals for which markets might be winners over the medium term, we find that it adds the most value in providing warning signs of vulnerabilities that precipitate market shocks. You do not want to be around in a country like Argentina or Turkey when the liquidity tap shuts off.

Key input for managing China exposure

Liquidity analysis has been central to managing our portfolio exposure in China. As the chart illustrates below, observing the change in real narrow money growth is a key input for anticipating periods of out- or underperformance for the largest component of the EM benchmark. This is married up with qualitative macroeconomic research and in-depth economic value added stock analysis to determine exposure that aligns with our level of conviction.

MSCI China price index relative to MSCI EM & NS Partners’ active weight in China + Hong Kong

Chart 3: MSCI China Price Index relative to MSCI Emerging Markets Index and NS Partners’ active weight in China and Hong Kong from 2014 to 2022.
Source: Thomson Datastream.

Successfully navigating the violent boom and bust of Chinese equities from 2014 through to mid-2016 demonstrates the effectiveness of this approach. Improving narrow money through the beginning of 2014 preceded a lift in exposure to China as the market began to outperform. Conversely, money numbers deteriorated from mid-2014, a warning sign that the rally was on borrowed time. This formed part of our decision to begin cutting exposure ahead of the market peak in June 2015. Highly leveraged retail investors had fuelled the final euphoric stages of the rally. News of a softening economy saw sentiment for Chinese equities wane, with initial modest stock declines triggering a wave of margin calls that precipitated a frenzied sell-off.

CSI 300 index (rebased to 100)

Chart 4: CSI 300 Index performance from 2014 to 2016.
Source: Bloomberg.

Fearing the slump would trigger a major financial crisis, Chinese authorities stepped in to introduce short selling bans and stock “circuit breakers”, while loosening margin requirements to allay fears of further defaults. Lock-up periods were enforced for owners of more than 5% of a company’s tradeable stock, and mutual funds and pension funds were compelled to support the market. Critically, the PBoC stepped in to slash rates, providing a significant boost to money numbers. Sentiment remained fragile through the beginning of 2016 with investors concerned about the ability of Beijing to rebalance a structurally slowing economy with bad debts without triggering capital flight. We were more constructive than consensus and gradually lifted exposure to overweight, encouraged by money numbers signalling a stronger economy ahead and judging that authorities had the tools to keep forex and balance of payments risks in check.

More recently, having been significantly underweight through the brutal selloff in Chinese equities in 2021, we began lifting exposure at the end of that year in response to improving liquidity data, reaching a neutral weight by the middle of 2022. This was subsequently raised to overweight later in the year as money numbers improved further, some political headwinds eased and Beijing’s COVID-zero approach to the pandemic was rapidly abandoned. The weighting shift provided a boost to portfolio performance as Chinese equities rallied hard on the “reopening trade”.

CSI 300 & HSI index (rebased to 100)

Chart 5: CSI 300 and HSI Index performance from 2018 to 2022.
Source: Bloomberg.

Looking ahead, we remain modestly bullish on Chinese equities but believe that current monetary trends signal that the authorities are determined to avoid overstimulating and sparking a Western-style inflation surge, which would risk social disruption. This should support a gradual but more sustainable economic recovery favouring quality names, as opposed to more cyclical parts of the market and derivative plays in materials and energy. 

As outlined above, in addition to quantitative inputs to our process, we also consider shorter term political risks along with longer term measures of institutional quality. China faces major challenges on both of these fronts as the Sino-U.S. dispute intensifies and as Xi Jinping consolidates power at the expense of the intra-party pluralism established under Deng Xiaoping. It means that while a monetary and economic recovery provides a supportive backdrop, our qualitative assessment of political and policy risks limits our conviction and consequent portfolio exposure to China.

Is China finally coming back?

China’s economy seems to be bouncing back after a long hiatus, with Q1-2023 growth at 4.5%, March retail sales at 10.6% and positive infrastructure growth driven by steel and cement sales. Credit growth also increased to 10% year over year in March largely due to corporate loans for infrastructure projects. These indicators have historically been indicative of strengthening economic data in subsequent quarters.

This bodes well for emerging markets (EM) that depend on commodities, such as Indonesia, one of our primary overweights, which has a diverse range of metals that rely on China. Notably, about 56% of the world’s copper demand comes from China.

Is China close to initiating a cyclical upturn as in early 2016 or mid-2020? While it’s likely too early to know with any certainty, data seems to point in that direction. Geopolitical risks are still high and not all internal data is positive. March’s youth unemployment rate was high (19.6%) and it’s unlikely China will introduce stimulus to boost spending as we saw in the West. Moreover, property sector recovery is still unclear. We believe China will likely surprise to the upside compared to projections from the beginning of the year and its own “around 5% GDP growth” expectations.

Mexico had an excellent quarter, despite the slowdown in the U.S. This was mainly the result of nearshoring trends, with increasing numbers of Asian companies transferring their production capacity to Mexico. This represents a more than US$30 billion opportunity for the country. For example, one of our holdings in Taiwan, Nien Made (8464 TT), has a new facility in Mexico for custom-made window coverings that commenced operations in the second half of 2020.

However, it’s important to remain cautious as good news doesn’t last forever and ups and downs are to be expected. The most important thing to focus on is companies that can benefit structurally from this trend and manage risk effectively.

Regarding our banking exposure amid recent U.S. events, our largest allocations are in India, where we believe its domestically focused economy poses less risk. We have some commercial real estate exposure in one position in Mexico but of a different nature (logistics & industrial parks), which is linked to the positive trend of nearshoring that we anticipate will persist. Furthermore, this investment is concentrated in northern Mexico, which generally experiences faster growth compared to the entire economy. Nevertheless, we remain cautious about potential contagion and have reduced our exposure while closely monitoring the situation.

Our Global Alpha EM portfolio is overweight in China and Mexico, although selectively. In China, our primary focus is on local brands that serve the Chinese population, particularly in the consumer and manufacturing sectors as well as industrial automation. In Mexico, we seek companies that can directly benefit from nearshoring and also leverage their strong domestic operations. Our investment decisions are based on factors such as a good balance sheet, strong free cash flow, market leadership and positioning. In addition, we maintain a well-diversified portfolio.

BACK TO EMERGING MARKETS SMALL CAP

During the first quarter, the MSCI Emerging Markets Small Cap Index underperformed the MSCI EAFE Small Cap Index and the MSCI Emerging Markets Index.

Within the MSCI Emerging Markets Small Cap Index, information technology, which represents 18.1% of the Index, was the strongest-performing sector, delivering a 17.6% return. Energy was the worst-performing sector, returning -5.0% for the quarter, with an Index weight of 2.0%.

PERFORMANCE HIGHLIGHTS

In the first quarter, our Emerging Markets Small Cap composite delivered a gross return of 4.9%, outperforming the MSCI Emerging Small Cap Index by 1.1% (gross).

Our top performer for the quarter was Dentium Co. (145720 KS), a Korea-based manufacturer of dental implants and related instruments and materials. The company primarily serves EM countries and holds a 5% market share globally.

So, what drove the stock up?

In the first quarter, Dentium’s strong stock performance was due to the better-than-expected impact from China’s volume-based procurement (VBP) program and following the acquisition of its key competitor by a private equity firm at a premium valuation. Despite consistently delivering rapid growth and maintaining the industry’s highest margins, Dentium trades at a substantial discount to global peers.

Another top contributor in Q1 was Universal Vision Biotechnology (UVB) (3218 TT), Taiwan’s largest eye-care clinic chain with 28 clinics, 33 optical centers and a presence in China with 11 clinics. UVB is an industry pioneer, continuously introducing the latest technology to the market. The company is poised to benefit from the fast-growing demand for ophthalmic services in Taiwan and China, driven by structural demographic tailwinds.

What drove the stock up?

UVB’s stock performed well in Q1 due to strong Q4-2022 results driven by network expansion, high demand for advanced surgeries and cost control. During its earnings call, the company expressed a positive 2023 outlook supported by strong first-quarter sales.

Our top detractor for the quarter was City Union Bank (CUBK IN). CUBK is one of India’s oldest private sector banks specializing in serving the small and medium enterprise (SME) space. With over 700 branches, conservative management and an extremely granular balance sheet, CUBK has consistently delivered best-in-class profitability since listing.

What drove the stock down?

The main reason for the stock’s correction was the bank’s revised guidance on loan growth for the upcoming fiscal year. While the bank’s operating metrics have been moving in the right direction, management explained to us that they have chosen to be conservative and will accelerate loan growth later in the year while maintaining their focus on profitability. The uncertainty surrounding the CEO was another factor affecting the stock’s performance, but this issue is expected to be resolved by the end of April. With a stronger balance sheet post-COVID and credit costs moderating, we expect CUBK to outperform its peers.

NEW POSITION

One of our new positions this quarter is Park Systems (140860 KS) in Korea. Park is a pioneer in manufacturing Atomic Force Microscopes (AFM), which are used to observe ultra-fine structures that cannot be measured with an electron microscope.

In addition to its current use in academic research and the semiconductor industry, AFM has future applications in industries such as new materials, energy, environment, biotech and medical diagnosis. Park Sang-Il, the founder and CEO of Park Systems, was a member of the original research team that developed AFM at Stanford University.

With 32 patents and low international sell-side coverage, we were attracted to Park for its technology and market leadership (#1). Park’s customers include universities (such as Harvard), national laboratories (such as NASA and IBM research) and the top 20 semiconductor companies in the world. With an innovative R&D pipeline and a strong management team, we see a long runway for growth as AFM technology is adopted in new areas, including display and biotechnology.

OTHER NEW BUYS AND SELLS

During the quarter we also initiated new positions in Grupa Kety, CMGE Technology Group and Logo Yazilim. We exited Puregold Price Club, Muthoot Finance and Inter&Co.

WHAT IS OUR EAR-TO-THE-GROUND APPROACH TELLING US?

Global Alpha was back on the road in the first quarter of 2023, covering more than 60% of our holdings through in-person meetings and conferences.

We have observed a faster-than-expected recovery in China, with encouraging economic data and revised forecasts. We are overweight in China and believe our portfolio is well-positioned to benefit from emerging growth opportunities.

In Korea, we are closely monitoring companies linked to EV battery development. Although we believe that some stocks in the sector have exceeded their fundamentals, we recognize the exponential growth in the number of electric cars and the increasing penetration of EV battery materials, such as silicon anodes or electrolytes, which will benefit related companies.

We continue to monitor developments in Poland, where we initiated positions in two companies this year. Poland’s stock market offers diverse alternatives in various sectors, making it an attractive investment opportunity.

Our positive views remain on Indonesia, Mexico, Poland, Chile and China based on our bottom-up approach. We constantly look for alternatives in other geographies and our portfolio remains well-diversified among countries, industries and currencies.

The Global Alpha team

Click here to view a PDF version

Is China finally coming back?

China’s economy seems to be bouncing back after a long hiatus, with Q1-2023 growth at 4.5%, March retail sales at 10.6% and positive infrastructure growth driven by steel and cement sales. Credit growth also increased to 10% year over year in March largely due to corporate loans for infrastructure projects. These indicators have historically been indicative of strengthening economic data in subsequent quarters.

This bodes well for emerging markets (EM) that depend on commodities, such as Indonesia, one of our primary overweights, which has a diverse range of metals that rely on China. Notably, about 56% of the world’s copper demand comes from China.

Is China close to initiating a cyclical upturn as in early 2016 or mid-2020? While it’s likely too early to know with any certainty, data seems to point in that direction. Geopolitical risks are still high and not all internal data is positive. March’s youth unemployment rate was high (19.6%) and it’s unlikely China will introduce stimulus to boost spending as we saw in the West. Moreover, property sector recovery is still unclear. We believe China will likely surprise to the upside compared to projections from the beginning of the year and its own “around 5% GDP growth” expectations.

Mexico had an excellent quarter, despite the slowdown in the U.S. This was mainly the result of nearshoring trends, with increasing numbers of Asian companies transferring their production capacity to Mexico. This represents a more than US$30 billion opportunity for the country. For example, one of our holdings in Taiwan, Nien Made (8464 TT), has a new facility in Mexico for custom-made window coverings that commenced operations in the second half of 2020.

However, it’s important to remain cautious as good news doesn’t last forever and ups and downs are to be expected. The most important thing to focus on is companies that can benefit structurally from this trend and manage risk effectively.

Regarding our banking exposure amid recent U.S. events, our largest allocations are in India, where we believe its domestically focused economy poses less risk. We have some commercial real estate exposure in one position in Mexico but of a different nature (logistics & industrial parks), which is linked to the positive trend of nearshoring that we anticipate will persist. Furthermore, this investment is concentrated in northern Mexico, which generally experiences faster growth compared to the entire economy. Nevertheless, we remain cautious about potential contagion and have reduced our exposure while closely monitoring the situation.

Our Global Alpha EM portfolio is overweight in China and Mexico, although selectively. In China, our primary focus is on local brands that serve the Chinese population, particularly in the consumer and manufacturing sectors as well as industrial automation. In Mexico, we seek companies that can directly benefit from nearshoring and also leverage their strong domestic operations. Our investment decisions are based on factors such as a good balance sheet, strong free cash flow, market leadership and positioning. In addition, we maintain a well-diversified portfolio.

BACK TO EMERGING MARKETS SMALL CAP

During the first quarter, the MSCI Emerging Markets Small Cap Index underperformed the MSCI EAFE Small Cap Index and the MSCI Emerging Markets Index.

Within the MSCI Emerging Markets Small Cap Index, information technology, which represents 18.1% of the Index, was the strongest-performing sector, delivering a 17.7% return. Energy was the worst-performing sector, returning -4.9% for the quarter, with an Index weight of 2.0%.

PERFORMANCE HIGHLIGHTS

In the first quarter, our Emerging Markets Small Cap composite delivered a gross return of 5.0% (4.7% net), outperforming the MSCI Emerging Small Cap Index by 1.1% gross (0.8% net).

Our top performer for the quarter was Dentium Co. (145720 KS), a Korea-based manufacturer of dental implants and related instruments and materials. The company primarily serves EM countries and holds a 5% market share globally.

So, what drove the stock up?

In the first quarter, Dentium’s strong stock performance was due to the better-than-expected impact from China’s volume-based procurement (VBP) program and following the acquisition of its key competitor by a private equity firm at a premium valuation. Despite consistently delivering rapid growth and maintaining the industry’s highest margins, Dentium trades at a substantial discount to global peers.

Another top contributor in Q1 was Universal Vision Biotechnology (UVB) (3218 TT), Taiwan’s largest eye-care clinic chain with 28 clinics, 33 optical centers and a presence in China with 11 clinics. UVB is an industry pioneer, continuously introducing the latest technology to the market. The company is poised to benefit from the fast-growing demand for ophthalmic services in Taiwan and China, driven by structural demographic tailwinds.

What drove the stock up?

UVB’s stock performed well in Q1 due to strong Q4-2022 results driven by network expansion, high demand for advanced surgeries and cost control. During its earnings call, the company expressed a positive 2023 outlook supported by strong first-quarter sales.

Our top detractor for the quarter was City Union Bank (CUBK IN). CUBK is one of India’s oldest private sector banks specializing in serving the small and medium enterprise (SME) space. With over 700 branches, conservative management and an extremely granular balance sheet, CUBK has consistently delivered best-in-class profitability since listing.

What drove the stock down?

The main reason for the stock’s correction was the bank’s revised guidance on loan growth for the upcoming fiscal year. While the bank’s operating metrics have been moving in the right direction, management explained to us that they have chosen to be conservative and will accelerate loan growth later in the year while maintaining their focus on profitability. The uncertainty surrounding the CEO was another factor affecting the stock’s performance, but this issue is expected to be resolved by the end of April. With a stronger balance sheet post-COVID and credit costs moderating, we expect CUBK to outperform its peers.

NEW POSITION

One of our new positions this quarter is Park Systems (140860 KS) in Korea. Park is a pioneer in manufacturing Atomic Force Microscopes (AFM), which are used to observe ultra-fine structures that cannot be measured with an electron microscope.

In addition to its current use in academic research and the semiconductor industry, AFM has future applications in industries such as new materials, energy, environment, biotech and medical diagnosis. Park Sang-Il, the founder and CEO of Park Systems, was a member of the original research team that developed AFM at Stanford University.

With 32 patents and low international sell-side coverage, we were attracted to Park for its technology and market leadership (#1). Park’s customers include universities (such as Harvard), national laboratories (such as NASA and IBM research) and the top 20 semiconductor companies in the world. With an innovative R&D pipeline and a strong management team, we see a long runway for growth as AFM technology is adopted in new areas, including display and biotechnology.

OTHER NEW BUYS AND SELLS

During the quarter we also initiated new positions in Grupa Kety, CMGE Technology Group and Logo Yazilim. We exited Puregold Price Club, Muthoot Finance and Inter&Co.

WHAT IS OUR EAR-TO-THE-GROUND APPROACH TELLING US?

Global Alpha was back on the road in the first quarter of 2023, covering more than 60% of our holdings through in-person meetings and conferences.

We have observed a faster-than-expected recovery in China, with encouraging economic data and revised forecasts. We are overweight in China and believe our portfolio is well-positioned to benefit from emerging growth opportunities.

In Korea, we are closely monitoring companies linked to EV battery development. Although we believe that some stocks in the sector have exceeded their fundamentals, we recognize the exponential growth in the number of electric cars and the increasing penetration of EV battery materials, such as silicon anodes or electrolytes, which will benefit related companies.

We continue to monitor developments in Poland, where we initiated positions in two companies this year. Poland’s stock market offers diverse alternatives in various sectors, making it an attractive investment opportunity.

Our positive views remain on Indonesia, Mexico, Poland, Chile and China based on our bottom-up approach. We constantly look for alternatives in other geographies and our portfolio remains well-diversified among countries, industries and currencies.

The Global Alpha team

Click here to view a PDF version
A welder working on steel plates.

Summary

Emerging market equities fell in February (the MSCI EM Index was down 6% in USD terms) as investors took profits in China, and with strong wage, consumption and services data in the U.S. fuelling fears of persistent inflation and risks that the US Federal Reserve would press on with monetary tightening for longer than anticipated. This supported a modest bounce back in the dollar after a sharp decline through Q4 last year, which was an added headwind for EM.

The reopening trade was the catalyst for the biggest rebound for Chinese equities outside of the Global Financial Crisis. Higher beta H-share names were beneficiaries of extreme flows buying into laggards. These stocks were softer through February, with Alibaba and China Education Group leading portfolio detractors.

We wrote last month that A-shares across a number of sectors were attractive given their underperformance relative to H-shares since November. Despite posting slightly negative returns in February, it was pleasing to see A-share names like heavy equipment maker Sany Heavy, industrial automation leader Shanghai Baosight, and Spring Airlines post positive relative performance at the country level.

Investors are now looking to the two sessions in March, namely the National People’s Congress and the Chinese People’s Political Consultative Conference, for major announcements and key government appointments to gauge policy direction. Brazil and Saudi Arabia continued to underperform with South Africa joining them, reflecting our view that poor global liquidity data signals a deteriorating economy that is set to drag on more cyclical markets. Reopening in China will not match the boom we saw in the West as monetary and fiscal policy remains conservative. Weak global demand will also weigh on China’s export markets. Therefore, while we are encouraged by the recovery in China’s economic activity, we are not playing derivatives of the reopening through commodities.

Modi silent on Adani

Last month we flagged that the fallout from allegations of fraud and stock manipulation levelled against the Adani Group would test India’s ascent up the development ladder. Prime Minister Narendra Modi has been the driving force for a number of crucial reform initiatives, including the electrification of poor villages, providing better sanitation in rural areas, the introduction of a bankruptcy code, a nationwide goods and services tax, and establishing digital land records and biometric identification which together underpin a virtuous circle of development. With general elections approaching in 2024, it was hard to see how Modi would lose, particularly given weak and fragmented opposition.

The fallout from Hindenburg’s short report on the Adani Group presents a key test for PM Modi, as his rise, along with that of Adani and India itself are in many ways intertwined. Modi forged his reputation as a pro-business Chief Minister of the Gujarat province in the early 2000s, with rapid economic modernisation and growth propelling rising industrialists such as Adani to the forefront of India’s growth story. As Modi rose to the office of PM, Adani was a key supporter and beneficiary of the government’s nation-building plans, enabling him to build an industrial empire across ports, power plants, resources, renewable energy and airports. India’s opposition parties, who have accused Modi of crony capitalism through helping Adani secure lucrative projects across a host of sectors, have seized on the report as evidence of corruption. Modi on the other hand has kept quiet while his spokespeople characterise the accusations as an attack by elites in Congress and the media on the BJP’s pro-growth agenda. Our view at this early stage is that the risks appear unlikely to be systemic. Hindenburg’s report outlines what looks to be a stock “ramp,” with shell entities buying up stock to lock up free float while hiding this from index providers. Ostensibly meeting liquidity and market-capitalisation requirements enabled index inclusion with a disproportionately large weighting for thinly traded Adani stocks, which was in turn fuel for a massive rally across the Adani Group. While high debt levels are a concern, the collateral tied to many of the loans are high-quality infrastructure assets, with state banks and foreign lenders bearing much of the counterparty risk. Should fallout be contained, the controversy could present a buying opportunity in some of our favoured names while encouraging better corporate governance in India.

Globalisation is not over

While globalisation is clearly changing, we can’t see it reversing. China’s export machine continues to power ahead, while developed countries wisely diversify supply chains to the benefit of other rising export players such as Vietnam, Indonesia and India. Indeed, the combination of incredibly tight labour markets in the West (the U.S. in particular) and extremely cheap real effective exchange rates across a number of emerging markets make these countries incredibly attractive investment destinations in our view. Real effective exchange rates incorporate relative levels of inflation and “trade weights” to account for a country’s largest trading counterparties. As per the following chart, some EMs are more competitive than they have been for a decade or more.

Real Effective Exchange Rate

Chart showing the real effective exchange rate of emerging markets from 2010 to 2022.
Source: Refinitiv Datastream

Chinese EVs are beginning to go global

Leading Chinese electric vehicle (EV) stocks have been sold heavily over the past 12 months, with the pandemic disrupting supply chains and sapping consumer demand. Premium EV manufacturers were hit particularly hard as sentiment soured on reports of missed delivery targets in late 2022, along with a soft outlook for the next quarter or so. Despite the setbacks, the industry’s long-term prospects remain bright. The core investment case revolves around the following factors:

  • EVs are approaching purchase-cost parity with internal combustion vehicles (ICEs); 
  • a long runway for EVs to take share from ICEs;
  • increasing battery density and longer-range;
  • build out of charging infrastructure; and
  • domestic EV players successfully positioning themselves as leading premium brands in China.

What makes this a particularly attractive opportunity is the potential for Chinese EV companies to scale up in a continental-sized market. As this plays out, industry leaders will emerge within China that possess the scale and technology to go global and potentially dominate foreign markets. This is starting to play out now from a low base, with China becoming a net exporter of autos for the first time in 2022, led by EV manufacturers (HSBC Research, February 2023).

Share of NEVs as a % of China passenger vehicle exports

Source: CAAMM, QIANHAI Securities

2022 global EV volume mix

Source: EV-Volumes, HSBC Qianhai Securities

China exported 2.5 million EVs in 2022, up 57% year-on-year. Chinese brands are in the early stages of establishing themselves in foreign markets (particularly in Europe), which are less competitive than China. While a compelling story, investors need to keep expectations in check. It is likely to take years for Chinese EV players to build meaningful traction through increased brand familiarity, localising some production and distribution as well as navigate growing protectionism. If brands like NIO and BYD can manage these risks, they will be set to challenge foreign rivals by drawing on the largest EV production market in China and the strongest battery supply chain globally.

View of Abu Dhabi Skyline at sunset, United Arab Emirates

The strategy generated a net return of -0.8% in Q4 2022 bringing returns to -3.7% for the year-to-date period ending December 2022. The strategy generated net of fees excess of the benchmark returns of 4.9% and 0.8% for the quarter and year-to-date, respectively.

 Gulf equity markets rolled over in the fourth quarter and materially underperformed emerging markets. This marks a stark but predictable (as we wrote in our last Q3 letter) reversal in fortunes, with tailwinds of the outperformance in the last 18 months turning to headwinds. We summarize the key drivers of the weakness in Gulf equity markets in the fourth quarter below:

  1.  Lower oil price and a different transmission mechanism – Gulf economies are highly levered to oil prices. While a Brent oil price of $80 is healthy for most Gulf economies, surpluses will naturally be lower as prices come down and barrels produced and sold remain static. Moreover, and focusing on Saudi Arabia, the share of oil revenue proceeds going into the banking system has come down considerably as the government allocates an increasing proportion of oil revenue to its sovereign wealth fund where the trickle down to economic activity is seemingly less visible (for now).
  1. Higher interest rates – Gulf currencies are effectively pegged to the U.S. dollar and central banks have had to adjust to the Fed’s four rate hikes of 75 basis points in 2022. The relative attraction of owning equities with three months SIBOR rates reported at 5.59% is understandably low. Gulf investors have more alternatives than ever before to invest their money, with the recent Al Rajhi Bank Sukuk proving to be particularly popular among retail investors. Higher rates are also putting pressure on the net interest margins of banks as they compete to attract deposits. This phenomenon is likely to be especially acute in Saudi Arabia, where the liquidity environment has tightened n the fourth quarter of 2022. Saudi banks represent ~23% of most MENA indices and so the aforementioned profit margin compression has a material impact on the market’s aggregate EPS growth expectations for 2023. In other Gulf markets like the UAE and Qatar, state and quasi-state companies have been pre-paying debt at a rapid pace to avoid higher interest rates, leading to anemic corporate loan growth and further pressure on profitability.
  1. Weaker USD – Gulf equities are effectively US dollar-denominated assets and are generally more attractive for global investors when the U.S. dollar is appreciating. This relationship has become stronger since Gulf equity markets became a large component of emerging market indices. Active Global Emerging Market (GEM) investors are not incremental buyers of Gulf equities in a weaker USD environment and their current underweight exposure to the region suggests they prefer to own assets denominated in non-pegged currencies.
  1. Valuations – Gulf equity markets are coming off excessive valuation levels that reflected over-optimism on the degree and timing of the impact of reform program announcements, and robust foreign inflows following the deletion of Russia from the emerging market universe in March 2022, which we discussed in our second quarter letter.
  1. A wall of offerings – 2022 was a record year for capital raised through primary and secondary transactions and the number of deals closed in the region with 47 listings raising a total of $26.5 billion. A large number of deals and the prospect of share sales by government and quasi-government shareholders took the air out of the market. We think it is wise for government funds to reduce or float their stakes in strategically listed companies given the level of ownership is far above what is required to retain control. However, this is likely to weigh on the share prices of many of the large-cap companies in the market where those entities are key shareholders. On a lighter note, overexcited bankers salivating at the prospect of fees from investment banking deals continue to be a reliable indicator of negative future market performance.

 As for the strategy, we managed – to a large extent— to avoid the significant drawdown that the region experienced in the fourth quarter. Three factors helped us achieve this outperformance:

  1. Sticking to high conviction portfolio companies like Saudi Dairy and Food Co. (SADAFCO) where management execution and weaker competition are leading to significant earnings growth that the market has been behind on for a few quarters now. 
  1. Adding to high conviction portfolio conviction companies that we believe are likely to experience an improvement in an operating environment like the National Company for Learning & Education (NCLE). NCLE’s eleven K-12 schools are experiencing a noticeable increase in utilization as students return to in-person learning in Saudi Arabia and management’s various initiatives (which focus primarily on quality of education in existing schools, M&A and greenfield for new schools) bear fruit.
  1. Reducing or exiting portfolio companies we believe have reached valuation levels that are no longer attractive. A good example of this is Saudi Tadawul Group (STG), the country’s stock exchange which we exited at nearly peak average daily traded value. Over 60% of STG’s revenue is linked to traded values on the stock exchange and our exit decision reflected an understanding that traded values cannot just continue to go up, a view that the market is only getting around now as traded values have dropped 50% y-o-y in recent months.

 We continue to see a strong opportunity for the strategy as the market begins to reflect the “bad news” in the price of assets we like, and as investments in companies we’ve made in the last 6-12 months or earlier continue to deliver. 

 While we acknowledge that the environment has been favourable for the strategy, and decisions we made have on the whole been good ones, we are not resting on our laurels and will endeavor to continue delivering differentiated value-added returns for our clients looking to access the growing investable opportunity in the MENA region. 

Vergent Asset Management LLP