Is caution the most effective strategy?

Emerging markets are one of the classic ‘looks cheap’ asset classes, offering higher credit spreads and lower P/E ratios than developed markets. However, they have a habit of dishing out painful investment lessons to naïve investors. This has been exacerbated by the Covid-19 pandemic and it is probably truer than ever to point out that not all emerging markets are the same.

In this Collections piece, we ask emerging markets managers Rasmus Nemmoe, FSSA Investment Managers; John Malloy, Jr, RWC Partners; and Alex Duffy, Fidelity Investments whether the pandemic has changed how they invest across the EM universe and if there are any countries or sectors that are best avoided in 2020.

Focus on dominant consumer, financial or services companies

Rasmus Nemmoe, FSSA Investment Managers

The pandemic has not changed our approach to a large extent. Our portfolio actually looks reasonably similar to what it was pre-Covid-19. We specifically focus on strong management teams in quality franchises with defensive characteristics such as high returns and recurring cash flows. Often, they can be found among the dominant consumer, financial or services companies in the less developed parts of the market. Not only are penetration rates low for many goods and services, providing a favourable long-term secular demand backdrop, but also a high level of informality in many of these countries raises the entry barriers substantially.

This often facilitates a benign competitive environment that allows many of the dominant companies (with a brand, distribution or scale advantage) to generate high margins and high returns and, as a result, strong free cash flow over the cycle. Over the past couple of quarters, we have generally reduced our positions in Covid-19 beneficiaries as the valuation premium towards the rest of the market has widened too much. Instead we have selectively added to quality companies, which are near-term challenged but have bright long-term prospects.

Looking out for new themes in rapidly evolving markets

John Malloy, Jr, RWC Partners

We have not changed our investment process or strategy as a result of Covid-19. While more discretionary-related themes will likely take time to recover, such as tourism, many secular growth opportunities remain attractive in emerging and frontier markets. Technology disruption continues to be a key area of focus due to structural growth advantages such as lower penetration in fields such as smartphones, payments and food delivery.

Moreover, we continue to see opportunities in the cloud and 5G spaces, mainly in North Asia. The recovery in commodity prices and the persistent electrification of the economy should bode well for holdings in our copper, sustainable energy and new auto technology themes. The team continues to search for new themes and new ideas in our rapidly evolving universe.

Cautious on Brazil given ongoing political noise, currency risk

Alex Duffy, Fidelity International

The recent crisis has highlighted the importance of investing in high-quality names, characterised by sound balance sheet structures that enable them to weather more challenging environments and come out of the volatility stronger than peers. Solid corporate governance and underlying incentive structures are paramount to ensure businesses treat capital prudently and try to grow shareholder value.

We remain committed to our robust and repeatable investment process, which we have adopted since the strategy’s inception, and which enables us to deliver attractive returns to our investors. Our focus is owning well-managed businesses with attractive return profiles, an accretive reinvestment opportunity and a valuation that offers an adequate margin of safety on a free-cash-flow basis.

Finally, whilst our country and sector positioning are purely residual, we are continually monitoring the impact of the crisis on EM economies and assess our companies’ valuation models to ensure that they appropriately reflect potential macroeconomic risks. For example, we’re more cautious on Brazil given the ongoing political noise and currency risk. At the sector level, we are seeing a challenging operating environment for travel-related names with the heightened levels of uncertainty and its impact on global travellers’ mobility.

Conclusion

Despite the Covid-19 pandemic, there are good investments to be found in emerging markets and our managers have not had to significantly alter their strategies. Selectively adding quality companies, which are near-term challenged but have bright long-term prospects, to their portfolios seems the smart play.

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