No rule of law in emerging markets

There are a few components that the Skerryvore Asset Management team looks for to identify resilient companies in emerging markets, but government contracts is a red flag.

According to Glen Finegan, Lead Portfolio Manager at Skerryvore, the team steers clear of any close ties with emerging market governments because “there is no rule of law in emerging markets”. You can’t rely on contractual agreements to stand up in court, nor for regulations to be consistent.

After identifying companies with strong brands and customer relationships that have the ability to move prices, an assessment of integrity is key to the boutique's process. ESG is also more than a buzzword at Skerryvore.

“If you compromise on ESG, on any aspect of environment, sustainability, governance, you’re exposing yourself to losses because at some point, you could be a victim of these poor practices.”

In this edition of Expert Insights, Finegan discusses how to identify resilient businesses in emerging markets, why pricing power is important and the advantage that emerging market businesses may have in the current inflationary markets over developed market counterparts.

Key takeouts:

• Resilient companies typically have strong brands and customer relationships, allowing them to move prices in inflationary environments.
• Integrity and ESG measures are equally important to returns when assessing emerging market companies.
• Emerging market companies typically have management experience around inflation, which may offer an advantage against developed market companies.

Transcript

How is identifying resilient companies different in emerging markets compared to developed markets?

In terms of thinking about resilient companies in emerging markets, I think the first thing you need to think about or to step back and consider is the fact that there's very limited rule of law in emerging markets. So in the way you might expect to be protected as a minority shareholder in say an Aussie equity, you can't rely on that type of protection in emerging markets. So you have to start by trying to figure out how to protect yourself.

And you do that by studying ownership of businesses, understanding who are the capital allocators behind businesses you might be looking at, and then trying to do as much due diligence, studying the history of how these individuals have built their businesses, how they may have acquired the assets in the first place, how they've treated all stakeholders in their business over time, do they pay their taxes. All these sorts of things help you build a picture of the integrity of the people behind the business you're going to be investing alongside. And integrity is a very important part, of course, of hopefully never needing legal protections. So that's really the starting point.

So our team really are as much historians as they are financial analysts. We're studying businesses all around emerging markets and trying to identify a subset of businesses which are backed by founders, families, or governance structures that we truly believe we can become properly aligned as minority shareholders, and where our interests are likely to be protected. And the best way to judge integrity is to look at how people have behaved in the past. So that's a big part of how we try to identify businesses that might meet that resilience test.

And then we think a lot about risk when making investments in emerging markets. We don't forecast macro, but we want to invest in businesses that can survive crises. No one saw a pandemic coming, but none of our businesses experienced any financial stress, because we own businesses with strong balance sheets, cash generative business models, that we're able to carry them through. Many businesses were disrupted, but no one got into trouble, not because you're thinking about a pandemic, because you're thinking, you don't know what's coming, you want to ensure that the businesses you own have strong balance sheets and cash generative models. So that is another way of being resilient through cycles in emerging markets.

But I think the key thing in EM and the differentiation maybe with DM investing is you're not going to go to court and get your money back. So you better not be in a situation where you might need to go to court. And the best way to do that is identify the best governed businesses that you can.

How do Environmental, Sustainability and Governance (ESG) factors influence your process?

I talked earlier about only investing alongside owners, managers, governance structures, where you can prove to yourself there's a high level of integrity. How do you judge people's integrity? Look at how they treat others. So if their business is based on exploitation in the labour chain, the supply chain, ignoring maybe child labour problems further down the supply chain, if the business is just an environmental arbitrage, are they just manufacturing in a region or a country because they can get away with dumping hazardous waste and not treating it and therefore make greater profits.

If businesses are run by founders, managers, whoever maybe in charge of the decision making behind the company, who are cutting those corners or making those compromises, did they just bribe to get the licence to do their business in the first place, if they're making those kind of compromises, it's telling you something about the integrity and therefore the riskiness of the people you, as a minority shareholder, would be invested alongside.

So not only is factoring in sustainability important for businesses to prosper in the future, it's also an extremely important way of avoiding the worst actors around emerging markets. So for us, we put sustainability and returns on unequal footing. We think there're two sides of the same coin. I think we're certainly not a fund that prioritises ESG above returns. We think if you compromise on ESG, on any aspects of environmental, social, governance behaviours, you're exposing yourself to losses, because at some point you could be a victim of these poor practises. So it's completely embedded in trying to identify a good quality company.

The skerryvore process views pricing power as important. Can you explain this further?

As a EM investor, you should reconcile yourself to the reality that EM currencies are likely to be weak over time. And therefore, any investment you make in EM or an in an emerging market company, you should be very confident that it has the pricing power to be able to keep up with the inflation created by devaluing currencies. We're in another situation at the moment, of course, where inflation is coming from other areas like the rising commodity prices and things like that. But again, pricing power should be able to protect you to a great degree. So trying to identify businesses that have pricing power is an important part of our process.

Thinking about businesses that don't have pricing power, we stay away from regulated assets. So an example of that might be a toll road business or a power generation business that has a regulated return, which is essentially a legal agreement with an emerging markets government. And you might have got the impression so far, but we're not that trusting of emerging market governments. And therefore, we're quite nervous about regulatory agreements being honoured. So I think there are examples going back over the time we've been running money in emerging markets, where inflation starts to pick up and that the toll road company wants to increase its price in line with its agreement. And it's just told it's not allowed. So those regulated assets in EM, because rule of law isn't so strong, can lack the sort of pricing power that you might hope you had, because it was written on a bit of paper. But unfortunately, that bit of paper is an agreement with an emerging markets government.

So those types of businesses, we tend to avoid, preparing businesses that are more in control of their own destiny and either are able to offer products and services that customers value, or have very strong brands that they can use to pass on price.

Can you discuss an example of a business you invest in with pricing power?

Just thinking a little bit more about businesses in the portfolio that we think exhibit some of the characteristics of resilience and pricing power. I'd highlight FEMSA in Mexico, which is a very large position in the fund today. It's the leading convenience store operator. It's a family controlled business and it's the leading convenience store operator in Latin America. They've got 20,000 stores across Latin America, and a well run convenience retail business should be relatively inflation proof. Because if the price of the products the store is selling is going up and they pass that price through, it drives revenue up and you get the sort of operating leverage through an efficient business model. So up to a point, up to a certain level of inflation, that should be a pretty resilient franchise. And it's continuing to roll out stores. It's actually expanding into Brazil as well. So those types of very well run retailers.

And actually, just one thing I'd highlight is the idea of emerging market management teams and inflation. Most of our management teams have experienced bouts of high inflation in their careers, and I think that differs quite substantially to managers working in the developed world who really, this is the first experience they've ever had of inflation. And when I look at businesses that you might have thought would be resilient, like retailers in the U.S., we're seeing that are not as resilient as you might have expected. And I think that's probably because the management teams don't necessarily know how to deal with inflation. Whereas, I can think of Brazilian retailers who we know well, who have histories of increasing the prices three times a day in high inflation. So I think there's a management experience around inflation in emerging markets that doesn't exist in the developed world.

Far-sighted and fair-minded

Skerryvore Asset Management is a boutique of BennBridge, the UK arm of Bennelong Funds Management. The team are fundamental, bottom-up investors seeking to create high conviction portfolios of reasonably valued, high quality companies that are exposed to, or operate in, emerging markets. For more insights, visit Skerryvore's website.