Exploiting Behavioral Inefficiencies in Emerging Markets
Advisory Research Emerging Markets Opportunities Fund
Author: Ticker Magazine
Last Update: Dec 18, 11:14 AM EST
|While emerging markets represent the majority of the world’s population and continue to grow economically faster than developed markets, they still remain underweight relative to their global contribution in U.S. investor portfolios. Kevin Ross, co-manager of the Advisory Research Emerging Markets Opportunities Fund, believes that the challenges associated with the asset class actually create significant opportunities for active managers with the right infrastructure and capabilities.
“We align ourselves with management teams who can ensure that if the industry is growing, we as minority shareholders will be entitled to a piece of that growth.”
Q: What is the history and the scope of the fund?
The fund was launched on November 1, 2013, but our firm has been investing in emerging markets since 2010. I have been dealing with many of these markets for more than 10 years and became the portfolio manager on January 1, 2017.
Under the emerging markets strategy umbrella, we manage the mutual fund and separate accounts. We manage a total of about $150 million in the strategy, while in the mutual fund we manage assets of about $40 million.
Q: Which part of the emerging markets do you focus on?
We look for companies that have the majority of their revenues or assets in the emerging markets as defined by MSCI or World Bank classifications. The universe includes places like China, Korea, Taiwan, South Africa, Brazil, etc. So, we have the flexibility to invest in companies that are listed in developed markets, but generate the majority of their revenues from the emerging markets or have their assets there.
A Japanese company with significant assets in China and Asia would qualify, as well as a company listed in the U.S. that generates most of its revenues from Latin America. We believe that having such investing flexibility gives us as active managers an edge over the emerging market ETFs.
Q: What are the main challenges of investing in emerging markets?
First, there are language barriers, so we need to have a strong and deep network on the ground to navigate those markets. That network includes various company contacts, industry experts and analysts.
The other challenge is related to the information flow and analyst coverage, which is much smaller than in the developed markets. For example, the average number of sell-side analysts covering a stock in the emerging markets is four, compared to 21 for stocks in the S&P 500 Index and 16 for the stocks in the developed MSCI EAFE Index.
However, these challenges create significant opportunities for active managers, who have the infrastructure and the capabilities to capture these informational inefficiencies. Emerging markets account for 85% of the world’s population, about 25% of global equity market cap and roughly 15% of the MSCI ACWI Index. They continue to grow both in terms of their economies, as well as in terms of the number of listed securities.
At the same time, the asset class is clearly underrepresented from a global perspective as U.S. investors have less than 5% of their portfolios in emerging markets. The asset class is trading at much lower multiples than the U.S. equity markets and is undervalued relative to its historical levels and to the developed market benchmarks.
Q: What core beliefs drive your investment philosophy?
We have a value-based approach and our portfolio exhibits lower earnings and book value multiples compared to the benchmark. Academic research has proven that value investing works in emerging markets, which we believe can be attributed to the behavioral biases of investors. While emerging markets grow faster than developed markets, investors tend to overpay for growth in these markets.
That dynamic allows value to work significantly over the years. Another core principle is that our alpha or additional return to benchmark comes from security selection, not from unintended currency or country bets.
Q: How do you define value?
That definition varies in the different industries. The value approach incorporates downside protection as we need to understand our potential for permanent capital loss in a bear-case scenario. We utilize a combination of factors to determine the fair value of a particular opportunity.
For example, in the financial industry, we look at price-to-book value compared to the return on equity that the company generates. In the consumer staples or discretionary space, we look at price-to-earnings using very conservative downside scenario assumptions. For industrial companies, we examine the EV/EBITDA multiple, again using fairly conservative assumptions in a down-cycle scenario. Then we compare our downside case with the upside catalysts and the steps for the companies to unlock value.
Q: Would you explain your investment process?
We are active managers and our portfolios have high active share. We incorporate quantitative tools for screening and rigorous fundamental research in our bottoms-up analysis. The fund invests across the entire market-cap spectrum within emerging markets, but we look for a minimum of $1 million trading per day, because we need to know that we can easily exit a security from a risk management standpoint should our thesis not play out according to plan.
The first part of the process is to identify our opportunity set. The universe within emerging markets is quite large, with more than 5,000 securities, so we use proprietary quantitative tools to narrow it down. Our quantitative screens incorporate a robust scoring tool that utilizes a multi-factor approach through FactSet. The goal is to determine the top 20% of companies within the universe that we believe have the highest probability to outperform over a medium term investment horizon while also meeting our strict valuation criteria.
We use that tool in conjunction with our network on the ground to source new investment ideas. The network includes sell-side analysts, specialists that we have met over the years, as well as reports and publications.
The second step of the process is downside protection. At this stage, we try to understand our risk of permanent capital loss. We examine historical data and we perform peer-valuation analysis. We extensively examine the cash flow generation abilities, because we look for businesses that generate cash flow through the cycle. We don’t buy businesses in deep turnarounds, so we need to see profitability through the cycle. Typically, we buy companies with strong balance sheets and low leverage levels.
After analyzing the balance sheet strength, we focus on corporate governance. That part is of critical importance in emerging markets, where governance standards and practices are not as high as in more developed markets.
If a company meets all the criteria in the downside protection analysis, we move to step three, which is our upside potential. We talk to the management teams to understand their strategic plans for unlocking value both operationally or through asset optimization. We evaluate the capital allocation to see if the companies maximize value. We look closely at the absolute levels of ROE and the potential for ROE improvement through better capital allocation. Another upside catalyst could be some positive change in corporate governance, which might include new members to the Board or changes in compensation structure.
The upside catalysts could also take place at the industry level. We don’t necessarily set timelines for these catalysts to be realized, but we need to be able to define what those catalysts are. We do extensive industry and competitive advantage analyses to understand if there are any potential positive changes that could help unlock value in the shares.
Once the downside protection and the upside potential analyses are quantified, we look for opportunities with upside potential that is two-to-three times higher than the bear case scenario.
Q: Could you illustrate your research process with specific examples?