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Base Case, Upside and Downside
AMG Trilogy Emerging Markets Equity Fund
Interview with: Pablo Salas

Author: Ticker Magazine
Last Update: Nov 14, 12:44 PM EST
A broader global perspective and a highly experienced team are among the key differentiators at the AMG Trilogy Emerging Markets Equity fund. Portfolio manager Pablo Salas navigates the seas of emerging markets relying on a bottom-up approach, fundamental research, quant screens, and macro trend analysis. With risk management embedded in the process of security selection, the fund aims to invest in sustainable growth companies at a reasonable price.

“We quantify the potential downside risk at the company level and we come up with a pessimistic case scenario and price target. So, when we select the stocks, we don’t just look for better upside potential, but we evaluate the potential upside return relative to the downside risk.”
Leverage is important, because companies with stretched balance sheets and high leverage have more downside risk during unexpected macro shocks, which come to emerging market economies more regularly than we would like to see. There is a long list of companies that went out of business in economic downturns because of excessive leverage.

Another important screen is proven growth metrics, or a set of historical factors. We also have a set of forward-looking factors to achieve a balance between traditional and early-stage growth companies.

For the traditional growth companies, we look for strong returns on equity relative to their peers in each sector. If we are looking at consumer discretionary, for example, we’ll examine how all the companies in that sector rank in terms of return on equity, and look for those that rank in the top 30% of the sector.

The superior track record in generating returns on capital is an essential factor for GARP funds. The companies that sustain high returns on equity have the ability to compound value for the shareholders at a more rapid pace. That’s why return equity is one of our key metrics.

Another important metrics is the history of earnings growth. We examine the normalized earnings growth for the last five years to see how a company is ranked in the sector. Again, we look for the top-ranking 30% of the sector. We also select the ones with the lowest historical volatility of earnings, because they are able to sustain longer and higher growth.

Forward looking, we search for strong cash flow generation. The difference between reported net income and operating cash flow helps to select the companies that are better at converting reported earnings into actual cash. Growing receivables or inventories, for example, could potentially result in severe write-downs at unexpected times.

We also look at the earnings improvement potential and we examine analyst revisions over the last 90 days to search for companies with strong revisions relative to the sector.

Overall, between the quant screens and our fundamental day-to-day work, we identify about 200 companies with GARP-like characteristics that we can take to the next level.

Q: Would you highlight the next step, the fundamental analysis?

A: The goal of the fundamental analysis is to understand the positioning of a company within its sector, the major competitive threats, the macro-outlook in its markets, the regulatory factors that could potentially impact the company, the quality of the management, etc.

Our analysis takes all of these factors and we come up with our own forecast on the earnings and the cash flow. We use that forecast and the historic earnings for the valuation of the company. For each company, we consider the potential profitability over the next three to five years and, based on that analysis, we come up with a price target.

A unique feature of Trilogy is that we have been doing this work under three scenarios. The first one is the base case, or the assumptions that we consider most likely. Based on these assumptions, we come up with a base-case price target.

The second one is evaluating the downside risk. For us, a big part of risk reduction is quantifying the downside risk at the security level. This is where we try to understand the key risks for the company and to quantify them. What are things that can reasonably go wrong? If these risks materialize, what would this business look like? What would be a fair valuation based on that scenario?

Then we can compare the base-case potential return with the downside return. So, if we’re looking at two companies with similar upside potential, but we find significant difference in their downside scenario, the one with the lower downside risk will be more attractive.

The third scenario is the optimistic case. We do this work across all sectors and for all the companies that go through the due-diligence process. The three scenarios result in three price targets that we call a return distribution. The companies with the most attractive return distributions are included in a sector buy list.

The sector buy lists represent our best ideas for each sector and are a key tool in constructing the portfolio. In that process, we can compare companies across sectors, countries and regions based on the framework of potential upside return relative to downside return. This process steers the portfolio to the areas where we find more attractive ideas with better upside relative to the downside.

Sometimes we find more ideas in one particular sector, or in a few sectors, or in some parts of the world. Our sector and geographic distribution is a reflection of our bottom-up work. So, although we do the stock selection on a sector basis, the bottom-up process drives both sector and country exposures.

For example, in 2007 the Chinese market had gone through a bubble and many stocks were trading at more than 40 times earnings. A year earlier, MSCI China stocks had been trading at about 13 price-to-earnings, which was in line with the emerging market universe. But during in 2006 and 2007 many stocks went up 200%, which led to the high multiples.

Our exposure to China at that time was quite low, because the stocks were becoming more expensive and we were exiting Chinese stocks. The downside risk was becoming more pronounced relative to the potential upside and, in many cases, we didn’t see much potential upside left. Our weight in China in September 2007 was close to 3%, which is very low compared to the 17% weight of the country in the MSCI EM universe at the time.

Q: Can you provide some examples of specific holdings and their investment merits?

A: One of our larger positions is the internet search company Baidu. We have owned the stock for three or four years already and have been following Baidu since its initial public offering in the U.S.

Because of our global sector view, we had already analyzed and owned similar companies in the global and emerging portfolios. In the past, we had owned Google in the U.S. and Naver, the leading search engine in Korea. The industry was very interesting as it was taking share from traditional advertising media and becoming a very cost-effective advertising vehicle. In that growth industry, once a company had established a dominant position, it was quite difficult for competitors to erode it.

As we were working on Baidu, we saw many similar characteristics with Google in the U.S. and Naver in Korea. But although we liked the business, the competitive position, and the growth story, during the IPO the valuation quickly became too high. We had to wait until 2011, when the stock became more attractive. The stock has remained relatively flat for two years, while earnings were still growing with more than 30% annually. That meant that the P/E was coming down and we started a position in early 2011.

Q: How important is diversification in your portfolio construction process? Do you have any geographic or sector limits, and what is the maximum position size?

A: As I mentioned, our team has been in the industry for a long time and we were among the first to acknowledge the importance of proper diversification. Anyone can be wrong, so certain risk controls in the portfolio are necessary. On the other hand, we also understand that to outperform the benchmark, you need to have positions that can generate alpha.

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