Ahead of the Curve in Emerging Markets
Principal International Emerging Markets Fund
Author: Ticker Magazine
Last Update: Dec 06, 10:48 AM EST
|A process focused on identifying positive change requires disciplined research, especially when it comes to fully understanding the capital allocation model of a business. Mohammed Zaidi explains how the portfolio managers of the Principal International Emerging Markets Fund and a team of analysts combine fundamental analysis and behavioral finance disciplines in detecting and selecting companies undergoing change not recognized by the market.
“We are fundamental investors focused on earnings and cash flows. We have a systematic approach leveraging technology and focused fundamental research to identify where positive change might offer relative value, and it’s sustainable.”
If Alibaba started returning all of its capital to shareholders instead of deploying it for future growth, they would not have the multiple they have now. And if the mining companies did what Alibaba is doing, and started building and opening up mines and levering up versus returning capital to shareholders, their valuations would be a lot lower. One must follow both management strategy and how the market views it, and it’s done by following the money through the business itself and seeing what the business is doing.
As an organization, our ESG (environmental, social, and corporate governance) engagement is becoming a formal part of the process. Improving governance begets better valuation multiples, and vice versa, but at the same time, in emerging markets, that also speaks to the importance of focusing on trends versus levels.
Today, if we look within any industry, European-based companies tend to score better than those in the emerging markets companies, and the U.S. and Japanese companies tend to fall in between. But while some of these emerging market standards might be lower than those in Europe, companies in emerging markets have more runways for improvement, which provides another source of added value for our clients.
Q: How do you construct your portfolio?
There are just over 90 companies in the portfolio—it’s diversified, but by no means a closet hugger. Emerging markets is a very top-heavy universe, and mega cap companies are chunky weights in those benchmarks, so we are thoughtful about how we position around that.
By and large, we pursue an all-cap strategy. One of our competitive advantages has been delving more into the small and mid cap spaces than some of our peers, and, most importantly the way we look at risk from a multi-dimensional perspective. We don’t engage in active short-term market timing, and generally keep cash balances at a minimum. The overall beta profile of the portfolio is close to one (1) at all times so that stock picking drives results rather than bold calls on macro themes. By design, 80-plus percent of our relative returns are derived from stock picking, rather than country or sector allocation. Year-to-date, our stock selection comprises 95% of our outperformance.
The individual country, sector, and stock allocations depend on client needs, but the broad rules of thumb are plus or minus 5% at the country and sector levels (for larger countries and sectors we can go plus or minus 10%), and at the stock level we generally limit concentration to 2% or 3% over the benchmark weight. For segregated accounts we can tailor to higher-risk/risk-tolerant and less risk-tolerant parameters, depending on the client needs.
We avoid extreme overweights in any particular area, or forced exposures to areas that we don’t particularly like, and use more of our latitude on the underweight versus the overweight side.
Q: How do you define and manage risk?
Multiple levels of risk exist, from the stock research and selection levels down to portfolio construction.
At the portfolio construction end, we look at risk two ways: through the portfolio’s factor exposures, like momentum or earnings, and macro factors, like currency or commodity risk; and via exposures in terms of market cap, valuation, earnings growth, etc. We quantify this and update it every day, using our own internal risk model.
Another way we look at risk is to use the same quantitative model we use to find investment ideas (making this unique to us) in order to minimize the risk in the portfolio relative to our model. We assess daily if are we overweight or underweight any exposure to a level that adds too much risk of reversal.
Yet another level of risk lies at the stock level, and that’s an iterative process of the fundamental analysis, determining if our level of conviction and thesis still hold, what the market thinks of that thesis, and the fundamental analysis level to confirm whether, at the stock level itself, the investment is appropriate.
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