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.”
A good example would be Anhui Conch Cement, the second largest cement manufacturer in China, which has market share of about 10% and is geographically diversified. We like the company, because it is the cement producer with the lowest cost of production which allows it to achieve the highest margins in the industry. We believe this will enable Anhui Conch to further expand its market share and to consolidate the industry. The company also has strong pollution controls at their plants due to significant investments in such facilities over the last couple of years.
Our investment thesis is supported by limited supply growth in the cement industry. We expect the supply to grow at CAGR of only 1% over the next three years. That should allow the industry to have much stronger pricing power than in the past. The superior pricing should lead to higher profitability on a per ton basis.
We found the company through a quantitative screen. Then we thoroughly researched the industry to understand the supply-demand dynamics. Anhui Conch stood out from our downside protection perspective, because it was undervalued. It is currently trading at 10 times earnings, six times EV-to-EBITDA, and 1.5 times book value. That’s quite low compared to the historical average of about 17 times earnings and almost nine times EV-to-EBITDA. We believe that there is mean reversion potential as the industry supply-demand dynamic improves.
In addition, the company exhibits a strong balance sheet and generates 7% free cash flow yield with low capex planned in the medium term. Price increases have started to flow through and the company has significant operating leverage. At the same time, inventory levels across the industry are quite low at about 65% below the average levels in the last five years.
Anhui Conch is slowly expanding outside of China, primarily in Southeast Asia. It has already built plants in Indonesia, Vietnam and Cambodia. In terms of asset utilization and capital allocation, we are very excited about the investment opportunities in those markets as they have low per capita consumption of cement currently.
Lastly, the dividend payout ratio is only 30%. With the company generating free cash flow of more than 7% and having a net cash balance sheet, we believe that the dividend will increase in the next couple of years.
Q: What is the reason behind the low valuation? Could you explain the supply-side constraint dynamics in the Chinese cement industry?
The multiple is below its historic average, because the market focuses too much on the long-term prospects for cement demand in China. Right now, the cement per capita demand in China is quite high relative to other countries and is expected to gradually decrease.
But we believe that the market is underestimating the supply outlook, which will lead to price increases. One of the reasons for the supply constraint is that the government wants to eliminate the smaller plants with significant emissions and poor pollution controls. We are seeing stringent government control in the commodity sector; no new plants are being approved, while demand remains strong.
Within the cement industry, about 40% of the demand comes from property, 25% from infrastructure, 25% from rural, and 15% from other areas. We think that the market is overly concerned with the 40% coming from property and that’s why valuations are low. However, demand from other areas remains strong.
Q: How do you assess the growth potential of an industry?
It is critical to understand the industry dynamics and the barriers to entry when we invest. For example, the renewable energy in China is still growing at 20% CAGR per year, but there are very low barriers to entry. The excess return just gets eaten away by new entrants and, as a result, many companies haven’t generated any return for investors.
The key element, even in growing industries, remains capital allocation and generating appropriate return for the shareholders. There is significant difference between top-line growth, earnings per share growth, and capital returns to shareholders.
For example, a state-owned enterprise may continue to grow its top line without the focus on generating returns for shareholders. In an ideal case and what we look for, is when there is alignment between a management team and a strategic investor base that aims to create value for all stakeholders. That’s the critical distinction and that’s why active managers can add value, in our view. We align ourselves with management teams who can ensure that if the industry is growing significantly, we as minority shareholders will be entitled to a piece of that growth.
Q: What is your portfolio construction process?
We typically have between 60 and 100 positions in the portfolio; right now we have approximately 80 names. We look for maximum exposure of 4% to any individual investment and 30% to any single country or sector. Although we can invest in frontier markets, we restrict that exposure to less than 20% of our investment capital. Right now, we have only one or two investments in frontier markets.
After we quantify the upside and downside potential for each investment, we use that analysis in conjunction with a portfolio optimization tool to determine the appropriate weights, while minimizing portfolio risk. Our optimization tool also helps us to make sure that we don’t take on any unintended sector, country, or factor bets. Finally, a security is bought with an absence of veto from either of the two portfolio managers.
The primary benchmark is the MSCI Emerging Markets Index, but we also compare our fund versus the MSCI Emerging Markets Value Index. Because of our value investing style, we think it is appropriate to look at both.
Q: What is your sell discipline?
If we believe that the full valuation of a particular investment has been reached and the upside potential left is limited, we will take profits and move on to the next opportunity. The second reason for selling a stock is identifying better investments. We always evaluate our opportunity set and if we see an investment with a superior risk-reward potential, we may swap a position.
We would also sell a stock if any news negatively alters our investment thesis. These could be company-specific news or changes in the macro picture and the industry environment. We constantly evaluate and revisit the underlying investment thesis to see if there are developments that would require a change in the position. Finally, we would sell if a company is acquired and we do not want to hold the acquiring company.
Q: How do you define and manage risk?
We focus on valuation risk and the price that an investor pays for an asset. We aim to minimize that risk by purchasing companies that are undervalued and with limited downside potential.
We also consider the financial distress risk by targeting companies with strong balance sheets and that generate cash flows through the cycle. We avoid companies that require access to the financial markets on a regular basis.
At the security level, we avoid business models that are at risk of obsolescence or models with binary outcomes, like biotech and early stage energy exploration companies.
At the portfolio level, risk management aims to minimize any unintended bets. That’s where the optimization tool helps to make sure that our alpha comes from bottom-up security selection. We want to allow the individual stock selection to generate the portfolio alpha’s and we seek to outperform our benchmark by 200-300 bps per year on average.
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