Earnings Compounders in Emerging Markets
BMO LGM Emerging Markets Equity Fund
Author: Ticker Magazine
Last Update: Aug 08, 1:31 PM EDT
|With incomes steadily growing in emerging markets, discretionary consumer spending has been on the rise as well. Portfolio manager Irina Hunter explains how the BMO LGM Emerging Markets Equity Fund scours these markets in search of companies that benefit not only from the growth in spending but also from compounding earnings at a steady pace.
ďWe tend to find more quality companies among domestically oriented businesses in consumer discretionary, consumer staples and financial services. We donít target these sectors, but we tend to favor them, because they display the ability to generate cash and returns.Ē
No, we do not have a specific number of how quickly we want a company to grow or what type of compounders it should have. We make sure to find a company with a dominant business, which generates high returns and cash, and operates in an environment where it can grow. In emerging markets, thatís the environment that we want to see.
Because of their dominant position and pricing power, these companies typically have the ability to pass on inflation to the final consumer, so their margins and earnings donít get destroyed. We keep in mind that we need to grow our investments in U.S. dollars and thatís why we focus on companies with high branding power and the ability of passing on inflationary pressure better than the competition.
Q: How do you differentiate between earnings growth and compounding earnings?
Philosophically, if a business grows at 8% or 10% every year for the next five years, that is compounding. We wouldnít penalize a company if one year it achieves less than we expected as long as there is an explanation. It depends not only on the market and the industry, but also on the management and who is behind the business.
For example, since 2015 we have owned India-based Yes Bank, which has a compounding ability of about 25% or 26%. At the same time, the compounding ability of Hindustan Unilever is in single digits, but the stock is trading at high valuations. When we analyze the ability to compound, we take into consideration not only the sector, but also the ambition of the owners and the ability of the management to execute in the context of the market and the market growth potential.
Q: Do macroeconomic factors affect your strategy?
We are a bottom-up investment house, but we do pay attention to macroeconomic factors. Typically, we differentiate between important and not-so-important macro factors. A not-so-important macro factor would be a factor related to the U.S. monetary policy, for example. The more relevant macro factors take place inside the country, such as local monetary or fiscal policies, which have a direct impact on the investment.
Q: What is your buy and sell discipline?
We understand what the quality companies are and when these companies hit a bump on the road, we would analyze whether it is just a bump or a structural change. We are active investors; we usually know these companies, so we can make a decision rather quickly. When the price is too high, we may patiently wait for it to drop.
When it does, we can buy into the companies or use the opportunity to add to our existing positions. Itís not that we are contrarian, but due to our active travel and the ability to identify quality companies ahead of time, we know them well and we take action when opportunities present themselves.
Q: Could you illustrate your process with a few examples?
A good example would be Mr. Price Group, a South African retailer. It is a well-known brand for local consumers who donít have the ability to buy expensive clothes. The company focuses on increasing sales densities as opposed to growing by opening new stores. That strategy has enabled it to double its margins and returns over the past 10 years. The management team is committed and focused. Thatís what attracted us to Mr. Price and we were lucky to become shareholders when there was a bump on the road. We bought the stock when it was down 40% in U.S. dollars at the end of 2016 and we were rewarded as shareholders.
They hit a bump when they didnít have the necessary inventory in terms of fashion and when the weather was not on their side. For the first time in their long history, returns dropped and the market began questioning the strength of the business model. After talking to the management and analyzing, we realized that it was a short-term problem and that the company can quickly regroup and continue to generate high returns and to give cash back to the shareholders.
It took the management some time to regroup, refocus, and fix up a brand that was underperforming. It also got the supply chain in better shape, which resulted in even better cash flow generation. Thatís what we like about the management and what ensures us that this company will continue to be a high cash-flow generator. The earnings exhibit double-digit growth, despite the unexciting macro and challenging polity of South Africa. Mr. Price Group doesnít have any leverage on its balance sheet.
Q: How do you go about building the portfolio?
We typically have a concentrated portfolio of 35 to 40 names. The exposure to undervalued high-quality companies could be anywhere from 3% to 7%. Fairly valued companies start at a modest position of 1% to 3%. We would not buy companies that are overvalued, but such companies would be on our watch list until there is an opportunity to include them in the portfolio.
Our benchmark is the MSCI Emerging Markets Index, but we donít consider its constitution. Unlike the benchmark, we have a significant exposure to consumer names and financials, while we donít own anything in materials or energy. We have very little in IT, because the IT companies in emerging markets are the ones that make components for Samsung and Apple. They are not the brand bearers, but OEM providers, so their margins and returns are squeezed and the cash flow is patchy.
On the country level, there is also a big deviation from the benchmark. For example, we donít own anything in Korea, but we have a high allocation to India of about 20%. By benchmark standards, we are underweight in China. Overall, the portfolio is intuitive and bottom-up driven. The cheaper the high-quality company is, the higher weight it could get into the portfolio.
Q: How do you define and manage risk?
We have a different view on risk. Our first consideration is to know our companies. We control risk by knowing our holdings and meeting with their managers several times a year. Second, despite being a bottom-up fund, we also consider how much capital could be allocated to an individual market.
For example, we would need to think whether allocating 20% to Turkey in the context of emerging markets is a warranted decision because of the other choices we have. Then we need to consider what that allocation would mean to the U.S. dollar return that we generate in the particular market. We discuss risk at the portfolio managers meeting from the perspective of how much capital is allocated to the market.
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