Latest Emerging Market Viewpoints
From Matt Linsey and the North of South Capital team
We have written a number of times in the past regarding our investment process which has a clear focus on value. Our definition of value is relative and we believe that measuring value only in an absolute sense is dangerous. A low price earnings ratio or high dividend yield in isolation provides only a partial indication of a company’s worth. Stocks are a very long duration instrument – the typical analyst forecast period of 2-3 years usually only accounts for less than 10% of the value of the business. Therefore, it is imperative to have a robust process in determining the cost of capital which is used to discount and value the future cash flows.
Because we deal with such a wide range of markets, we place a particular emphasis on using the appropriate risk free rate as a basis for our calculations. The starting point is generally the yield on the ten year bond in local currency. This is a powerful, market based indicator that acts as a proxy for the expected annual depreciation of the currency over the mid to long term. It helps us avoid the “monetary illusion” trap, where nominal growth in local currency turns out to be a function of a drop in value of the currency itself and of no value to the international investor.
While our investment process governs how we analyse stocks, there are broader underlying philosophical points that underpin it. These have been developed over the decades that our team has spent investing in Emerging Markets. Some of the key points are:
1) We and our investors are ultimately dollar based and all analysis must begin from this perspective Investments returns incorporate gains and losses from currency exposures. While over the short term, currency moves are unpredictable, over the long term there is no free lunch and currencies with high relative yields eventually depreciate. As such, we try to avoid being seduced by a monetary illusion, and prefer to focus on real growth rates that will outweigh such depreciation.
2) Ultimately, we are buying stakes in businesses and their future cash flows: Our focus is on understanding how a company is run, is it for shareholders or other stakeholders? We prefer the former. We enjoy meeting management and try to understand what makes a company unique. Most importantly we try to ascertain whether they can they generate a return on capital above their cost of capital on a consistent basis.
3) Our approach is analytical and often contrarian: We aim to invest when and where our process highlights value. This can often lead us to being early both in our buy and sell decisions. We have no problem trying to buy bottoms, or sell tops. When we see that reality (based on quantitative data and qualitative observations) is different from investor perceptions, or consensus, we will act.
4) We are naturally optimistic, change has generally been for the good: Although there are exceptions, most of the countries in the emerging markets universe have seen major increases in living standards over the past decades. We are very respectful of the power of compounding, both at the company and country level. While GDP growth alone does not correlate to market performance, it creates opportunities for individual businesses that simply do not exist in developed markets.
5) Our markets exhibit a high divergence and periods of significant volatility that require active rebalancing: While we approach our investments from a long term perspective, we try not to fall in love with individual stocks or markets. If stocks move and valuations change, we will adjust our positions and actively shift the portfolio.
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