Emerging Markets – 2019 Review
From the North of South Capital team
Global Emerging Market equities finished the year on a strong note in December, with the fund returning 20.7% for 2019 – ahead of the MSCI Emerging Markets index by 2.3%. This marks the fourth consecutive year of outperformance and the sixth out of eight calendar years that North of South has been managing this long only strategy with a focus on Value.
Meanwhile, the MSCI Emerging Market Value Index underperformed its Growth equivalent by almost 13% in 2019. As we have mentioned numerous times, these style indices obscure the essence of value and growth. Buying stocks in EM purely on valuation screens can be quite dangerous, given the frequent lack of good corporate governance - particularly amongst companies whose profitability is managed by politicians. Just as dangerous in our opinion is extrapolating current high growth rates too far into the future and making what are essentially guesses to justify very optimistic price targets. For this reason we avoided owning both Alibaba and Tencent last year. This hurt the fund on a relative basis, particularly given Alibaba’s 55% increase over the year. Despite this, we were able to find enough undervalued stocks, taking into account both cost of capital and growth prospects to more than make up for our zero weighting in these two widely owned stocks which account for more than 10% of the index.
As the cost of capital is a key input into our valuation models, we have been focussing on markets with low (Taiwan) or declining (Brazil, Russia) interest rates. They have all positively contributed to our performance, although for different reasons. We have long owned technology stocks in Taiwan because they had strong cash-flows, balance sheets and generous dividend pay-outs. They were also trading at very low multiples, both in the context of Taiwanese domestic interest rates and compared to global technology peers. In 2019, led by TSMC, the market saw some multiple expansion as global investors began to realise this. However we continue to see upside to fair values and support from generous dividends for our stocks there.
In Russia, on the other hand, the cost of capital has historically been high due to a volatile macro environment and poor governance. Stocks were cheap on any measure, but they had to price in these risks. Both of these negative issues have seen significant improvements in recent years which has been a driver for a strong performance in many of our stocks.
Brazil has not always been an attractive market, at times combining relatively high valuations and high cost of capital. However last year saw an unprecedented decline in interest rates, driven by significant economic reforms – this has been the primary driver behind the market’s performance and why we had been so active there in recent years.
South Korea and Mexico are two other markets where we have been overweight last year – both ultimately underperforming the broader index due to negative investor perception. As we feel this is not fully justified, we have been using this as an opportunity to add positions and expect valuation discrepancies to eventually narrow. Gradual improvements in corporate governance in Korea and continued moderate policy in Mexico should help.
It is worth remembering however, that it is ultimately the individual stock holdings that drive our returns. China Meidong (an auto retailer) and Cosan Ltd (a Brazilian conglomerate) which were up 257% and 154% respectively this year were core to performance – both starting the year at deep discounts to what we considered fair value. These were both sub US$2bn market cap stocks at the start of the year, highlighting the scope for mispricing among smaller stocks that we look to exploit.
We have started 2020 with much geopolitical noise although we find that initial responses by the market tend to offer opportunities for active investors like us. We remain guided by our valuation approach and focus on cost of capital in what broadly remains a benign albeit unexciting macro environment. With this in mind, we look forward to the opportunities and challenges the year will bring to us and our markets.
IMPORTANT INFORMATION | Issued and approved by Pacific Capital Partners Limited, a limited company registered in England and Wales, authorised and regulated by the Financial Conduct Authority. The information contained herein is not approved for use by the public and is only intended for recipients who would be generally classified as investment professionals. Information or opinions contained in this article do not constitute an offer to sell or a solicitation, or offer to buy, any securities or financial instruments or investment advice or any advice or recommendation in respect of such securities or other financial instruments. Where past performance is shown it refers to the past and should not be seen as an indication of future performance.