During December the fund outperformed the MSCI Emerging Markets total return index by 0.2%, bringing it to a total outperformance of 5.3% for the year. This concludes the seventh consecutive year during which the North of South EM All Cap strategy has outperformed the index and makes it the ninth calendar year of outperformance out of the eleven during which the strategy has been running.
Positions in Mexico, Korea and Taiwan were the main positive contributors to relative performance. Profit taking in Brazil following the presidential elections was the main drag during the quarter.
One of the key aspects of our investment approach is that our models always assume growth rates for companies decline towards their domestic inflation rate after a three year period. In other words, long-term growth tends towards zero in real terms. While we aim to select businesses whose track record and quality should give them an advantage, we refuse to “pay up” for this distant prospect. This is an acknowledgement that our views on the remote future are highly likely to be wrong – uncertainty increases exponentially the further ahead in time we make predictions.
We have been asked whether this approach puts us at risk of missing out on innovative disruptors – the Googles and Teslas of the future. The answer is: yes it does. We are unlikely to have owned an early stage business that will, in hindsight, have created a whole new industry. On the flipside we will also not have owned any of the dozens or even hundreds of highly valued spectacular failures that ended up burning through their IPO cash and becoming nearly worthless. Brazilian Banco Inter’s market cap peaked at USD14bn and it is currently USD700. South East Asia’s Sea Ltd reached a market cap of USD200bn – it is down to USD29bn and still little prospect of generating cashflow. There are dozens of smaller companies that promised a revolutionary business but are today worth zero.
It is seductive to imagine an ability to pick future blockbusters in their early stages. We may find reassurance in seeing the spectacular track records of a handful of visionaries that had indeed been early into Tesla (or some other lossmaking but ultimately transformative business). With a nod to Nassim Nicholas Taleb’s “Fooled by Randomness”, we must remember that they might have just gotten lucky – survivorship bias is a dominant factor in growth investing. Many other such investors will have confidently picked different future “winners” but are no longer in business and we do not incorporate their negative returns.
At North of South we remain sceptical whether there is repeatable alpha in making heroic assumptions on long term value of unproven businesses. This is especially true for investors in listed companies (as opposed to venture capitalists that can dictate investment terms), where valuations tend to reflect lofty expectations from day one. High valuations can of course be driven higher still by the availability of eager cash but this tends to end abruptly as we have seen last year and many times before. In those cases there is no valuation support on the downside.
Rather than trying to identify future titans based on optimistic visions, we see our skillset as rather more mundane. We assemble baskets of companies that are undervalued relative to current and near-term cashflows. These cashflows typically support solid balance sheets and little risk of going out of business. We expect that some of these companies will prove our models to be too conservative, delivering additional upside. If they do not, we should still enjoy steady returns or, at worst, modest losses. In this light, it may not be surprising that this strategy has outperformed even the most high profile US “Innovation” ETF by a handy 35% over the past five US growth-dominated years.