During Q3, the strategy underperformed the MSCI Emerging Markets index by 2.4%, reversing some of the year’s earlier outperformance.
The relative lag occurred during August and September, when we found our stock selection turning into a persistent headwind. It is worth highlighting that the weaker returns were not driven by our overall AI exposure or lack thereof. The bulk of the reversal came outside the AI hardware supply chain, although stock selection within that space was also weaker.
This was particularly prominent in China, where we have been rebuilding exposure over the past twelve months in the consumer and industrial export sectors. We also saw a reversal in our relative performance in Taiwan where some of our mid-cap stocks faced significant profit taking even as TSMC held up. Exposures in smaller markets like Brazil, Mexico and South Africa also detracted and this was not fully offset by stronger performance in Korea and Poland.
With the relative weakness driven by individual stock positions, country allocation was actually a small positive and we remain comfortable with the geographic exposure. This is also true of our sector exposure although we tend to look at this differently from index classifications. This means we have been focussing on re-underwriting individual stock positions from a bottom-up perspective.
While the majority of stocks in our portfolio have seen their consensus earnings revised upwards during the quarter, around three quarters saw their P/E decline. Stocks with weaker earnings expectations have dropped by more than the revisions, while meeting or exceeding expectations has not resulted in stocks performing. It is true that the cost of capital has risen globally but there has not been a major impact on global equity markets valuations yet and emerging market bonds have held up better. The net effect is that for the majority of our holdings we now see higher upside to fair value than we did previously. It also means that on a forward P/E basis our portfolio’s discount to the market has widened in recent months.
Our approach is to view stocks that are delivering in line with the thesis, but whose shares have underperformed, as opportunities to add. At the same time, we are wary of adding to stocks that may be entering an earnings downgrade cycle which could extend long enough to undermine our valuation case. If we can see structural headwinds or other reasons to fundamentally reassess a company’s prospects, even an optically cheap valuation should not keep us invested.
The opportunity cost of tying up scarce capital, when we could be owning higher quality businesses at attractive valuations has to outweigh the endowment bias of a stock that has derated but still faces headwinds. This means we are reassessing some positions that still show upside to fair value in order to free up cash for new ideas. For example, we are re-examining our cautious stance on Brazilian equities following a sharp decline in the cost of capital. While we are sceptical on Flavio Bolsonaro’s intention and ability to cut government spending, a market belief in it may be self-fulfilling. Lower rates in themselves already improve the fiscal position. We are also reviewing opportunities in the UAE, where there is potential for significant government infrastructure spend on strategically reducing dependence on the Strait of Hormuz and some of the strongest balance sheets in the world.
In our experience, periods of churn in markets present opportunities to build up future outperformance. Sharp moves in global bond markets and a healthy dose of AI angst are certainly delivering this.
