Performance Review 2006
James Syme: "In 2006, the portfolio benefitted from overweight positions in Brazil and Russia. Stock selection in China also contributed positively. The overweight to Turkey detracted from performance, as did stock selection in Korea and Israel."
Performance Review 2007
James Syme: "2007 was a strong year for emerging market equities as investors sought exposure to riskier assets and diversification within their asset allocation. The portfolio benefited from overweight positions in growth markets, such as China and Brazil, and lack of exposure to Mexico and South Africa. The underweight to India detracted, as did stock selection in Korea and Indonesia."
Performance Review 2008
James Syme: "An overweight position in China and relative lack of exposure to India and Central Europe aided performance in 2008. The overweight to Russia detracted, as did the underweight to Thailand and stock selection in Malaysia. Overall, emerging market equities suffered from a risk aversion as investors embarked on a flight to quality and into assets such as fixed income."
Performance Review 2009
James Syme: "2009 was a strong year for the emerging markets, with the MSCI Emerging Market Equities Index posting +79% for the year. At the country allocation level, the portfolio benefitted from overweight positions in Russia, Indonesia, Turkey and Brazil and from underweight positions in Central Europe and Korea. The underweight position in India detracted slightly. At a sector level, more economically cyclical sectors such as Materials, Consumer Discretionary and Financials outperformed (all of which the fund was overweight), while more defensive sectors such as Utilities and Healthcare underperformed."
Performance Review 2010
James Syme: "Emerging equity markets continued to perform well driven by a number of factors. Healthy government finances and high nominal bond yields were being sought out by international bond investors. Strong economic growth in emerging markets was attracting increased attention from investors worried about growth rates in the developed world. Additionally, corporate activity saw more investment in the emerging world, including merger and acquisition activity that was supportive of the equity markets. Finally rising expectations for emerging market corporate earnings were positive for equity valuations.
During the year, the country overweight positions in Indonesia, Turkey and Peru contributed to performance. Stock selection in China and India was a particularly strong contributor. The underweight positions in Taiwan and South Africa detracted from performance, with Taiwanese positioning in the portfolio a particularly significant negative contributor."
Performance since 2006
James Syme: "Between 2006 and 2007, emerging market equities continued to generate positive returns for investors, demonstrating their attractiveness in terms of having a low correlation with the developed markets, and offering diversification within a basket of equities. During 2008, outflows in the asset class increased as investors grew anxious over the global financial crisis and retrenched into safer assets. 2009 was a comeback for the asset class – investors benefitted from exposure to BRIC markets, coupled with rising commodity prices. Last year finished strongly (in December the MSCI EM Equities Index returned +7%), adding to an overall positive performance from EMEA though Latin America underperformed slightly.
As growth at reasonable price (GARP) managers, our bias to companies where we see potential for positive earnings surprise has been beneficial for performance relative to the index. A feature of our process is that we combine a top-down with bottom-up approach and expect to add value from each over the long term. This approach led us towards consumer-driven companies in Emerging Asia and EMEA; this added value relative to the index during the period under review."
Investment Process and Strategy – How does the Fund Manager Invest?
James Syme: "Our overall investment strategy is to identify the countries where we see the most conducive conditions for positive newsflow and upgrades of corporate earnings expectations, and then to seek attractively valued companies with strong business operations that we believe will most benefit from this supportive top-down environment.
Our portfolio remains focused on growth at reasonable price (GARP) opportunities. We remain positive on China, despite the challenges of the previous quarter, as we see strong growth in both industrial output and domestic consumption and we are exposed to both strongly-performing smaller/mid-size companies and more policy-dependent (but cheaper) larger companies.
Our emerging markets investment universe comprises an index of approximately 750 stocks combined with approximately 250 off-index stocks.
A liquidity screen is used to narrow this broad universe down to approximately 600 stocks. Fundamental research is then conducted on these 600 stocks.
Investment ideas are sourced mainly internally from our large pool of emerging market analysts, fund managers, and asset allocation team. We target well managed countries, industries and companies with unrecognised growth potential.
Country selection is a significant source of added value. Over time, we would expect to achieve 50% of alpha from this source. We use a common investment framework to structure our research into both countries and companies. The framework consists of five drivers that we believe are crucial to any analysis of a market or stock: Growth, Liquidity, Currency, Management and Valuation (GLCMV). Each emerging market country is scored, which gives a clear indication of the market’s potential to outperform on a 12-month view.
Stock selection
To enable us to identify companies with under-appreciated earnings upside, stocks are screened against the five criteria (GLCMV) mentioned above. The resulting stock recommendation is summarised as a ‘1’ to ‘5’ score that reflects the level of conviction about whether a stock will outperform. A ‘1’ score means that the analyst has a strong conviction that the stock will outperform its local market index on a 12-month view, whereas a ‘5’ score means that they have strong conviction the stock will underperform.
This research is deepened by regular contact with target companies. Company contact and visits let us gauge progress and ensure that our stock ratings reflect the latest information available. Typically, the manager can draw on a list of approximately 400 stocks rated ‘1’ or ‘2’, which falls to 200 stocks scored ‘1’ or ‘2’ in countries also scored ‘1’ or ‘2’.
Portfolio Construction
The managers work with the analysts and identify the stocks which they believe are best placed to deliver strong and accelerating earnings growth over 1-3 years. Positive active positions will consist of stocks scored ‘1’ and ‘2’ in countries also scored ‘1’ and ‘2’. Index relative constraints may require investments in countries and stocks with less appealing scores. Our portfolios typically hold between 50-70 stocks.
Quantitative risk analysis is part of the portfolio construction process. Exact security weights are determined through the use of pre-trade screening. This provides an allocation of portfolio risk between holdings as well as the aggregate tracking error and beta of the portfolio. An additional report details the overall expected sensitivity of the portfolio to changes in various macroeconomic characteristics.
Each portfolio is monitored by the Global Emerging Markets team daily. Formal weekly and monthly meetings are also held to ensure that portfolios reflect the agreed strategies.
All our stock research notes include a price target. Once a stock reaches its price target, we will review the investment case to ensure that it is still valid.
Our sell discipline is strictly adhered to; if the analyst has downgraded a stock to a 4 or 5 score we will eliminate it from our portfolios.
A global perspective on emerging markets
The Global Emerging Market team also draws on the expertise of nine global sector teams. Each global sector group contains at least one representative from the Global Emerging Markets team. This cross-pollination of global sector and emerging markets research helps to improve stock selection by fostering a greater understanding of global sector trends and their impact."
Investment Outlook
James Syme: "The strong economic growth and supportive valuations in emerging markets continue to attract both portfolio and direct investment from the developed world.
Emerging market demand growth continues to outstrip that in the developed world as stronger manufacturing output is in turn supportive of both investment (via capex) and consumption (via employment). The fundamental strength of emerging economies is generally supportive of emerging market currencies, which in turn raise emerging market purchasing power.
We continue to find that a substantial base of equity investors in the developed world have emerging market allocations below their desired levels and the ongoing flow of capital is a key driver of the asset class.
We have previously highlighted corporate mergers and acquisition activity as a further driver of the emerging equity asset class, with both developed and emerging market companies looking to invest their cash holdings and strong cash-flows in attractively valued growth assets. The portfolio has benefitted from this in recent months for example from the Pepsi bid for Wimm-Bill-Dann of Russia, and we forecast future M&A activity as a factor behind asset class growth.
2010 saw a recovery in emerging market growth on strong emerging market demand and global inventory restocking. Heading into 2011, there are a number of drivers that should support further growth: an increase in manufacturing after a softer second half of 2010 has caused some inventory draw-down, loan growth is strong and picking up across most emerging markets, higher commodity prices, low real interest-rates and rising employment and capacity utilisation. At the same time, the vulnerability of emerging markets to external shocks remains benign and policy-makers generally have significant capacity to support growth.
Anecdotally, many emerging companies are guiding towards strong capex in 2011, additionally, many cyclical leading indicators of capex such as corporate cash positions and operating cashflows and also business confidence look strong. We think that, given the rising return on equity of emerging companies, capex should accelerate in 2011, with positive implications for both South Korea as a country and for industrials and technology as sectors.
In terms of Taiwan, we remain underweight despite the high proportion of industrials and technology in the equity index. Taiwan is unusual in the emerging world with structurally low inflation, a declining real exchange rate, and emerging Asia´s lowest bond yields. The country has a mature economy, an aging population and is a net exporter of capital. Its industrial base suffers from competition with China, where many Taiwanese companies and skilled Taiwanese workers have relocated, and the inherent price convergence has given the country an economic profile more akin to Japan than to a typical emerging market.
China is a large equity market in its own right and remains a key driver of the wider global economy. China is currently in a period of strong growth (2010 real GDP growth estimated at around 10%), moderately high inflaiton (CPI inflation for the year to November 2010 of 5.1%) and tightening policy (particularly the interest rate and reserve requirement increases that the banking system has been subject to). However, we do not see broad price pressures in the economy and also expect the continued appreciation of the Yuan to put downward pressure on prices of imported goods. Consensus expectations are for real GDP growth to slow to about 9% in 2011, and we expect a stabilisation of monetary policy during the first half of the year, allowing a re-rating of Chinese equities from their current modest level of a 2011 P/E of 12.1x.
Valuations continue to look attractive for the asset class. The twelve month forward consensus price earnings ratio for the MSCI Emerging Markets Index is only 11.7x which is undemanding in the context of the historical valuations of the asset class, and also given the low levels of bond yields in emerging markets.
It remains our view that full normalisation of developed market monetary policy, probably marked by successive rate increases in the US and other core developed economies like the UK, will mark the end of the trend of strong emerging market equity outperformance. However this is not our core view and we expect good absolute and relative performance from the emerging market equity asset class in 2011."
Source: Factset, IBES, MSCI. MSCI EM valuation is as at 15/12/10.
