At GAM Investments’ Weekly Investment Meeting held on 29 May 2019 the speakers were Rob Mumford, who outlined his emerging market equity investment philosophy, and Jian Shi Cortesi, who offered her latest views on the health of Asian and Chinese equity markets.
Emerging Markets Equity
Emerging markets (EM) tend to be clustered together in one huge silo by investors and asset allocators, but the universe is incredibly heterogeneous. We favour a combined top-down and bottom-up methodology that includes extensive regression with which we seek to identify opportunities to buy higher-quality, liquid equities at attractive entry points. We believe many years of experience investing in difficult market conditions have demonstrated that this approach typically generates sound investment returns over time. This combination of top-down and bottom-up analysis aims to reduce the ‘risk of being wrong’ by exploiting cheaper entry prices in a consistent, repetitive manner.
Consequently, our philosophy, while being consistent and repeatable in nature, should definitely not be considered ‘systematic’ or ‘quantitative’ but a combination of science and artistry. In terms of the former, we have developed and refined a top-down proprietary ‘ value, momentum and risk’ (VMR) model over a period of years and we also deploy a ‘timing sheet’ to seek optimal entry and exit points. The bottom-up process starts with regression screening, while the artistry (or legwork) begins with bottom-up stock analysis to highlight valuation anomalies. This incorporates company meetings, cross-capital structure analysis and ESG considerations. We view the latter as both a risk mitigator and a potential alpha enhancer. The final step of the philosophy is stock-by-stock construction and risk management with a view to generating a portfolio that comprises approximately 40 high-conviction and 100-160 smaller positions with cross-asset, macroeconomic and stock specific perspectives.
Clearly, investors in EM equities have endured a roller coaster ride in recent times with 2017 proving a stellar year, while the latter half of 2018 saw a broad-based selloff, for reasons including escalating trade tensions. In the calendar year to date, we saw a significant rebound in risk appetite, but this has given way as the Sino-US trade spat has rekindled. All cycles tend to be different and investors in this cycle have had to contend with issues around the end of quantitative easing as well as a new batch of geopolitical tensions. Our philosophy of seeking high quality companies at cheap entry points can sometimes be challenged in the short term. However our experience has shown time and again such investments will not remain excessively cheap over the medium and long term especially if it is quoted in an investment grade country. Our philosophy tends to orientate us towards the better credit profiles, with positive free cash flow (FCF) or working capital, and such positions should be able to better weather any storms at the stock level. Currently we see a number of attractive investment opportunities and grounds for a positive return outlook for returns going forward.
The secular argument that EM equities are structurally under-represented in global indices relative to their contribution to global GDP and their ex-free float market capitalisation weights remains firmly in place. Other secular drivers include an explosion of a young affluent middle class, domestic consumer-orientated reform agendas and the reclassification of MSCI benchmark indices to incorporate greater China exposure.
In cyclical terms, EM equities appear to be entering a favourable risk-return quadrant, having given back all the outperformance, relative to developed markets, achieved in the 2004-08 and 2009-10 cycles. This means valuations are both favourable and compelling, in our view. Furthermore, with the attraction of positive ‘carry trades’ increasing (eg in Brazil) supportive liquidity flows can be anticipated. Finally, consensus GDP forecasts reflect an expectation that the EM / DM growth differential should widen going forward and the premium growth of EMs should finally be rewarded in equity prices (it is already creeping into credit markets and it is important to remember that sovereign credit ratings are considerably higher than in previous cycles). As such, we believe all the conditions are ripe for a potential positive re-rating and strong performance of EM equities.
Chinese and Asian Equities
Jian Shi Cortesi
In 2018 there were three major factors behind the difficult market conditions for both China and Asian equity markets and this impacted market performance generally. Firstly, the trade tensions between US and China generated a lot of market uncertainty last year; secondly, monetary policy in China was quite tight going into 2018; and finally, increased interest rates from the Federal Reserve (Fed) in 2018 weighed on risk assets globally. Until the start of May, all three of these factors turned positive in 2019, lifting equities. The impact of Chinese authorities easing monetary conditions in the middle of last year started to materialise in recent economic data and the Fed’s decision to pause hikes also improved market sentiment. However, initial hopes that the tension between the US and China could soon be resolved were shattered in May and these renewed concerns about the impact on global trade have determined market direction since.
We have refrained from making any predictions regarding the outcome of the US / China trade tensions as this situation is continuously moving back and forth. However, the more this tension amplifies, the more pressure will increase on both the US and China to reach an agreement. In China, domestic exporters and hardware companies are being impacted, while US businesses are also likely to see a significant impact, particularly if China retaliates; many US businesses have a large exposure to the Chinese market, for example General Motors sells more cars in China than in the US. Finally, China has stated it will not use its US treasuries reserves as a weapon in this dispute, but that could change if relations between the two countries deteriorate further. It is important to also note that the government in China still has scope to implement further supportive measures to stimulate its economy if required.
If you consider the longer-term movement of Chinese and Asian equities, it is noticeable that they tend to move in tandem and both react strongly to macro events. In our view, such moves create an opportunity to buy equities at more attractive valuations. So even though fear levels relating to the trade tensions are currently high, we believe this could be an interesting buying opportunity.
Within China, it is also important to be cognisant of the different ways to access the market be it through Hong Kong listed shares, Shanghai A-shares or American Depositary Receipts (ADRs). We believe having the flexibility to access the market across all three of these listing types is advantageous, particularly given the MSCI indices are starting to increase their weighting in A-shares which will likely have a knock-on effect.
In terms of long-term trends, we saw commodities and construction orientated companies dominate over the period from 2000 to 2010, but since then economic drivers have changed to consumption and innovation, globally, and these remain our key investment focuses, notably Chinese internet stocks.
Important legal information
Source: GAM unless otherwise stated.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. The companies listed were selected from the universe of companies covered by the portfolio managers to assist the reader in better understanding the themes presented. The companies included do not represent any recommendations by the portfolio managers. Reference to a security is not a recommendation to buy or sell that security.