Emerging market (EM) equities fell in sterling terms over the quarter; this was largely caused by relative strength in sterling, with the underlying markets generally producing flat returns. At a country level Greece, Turkey and Hungary were among the strongest while Qatar, Russia and Brazil were the weakest. The strategy underperformed the wider EM market over the period but has produced strong absolute gains over the last 12 months.
Sustainability and engagement remains key
As evidenced by investment activity this quarter, a core determinant of our view of the quality of a business is what we regard as the sustainability of a franchise. We believe that a business is either implicitly or explicitly granted a licence to operate by all of its stakeholders – communities, employees, customers, shareholders, government and the environment. In order for a company to have a sustainable business, we believe the interests of all of these stakeholders have to be considered.
Government-controlled banks compromise returns to minority shareholders
During the period we initiated the complete sale of Bank Pekao, a leading Polish Bank, based on governance concerns. Pekao has had a history of sensible, risk-aware capital allocation, and as such was previously attractive to us as a portfolio constituent.
We believe this approach will be threatened by the increasing influence of the Polish state, whose interests are unlikely to be aligned with minority shareholders. The shift in ownership occurred when troubled Italian bank UniCredit sold its stake in Pekao to the state-controlled insurer PZU in 2016.
When the deal was announced PZU stated that it would allow Bank Pekao to operate as an independent entity. However, the recent dismissal of Pekao’s supervisory board and the replacement of chief executive (CEO) Luigi Lovaglio with Michal Krupinski, previously a member of the Polish Treasury, demonstrates to us that Pekao’s independence is threatened and the value of the franchise may be impacted.
Indeed it is with interest that we note the recent comment made to the Polish media by the CEO of PZU: “While foreign-controlled banks in Poland make only the safest lending decisions, Pekao should become [a] lender which is ready to take on higher risk”. We believe that history demonstrates that when politicians become members of the lending department, returns to long-term equity holders suffer.
The quarter also saw a number of changes following a review of our information technology services holdings. We completely sold the holdings in India-based IT providers Tech Mahindra and Infosys, and bought a new position in Tata Consulting Services.
The rationale for selling Tech Mahindra was based on concern that management incentives had grown sharply and were not in proportion to the returns delivered to shareholders; to us this suggests a lack of alignment with minorities. The company’s acquisition of Pininfarina, an Italian car design agency, has also eroded our confidence in the capital allocation discipline of this group.
In contrast Tata Consulting Services has had a much smoother transition of executive leadership. The departure of its former CEO was based on a move to help with the evolution of Tata Sons, the family holding company. The former CEO remains on the board to provide input and was able to transition power to an insider, something which in our experience suggests a more predictable outcome.
We also like the fact that this business deliberately makes fewer acquisitions than its competitors, instead being a ‘fast follower’ that provides opportunities for its most talented employees to be more entrepreneurial. This avoids the cultural integration risk that comes from buying other services companies that can destroy value for shareholders.
Valuations have come under pressure recently due to concerns that changes in US visa rules will hinder the ability of these businesses to access the American market. We believe that while such restrictions may hinder business at the margin, it has not changed the long-term value proposition of both lower cost labour and valuable services, which help clients build more technologically capable enterprises. Often the scale of these changes, and the talent required to deliver them, are not available within a company and this continues to provide a longer term opportunity for the information technology services industry.
The portfolio has a bias towards companies listed in markets that bore the brunt of commodity declines such as Brazil, Chile and South Africa. The resulting economic shock resulted in weaker currencies, more attractive valuations and the tantalising possibility of improving national governance.
During 2016 emerging middle class voters in South Africa delivered a message to the ruling ANC party, demanding less corruption and more focus on improving living standards. In Brazil, ongoing political scandals appear to have delayed the implementation of some market-friendly reforms. The fact that corrupt politicians are being held to account demonstrates an institutional credibility in the country, something lacking in so many parts of the developing world.
The portfolio also currently has a bias away from Chinese equities. This is due to the presence of a large number of state-controlled enterprises, which raises concerns over the alignment of interests with minority shareholders. In our opinion, there is a significant risk that a large number of these corporations are required to perform ‘national service’ rather than focus on profitable growth and returning profits to shareholders. This means that, for the time being, the opportunity set for absolute return-minded, long-term investors such as ourselves, within China appears limited.
Enthusiasm for the emerging markets equity opportunity continues to increase, resulting in strong flows into the asset class. While positive in the near term, this does increase our level of overall caution. In our view, it is important to not compromise on quality, to maintain a long-term approach and to apply a strict valuation discipline.
With a long-term perspective, however, we are positive about the prospects that emerging markets offer equity investors. This is due to the opportunity they present to gain exposure to the structural trend of rising living standards in some parts of the developing world.