Glen Finegan, Head of Global Emerging Market Equities, provides a detailed update on the Janus Henderson Global Emerging Market Equities Strategy, covering performance, investment activity, portfolio positioning and his outlook for the asset class.
Q4 2017 market performance and investment activity
Emerging market equities rose in sterling terms during the quarter with South Africa and India among the strongest while Mexico, Pakistan and United Arab Emirates were the weakest.*
*Source: Thomson Reuters Datastream as at 31 December 2017
Selectivity is crucial
The team visited China in early December travelling from Beijing, through Hangzhou, Shenzhen and finally Hong Kong, meeting companies the strategy either owns or we think might be of acceptable quality to own one day. What was striking is how mature many products, services and companies now are, something that stands in contrast with the high stock market valuations that appear to imply continued rapid growth.
We have long believed in carefully considering how we, as minority shareholders, are aligned with the interests of the owners of the companies in which we invest.
China’s economy is also distinguished by the fact that in many instances State control is manifested not just through policies, laws or favourable incentives but through direct control of companies. Even when the State does not directly control a company, the government can easily compel it to do its bidding. This unusually makes companies that are large and cash rich more, not less, of a risk than we would see in other countries.
This is not to say that our interests and those of the government are never aligned. China’s well publicised effort to improve its dairy supply chain after an incident of melamine poisoning in 2008 has enabled State-owned China Mengniu Dairy to build a strong consumer products franchise in partnership with multinationals Danone and Arla.
During last month’s research trip we met with two companies controlled by the China Resources (CR) group. CR was established in Hong Kong in 1938 to raise funds and purchase supplies for the People’s Liberation Army. Its function over time grew into a trading company for the People’s Republic and as the country has opened up for business this commercial spirit has been harnessed to run State-owned enterprises in everything from beer to cement.
We had meetings with CR Phoenix, a hospital operator, and CR Pharma, a drug developer and distributor. The cost of an ageing population is a challenge for the government and CR has been enlisted to help drive down cost and improve transparency in healthcare. This work is only just beginning as most hospitals are still directly controlled by the state, giving CR Phoenix an estimated 0.2% of the total market. CR Pharma is one of three companies consolidating drug distribution in the country with a combined market share of around one third versus more than 90% in the US, according to company estimates. As investors, the key question for us is what level of return the government will permit CR to earn from these services?
We initiated a new position in Femsa, a Mexican multinational retail and beverage company. The business has evolved over the last decade from being a Mexican-focused brewer and Coca-Cola bottling franchise to now being dominated by OXXO, a convenience store chain. OXXO is one of the best run and fastest growing retail franchises across the emerging markets. The overall business, however, has been impacted by downward pressure on returns generated by Coca-Cola Femsa, which in turn has been affected by a number of recent bottling operation acquisitions that require restructuring. This has brought the stock back down to an attractive valuation for investors with a genuinely long-term time horizon. We believe that returns at the bottling business will improve and the retail business should continue to see robust growth.
We also initiated a new position in City Lodge, a South African hotel owner and operator that predominantly serves the business market. The company operates more than 50 hotels, with seven located in other countries. We recently met with City Lodge during a research trip to South Africa and are attracted by the quality of the franchise, its low-cost business model and a strongly aligned and very experienced management team. The operating performance of the business and valuation of the stock are both at subdued levels and we believe offer an attractive long-term opportunity.
The strategy’s position in Dr Reddy’s Laboratories, an Indian multinational pharmaceutical company, was sold to fund higher conviction opportunities within the portfolio. We have become disappointed in the management team’s inability to meet US Food & Drug Agency (FDA) manufacturing standards, and believe that the current valuation assumes a positive change in profitability that is unwarranted.
There is no significant change to our outlook or strategy over this period. We take a long-term approach to allocating capital and this can be illustrated by the portfolio turnover, which is running at an annualised level of approximately 12% per annum*. This is slightly lower than the level of turnover that one should expect from the strategy over time and speaks to our selectivity in putting new capital to work at a time of favourable investor sentiment towards many parts of the emerging markets. The asset class has produced strong absolute gains over the past 24 months and risk tolerance among market participants appears to be increasing. We find ourselves becoming incrementally more cautious and the cash level within the portfolio has risen during 2017.
At a country level, we continue to monitor developments in South Africa and Brazil closely and potentially positive moves impacting risk of owning companies operating in the regions. During 2016 emerging middle class voters in South Africa delivered a message to the ruling African National Congress (ANC) party, demanding less corruption and more focus on improving living standards. The recent election of Cyril Ramaphosa as the leader of the ANC demonstrates that a majority of its delegates see the peril that numerous corruption scandals bring to their shores. It still remains to be seen whether the day-to-day reality for business and investment can be improved significantly, but this is a step in the right direction. In Brazil, ongoing political scandals appear to have delayed the implementation of some market-friendly reforms. More positively though, 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.
There is a risk that we sound like a broken record but the past 12 months have seen continued enthusiasm for risky assets. Demand for the emerging markets asset class has also continued to increase. A number of lower quality and more cyclical equities appear to be pricing in a continuation of strong economic conditions and favourable monetary conditions for a significant period of time. Financial markets are at risk of being overly optimistic and in the face of this complacency we continue to believe that it is important to stick to our belief not to 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 to gain exposure to the structural trend of rising living standards in some parts of the developing world.
Note: The above stock examples are intended for illustrative purposes only and are not indicative of the historical or future performance of the strategy or the chances of success of any particular strategy. Janus Henderson Investors, one of its affiliated advisors, or its employees, may have a position in the securities mentioned in the report. References made to individual securities should not constitute or form part of any offer or solicitation to issue, sell, subscribe or purchase the security. Anything non-factual in nature is an opinion of the author, and opinions are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. It is not intended to indicate or imply that any illustration/example mentioned is now or was ever held in any portfolio. No forecasts can be guaranteed and there is no guarantee that the information supplied is complete or timely, nor are there any warranties with regard to the results obtained from its use.