1. Why Do We Do What We Do?

    Emerging Market Investing

    Claire Phillips and Andrew Keiller
  2. July 2017

    All investment strategies have the potential for profit and loss, your or your clients’ capital may be at risk.

    Since we started running dedicated emerging markets (EM) portfolios in 1994, the philosophy underpinning what we do hasn’t changed. We’ve always been active, always focused on growth and never allowed ourselves to get bogged down in short-term earnings estimates or price targets. This has resulted in portfolios which are considerably different from much of the market, and has afforded us the support of a number of long-standing clients. Here, we revisit the evidence backing our investment philosophy: why do we invest in EM equities in the way that we do?
  3. Summary

     

     

     

     

  4. Being Selective

    Active investment may have had a less than favourable press of late, but it will come as no surprise to those who know us that we remain confident in our active philosophy. We would strongly suggest that EM equity is an asset class where active management works best and where having a dedicated EM manager makes sense. InterSec research has shown that within the active manager universe, dedicated EM managers have added more value through active management than the EM portion of international equity portfolios has over the last ten years1.

    We warn against holding the index not just because passive investing forces investors to hold big companies which probably won’t exist in 20 years’ time, or because the EM index contains several state-controlled companies that do not have the dynamism that EM stocks are supposed to provide. In its simplest terms it’s because most ‘emerging markets’ don’t emerge. Being selective is critical, particularly now we are long past the China fuelled pan-EM boom.

    By definition, investing in EM means you are gaining exposure to the world’s fastest growth economies. But in truth, GDP growth doesn’t always lead to high stock market returns. Several studies over the years have examined this in detail2. Perhaps it is because GDP is an outdated and increasingly useless measure, but this is also the strongest argument for active investment in EM; you can’t hope that simply investing in a bunch of high growth economies will make you above average returns, in hard currency terms. Take Malaysia, for example, which has grown its GDP at an impressive 5.3% p.a. in US dollar terms over the last 20 years, and yet its stock market has contracted by 1.5% p.a.

     

    GDP Growth versus Market Return Over 20 Years

    Source: IMF, Bloomberg and relevant underlying index provider(s). Data from 1996 – 2016.

     

    Further to this, you only have to look at the evolution of the largest EM companies over time to see the importance of being active. An investment in the four largest index positions in 1994 may have been fruitful in the short term. However, today, one has been delisted, another has lost the majority of its value, and the others have gone nowhere in share price terms. Disruption of the telecommunications industry, and the inability of SOEs to adapt successfully, would have left investors disappointed in the long run.

     

    Largest EM Companies by Market Cap

     

    SOEs are still around 27% of the EM universe by index weight and today, we still see large swathes of the market under threat. It’s true that emerging markets have a higher proportion of entrepreneur controlled companies versus developed markets, but SOEs have served to drag down the absolute returns investors have achieved through investing in EM as a whole. All the more reason to be selective. For those still unconvinced that active management is vital in EM, look at the make up of the index and its incumbents today. A number of long-term threats are apparent. Will internet finance eventually displace traditional banks? Can online networks (in both social and professional walks of life) leapfrog telcos? Will electric vehicle specialists and battery producers outdo traditional car companies?

     

     

    Source: MSCI.

    1 InterSec 2016 Year-End Investment Industry Report of the US Tax-Exempt Cross-Border Marketplace

    One of the most prominent examples comes from Jeremy Siegel, 1998 Stocks for the Long Run: http://www.riosmauricio.com/wp-content/uploads/2013/05/Siegel_Stocks-For-The-Long-Run.pdf

  5. Raison d’être

    The whole raison d’être of EM investment is to capture the growth premium relative to developed markets. Is this true?, we hear our value peers exclaim; in a universe where hard currency growth is actually relatively uncommon, is value not the safer approach?

    Underpinning our commitment to growth investing is the belief that, ultimately, those companies which can sustainably grow their earnings will be rewarded by the market. To evidence this we looked at different quintiles of earnings growth, in US dollars, over five-year periods in the EM universe. We found that in the last 20 years, the best quintile of earnings growers were rewarded, on a median basis, with a near doubling in share price.

    The relationship is striking and demands our full attention. It underlines the importance of having a process with an unwavering focus on finding these companies that can grow their earnings over the long term at double digit rates. If we can find these companies, our clients will be handsomely rewarded.

    But that’s not to say that it’s going to be a smooth ride. For the long-term EM investor focused primarily on individual companies, an active approach and resultant skewed portfolio, especially in a volatile market, certainly leads to periods of pain. We all know, over short time periods (by which we mean three years or less) share prices can readily detach themselves from operating fundamentals. A great example of this was in 2016. For instance, 86% of Brazilian companies outperformed the broader EM index, as did 77% of Russian companies. It didn’t matter which company you were invested in: if you were in the market at all, the chances are you did well. These markets weren’t driven by earnings; in this instance they were driven by economic and political factors.

     

    Median Absolute 5 Year Return by 5 Year Earnings Per Share Growth Quintile

     

    Source: Baillie Gifford & Co, Factset, Worldscope and relevant underlying index provider(s).
    MSCI Emerging Market and FTSE Emerging Market Indices constituents as of the end of December of each year between 1997 and 2016 and with a market capitalisation larger than time-adjusted USD1bn. Earnings growth rates are based on previous fiscal year data, all in USD.

     

  6. Staying the course

    At the individual company level, we took a look at ‘big winners’ in EM, defining those as companies which have delivered 20% p.a. total return in US dollar terms over a ten-year horizon; i.e. more than a six-fold return. We find that these highly successful companies were subject to rocky price trajectories, suffering an average maximum drawdown of 69% during the ten-year window. Clearly this is significant and gives some indication of the tolerance required of investors in order to access these substantial returns over the long term. Short-term discomfort comes with the territory. This figure, for EM winners, is also the most significant globally, on a regional basis.

     

    Average Maximum Drawdown During 10-Year Winning Period

    Source: Baillie Gifford & Co, Factset, Worldscope, Datastream and relevant underlying index provider(s). Data from 31 December 1990 - 31 December 2016. Based on universe of global equities with market cap greater than $500m (historically adjusted) at start of period.

     

    Perhaps this begs the question, why EM? Can we access the same big returns elsewhere without having to tolerate such unease along the way? First of all, we observe that in the context of the average cumulative returns of big winners over ten-year periods, i.e. more than 1,000% on average, compared to 69%, drawdown figures appear less significant. The second important observation is that the average cumulative return of an EM big winner is, by some way, the largest on a regional basis.

     

    Asymmetry of Returns for Big Winners (10 Years)

    Source: Baillie Gifford & Co, Factset, Worldscope, Datastream and relevant underlying index provider(s). Data from 31 December 1990 - 31 December 2016. Based on universe of global equities with market cap greater than $500m (historically adjusted) at start of period.

    Upside = total return, Downside = share price return

  7. The opportunity set

    Staying on the topic of big winners for a moment longer, of course it’s not just the magnitude of returns available that’s important, but also the number of winners. Analysing big winners globally, we see that an increasing proportion can be attributed to EM. For periods beginning in the early to mid ‘90s, winners were dominated by North America, and less than 10% could be attributed to markets outside North America and Europe. Now EM contributes more than half of the best returning companies globally. The evidence is compelling, that in seeking the best investment returns globally, EM cannot be overlooked.

     

    10 Year Big Winners by Region

    Source: Baillie Gifford & Co, Factset, Worldscope and relevant underlying index provider(s). Based on universe of global equities with market cap greater than $500m (historically adjusted) at start of period.

  8. In today’s return environment, the need is as high as ever for equities to do the heavy portfolio lifting for our clients. EM equities specifically look very attractive, as long as the correct focus is maintained when investing in them. Our clients can be confident that in years to come we will still be working to the same principles that we do today. We will continue to invest in EM, we will be active, and we will be seeking to identify substantial growth opportunities with confidence that we, and our clients, will be rewarded over the long term.

    We believe that the chance of strong absolute returns from EM is significant on a long-term view, thanks to a number of strong businesses and improving macroeconomics for many countries. This is about a lot more than just high GDP growth, favourable demographics and rising middle class incomes as many might suggest. Many companies are displacing established peers and monopolising relatively new industries, whilst still growing at a rate well in excess of the broader market. EM investors are being given the opportunity to invest in companies that we believe will dominate in years to come, not just in their home markets but globally, and in the process, generate world class returns.
  9. Important Information and Risk Factors

    The views expressed in this article are those of the authors and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

    This communication was produced and approved in July 2017 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

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  10. Claire Phillips

    Client Service Manager

    Claire is a Client Service Manager and a CFA Charterholder. She joined Baillie Gifford in 2010 and spent 6 years as an analyst in the Investment Risk Team before joining the Clients Department. Claire graduated BSc in Mathematics and Statistics from the University of St Andrews in 2009 and MBA from Edinburgh Business School in 2019.

  11. Andrew Keiller

    Client Service Manager

    Andrew Keiller is a Client Service Director in the Emerging Markets Client Team and is a CFA Charterholder. He joined Baillie Gifford in 2011 as a Graduate Trainee and completed a two-year programme of secondments around the firm. Andrew graduated BSc (Hons) in Mathematics and Business Studies from The University of Edinburgh in 2011.