MARKET COMMENTARY

Emerging Markets: A Closer Look At Unfamiliar Opportunities

Lingering perceptions and new realities do not always align. From his Singapore vantage point, Chetan Sehgal, reveals long-term growth options that may surprise you.

11.02.2020 - Fiduciary Trust Canada

If “all the world’s a stage,” then US equities have been front and centre for the last few years. However, as Chetan Sehgal in Singapore explains, there is good reason to look at emerging market companies growing just beyond the spotlight. From his vantage point, closer scrutiny shows investors’ lingering traditional perceptions and today’s realities do not always match up. Closing the gap reveals long-term growth opportunities in resilient, but not so familiar names.

Q: What is important for investors to keep in mind these days?

Chetan Sehgal: We have seen a big evolution in emerging market businesses—from the early days, when we worked to just gain access to various emerging markets and their limited opportunities, through the years when successful companies were primarily tied to the commodities boom, to today’s innovative sectors such as Information Technology and Health Care. Looking at the investment opportunity, we now see more reprivatization and greater amounts of private capital in these markets. Where the BRIC countries once dominated the story, our experience has taught us that nobody has a monopoly on entrepreneurship.

"...companies sitting on net cash balance sheets (e.g., technology firms) are now more financially and operationally resilient than in prior decades.” - Chetan Sehgal

Q: Can you elaborate?

Chetan Sehgal: Countries like China and India offer a large opportunity set. However, smaller nations such as Korea, Taiwan, Mexico and Malaysia are essential components as well. For instance, we own Naspers, a worldwide Internet group and technology investment firm based in South Africa. Some years ago, they had the courage to invest early in the Chinese company, Tencent. Today, the multinational technology conglomerate dominates China’s digital market. Naspers remains a major shareholder and their original multimillion-dollar stake is now worth over an estimated $180 billion (US$).

On a different front, glove manufacturers in Malaysia have recently seen a dramatic surge in demand, driven by COVID-19. We believe in keeping an open mind and casting a wide net for opportunities.

Q: What is the connecting thread across the companies you own?

Chetan Sehgal: We focus on buying high-quality companies—with sustainable earnings power—at a discount. Our approach is bottom-up and fundamentally driven. Accordingly, our portfolios have evolved along with the changing emerging market landscape and our assessment of which companies have that critical, sustainable earnings power. Our holdings now feature a considerable commitment to multi-technology platforms.

Q: What are some characteristics that distinguish such companies, particularly during these unprecedented pandemic times?

Chetan Sehgal: There are a few key elements here. First, as a percentage of overall market capitalization, emerging market companies now generate higher levels of free cash as compared to the West. They are generating higher cash flow for their shareholders. Second, in the West, we see private equity firms taking over companies, leveraging them and pulling cash out. This use of debt is happening to a lesser extent in emerging markets.

Third, companies sitting on net cash balance sheets (e.g., technology firms) are now more financially and operationally resilient than in prior decades. While the pandemic raises grave challenges, companies are on firmer footing than during previous financial crises such as the Asian crisis in 1996 or the Argentina and Brazil crisis in 2000.

Finally, the rise in consumer spending and healthier economies in some emerging markets have sparked domestic and regional growth opportunities for businesses.

Q: Governance has long been seen as a weakness in emerging market companies.

Chetan Sehgal: Structurally things have changed dramatically, ranging from independent boards to minority shareholders having a greater voice, to increased stock market rules and securities boards having a tighter hold. The global accounting standard now in place allows us to more consistently evaluate companies as compared to dealing with each country’s nuanced accounting system. We have seen a mindset transformation as oligarchs have given way to a new breed of entrepreneurs. Have we achieved perfection? No, there are issues, but they are happening less and less. Governance is part of a broader evolution that goes hand in hand with environmentally and socially responsible policies and initiatives.

This, in turn, links back to the importance of companies having positive cash balances that enable them to do the research and development that will help future-proof their businesses. These pieces all contribute to what we see as an overall positive trend.

Q: Where are you finding opportunities?

Chetan Sehgal: Chinese companies, including names like Tencent and Alibaba, play the largest role in our portfolios; however, we also hold companies with significant headroom for growth in other countries. Many have achieved early market leadership and have a lot of adjacent areas in which to expand. Look at South Korean company, Naver, for instance. It began as a search engine, moved into online shopping, and added LINE—a WhatsApp equivalent in Japan. They are now offering cloud services to gig companies.

The market valuation of such companies is always a combination of the existing, slightly mature businesses and the new evolving businesses. In our view, the market is not paying full value for a lot of them. As a result, we believe there are upsides to many of these companies. For instance, South Korea’s Samsung—one of our largest holdings—is also currently incredibly cheap, even by traditional metrics.

While US equity markets outperformed by a large margin over the last few years, emerging markets have room to catch up.

Q: What are your thoughts on US/China relations?

Chetan Sehgal: We are mindful of the growing trade tensions and the impact this situation can have on companies and their earning power. We are already seeing some fallout from this situation. For example, Samsung supplies memory and is in the mobile phone business. So, if a competitor like Huawei is banned, they stand to gain some market share. However, Samsung also counts on that same company as a customer and so there is some unease associated with being unable to supply Huawei. This environment brings to mind the general rule of life that says: Whatever space is vacated will be filled. So, if one company does less, then another will come in, occupy that space and move ahead.

US/China relations and supply chain disruptions are real concerns as there are no easy long-term solutions on the horizon, much less being discussed. In our view, we have to work with the market’s evolution rather than focus on the tensions. As part of our ongoing analysis, the evaluation of earnings sustainability is very important, along with stress testing some companies for various scenarios that may develop.

Q: Do you expect change to arise out of the upcoming US election?

Chetan Sehgal: A potential change in the Oval Office will likely have some impact on some sectors. However, in terms of geopolitical issues like US/China trade, it is unclear whether either presidency would be more conciliatory towards China. I believe the structural trend is that the United States believes China is competing for technology leadership and, given US sanctions, China wants to be technology independent. Neither of these things are really going to change with the election. What could shift is short-term market sentiment as the campaigns unfold.

s investors, there is one constant amid the many challenges facing us all. That is our focus on buying emerging market companies with sustainable earnings power at a discount, companies that are leading in the ongoing evolution under way.

 

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