Martin Lefebvre
Thank you for tuning into our NBI podcast series on the markets and the economy. Today's topic is particularly timely. We're going to be talking about emerging markets. To help me navigate the subject, I'm joined by Sean McCoy of Artisan Partners. Welcome, Sean.
Let's begin with a simple question: Why invest in emerging markets (EM) at all?
Sean McCoy
Emerging markets are an exciting area. They offer a lot of growth. I think when most people think of EM, they think of growth. But taking a step back, it's an area that has a very large index with over 1,100 names in it. The opportunity for inefficiencies is very high and the opportunity for growth among these companies is quite high. EM represents a huge part of the world's population and it continues to grow. It is an area where investors can benefit from the rise of the middle class and expanding opportunities for wealth creation. Many of these countries are changing rapidly. Infrastructure is growing. Technology has been a particularly prominent theme recently. This is where some of the leaders in technology, e-commerce, and electric vehicles reside. There are many exciting developments in EM today and it trades at a very attractive multiple compared to other asset classes.
Martin Lefebvre
It seems to be cheaper than elsewhere in the world. Why can a conventional EM index have some concentration risk? We've discussed technology stocks, and some countries, including Taiwan and South Korea, appear highly concentrated in only a few names. How do you approach that and make sure you can have a more diversified portfolio?
Sean McCoy
In our portfolio, we tend to hold a relatively concentrated selection of 60 to 70 names, but we believe that, when you own a company, it is important to hold it at an overweight position relative to the benchmark. We do not believe in holding a company at a partial weight. This becomes particularly relevant when discussing an index such as EM, which has become highly concentrated. Most market-cap-weighted indices tend to favour the largest companies, but the composition of EM has changed quite drastically over the past few years. China represented 40% of the index a couple of years ago; today, it represents 20%. Taiwan and Korea have gained considerable ground through that growth. Much of the increase has come from technology companies such as Taiwan Semiconductor, Samsung Electronics, and SK Hynix. Today, those three companies represent close to one-quarter of the index. A few months ago, they represented approximately one-third. When three companies account for one-quarter of the index and the top 30 companies account for 50%, approximately 1,000 companies are left to make up the remaining 50%. These companies represent only a few basis points each and therefore have a limited effect on index performance. Following the strong performance of technology and the largest companies, some of which have risen by several hundred percent, those names have naturally attracted most of the attention. As active managers, we want to participate when we identify an opportunity. We will hold those companies at overweight positions when we have conviction and assign them a zero weight when we do not. This gives us the flexibility to overweight companies that are much smaller in the index and to invest selectively outside the index. By maintaining a relatively concentrated portfolio, we naturally differ from the benchmark while seeking opportunities in more differentiated areas of EM.
Martin Lefebvre
You talk about the index and the fact that China's weight has come down from 40% to 20% and South Korea is taking a somewhat larger position in it. But some other indices consider South Korea as a domestic economy. Is there a better index or are you just focusing on the one that's the most popular?
Sean McCoy
We find that in emerging markets, MSCI [Morgan Stanley Capital International] tends to be the leading index. That's the one we focus on. Yes, MSCI classifies Korea as an emerging market, whereas S&P and some other providers classify it as developed. We don't really think of ourselves as benchmark-focused. Our starting point is really more benchmark agnostic. Ultimately, it is important to us and our clients that we outperform a benchmark. The most popular one tends to be MSCI. We stick with that. But that doesn't define the companies we look at. We will look at companies outside of that.
Martin Lefebvre
How do you approach portfolio diversification? What should retail investors look at in terms of diversification when they buy into emerging markets? Right now, it seems that all of the growth is coming from Asia, correct?
Sean McCoy
It becomes a matter of timing. If you're investing today and want to buy an ETF and buy the index, it actually ends up being more concentrated than you might expect. As we discussed, it's very top-heavy, and you're buying companies that have performed extremely well. You have to ask yourself if this is really the right time to be putting that much of your investment in a handful of names.
Martin Lefebvre
That remains favourable as long as the momentum continues.
Sean McCoy
Exactly—as long as the momentum continues. However, who knows when that will change? I think that's where active management in general allows you to access EM in something that looks somewhat different from the benchmark. As active managers, we naturally favour this approach. But I think that allows you to find some of the companies that maybe right now are somewhat underappreciated. You can get positions in those companies somewhat earlier on and then, when the cycle changes, as it always does, you're better positioned for that. For investors considering EM, there's a great growth story there. You want to find a way to access it. Passive investing can also be effective, but generally active managers are doing a lot more research on the individual companies, trying to bring the best ones forward. That gives you an opportunity to outperform in an asset class where managers tend to outperform.
Martin Lefebvre
What should investors look at or try to evaluate when it's time for them to choose a fund or an index of emerging markets?
Sean McCoy
You're talking about an index that spans close to 20 different countries and 1,000 different companies. There are many country-specific regulations, laws, currencies, and political risks. There are many macroeconomic factors to worry about there. I think it's important to find investment managers who are familiar with those markets. We happen to be bottom-up stock pickers, so we have to think about macro because it's EM, but that's not what drives our decision. We do not make decisions country by country. We're trying to find the best companies. But I think in general, when finding any active manager in EM, you want someone who is familiar with the markets. If they're not based there, they should travel there frequently. That's what our team does. We think it's important to travel to get a sense of what's happening on the ground, then come back to the quiet of your office, do the work, and make sure the numbers align with what we observed. However, having someone with local knowledge who travels regularly is very important to understand the nuances of all these different countries.
Martin Lefebvre
We've seen spectacular growth, particularly in South Korea and Taiwan in terms of earnings expectations. What would challenge your current outlook on emerging markets and, specifically, what kind of indicators are you looking at in terms of making a good decision?
Sean McCoy
For our portfolio, we're ultimately looking at the upside of an individual company and that's really what gets a company in and out of the portfolio.
Martin Lefebvre
In terms of earnings revisions, you mean?
Sean McCoy
We begin by developing a five-year ROE [return on equity] forecast. We forecast a company’s five-year return on equity and then account for the country’s risk profile. Our analysts also establish a target price-to-earnings (P/E) ratio for the company. Comparing those two estimates with the company’s current trading price allows us to determine its upside potential, which is a major component of our process. We also use a sustainability assessment that considers a range of governance, environmental, and social risks. This assessment can adjust our upside estimate slightly upward or downward and serves primarily as a risk-mitigation tool for governance concerns or issues identified during meetings with management teams. Upside potential is the primary factor on which we focus. What could change it? A company might enter another business line or take an action that begins to erode its earnings. A change in the company’s strategic focus would affect our assessment. If a company has performed extremely well and its upside potential begins to dissipate, it may no longer warrant the P/E ratio we originally assigned. Our decisions are therefore driven primarily by changes in upside potential. From a macroeconomic perspective, the broader question is what could alter the strong demand for semiconductors. We currently hold positions in a couple of semiconductor-related companies and are closely monitoring the significant increase in chip prices. The market reflects both scarcity and strong demand. In our view, other countries—China in particular—will eventually begin producing greater volumes of chips, although this could take quarters or years. Both DRAM [dynamic random-access memory] chips and higher-precision chips may then become commoditized to some degree. When that occurs and the earnings outlook begins to change, it will significantly affect our estimates, market expectations, and our assessment of these companies’ sustainable earnings. We believe that many of these companies are currently earning above sustainable levels, although momentum remains strong. We are willing to maintain some exposure, but we have reduced these positions following the returns they have generated.
Martin Lefebvre
One last question for you, Sean, and then we'll turn to another topic. We've seen a lot of leverage on the part of local retail investors in parts of Asia. Is that something we should be worried about?
Sean McCoy
I think North American investors are somewhat insulated from that, especially when investing in emerging markets over the longer term. A lot of these countries are certainly setting guidelines to try to moderate some of the investments among local investors and global investors coming into the countries. In Korea, there has certainly been considerable momentum in local investment. There are times when that has pushed prices above levels justified by fundamentals. But over the longer term, if you're buying companies based on fundamentals you believe in and those companies are able to deliver, it shouldn't matter. If you're trying to keep pace with local retail markets, timing can be very difficult. But if you have a longer-term mindset for EM, I do not believe it should be a concern.
Martin Lefebvre
Sean, thank you very much for your time, and thank you to everyone listening right now. We'll talk again next month.
Martin Lefebvre
