Five principles for investing in emerging markets

December 2022

As long-term, bottom-up investors, our starting point for finding suitable investments is to seek out companies that benefit from structural tailwinds and have clearly-defined competitive advantages. We look for sustainable business models that are attractive not only from a one to two year perspective, but throughout the business cycle. 

In the FSSA Global Emerging Markets Focus strategy we have invested in quality businesses that have proven management teams and leading franchises. We believe they are well positioned to capitalise on the long-term secular trends that make emerging markets an attractive investment choice.

Whether it is the formalisation of the Indian economy, the continued financialisation of the South African population or the growing adoption of enterprise resource planning software by small and medium-sized companies in Brazil, we believe the investment opportunities are plenty. 

Yet, these kinds of businesses are often not well represented in broader indices and therefore we believe a bottom-up active investment approach has much value to add. This is especially important when markets are volatile, as they are today.

Our investment philosophy does not require us to follow an arbitrary index, nor does it entail buying poor-quality companies at 50 cents on the dollar. Instead, we focus on these five core principles that we believe will help us deliver attractive returns for our clients over the longer term.

 

Principle 1: “Time in” the market is more important than “timing” the market

The first principle for investing in emerging markets — particularly for long-term buy-and-hold investors like us — is patience. It is rare to identify companies that have both a quality management team and a franchise that compounds free cash flows (or book value per share) at attractive rates for long periods of time. Where we have managed to find such companies, we believe the most important thing is to hold on and do nothing.

A case in point is a company we have owned since inception of the strategy. It is one of the top contributors to performance over the past five years. As Latin America’s leading e-commerce company, sales have grown nearly eight-fold over the past five years, while free cash flow (FCF) has grown five-fold. This has driven the 28% CAGR1 total shareholder return over this period. Though we kept an eye on valuations and trimmed our position when it looked particularly heady, we have since bought back at lower prices. It remains one of our largest holdings.

 

1 Compound annual growth rate

 

Principle 2: Being bottom-up investors doesn’t mean ignoring the macro completely

As bottom-up investors, we look to identify companies with great management teams and strong franchises that are able to grow sustainably over the long term. We don’t pay too much attention to short-term macro forecasts or political events. They are outside of our control and we do not think we have any great ability to predict such events. However, in some rare instances, external macroeconomic issues can completely swamp even the best-run company.  

Our investment in an Argentine bank is one such example. During 2017, our meetings with the CEO and several other members of the senior management team pointed to a strong culture and franchise — the bank had averaged 37% return on equity (ROE) for the previous 5-year period, with performance underpinned by a good deposits franchise.

With the election of a new leader, President Mauricio Macri, it seemed as if Argentina would regain its former glory and the issue of hyperinflation would finally be controlled. However, politics in the country took a dramatic U-turn and the economy, which had been improving, was destabilised yet again. Intense currency headwinds meant that we subsequently sold out of our position at a loss.

This was an expensive lesson, with the outcome being that we now systematically check and limit our portfolio exposure to so-called “high-risk” economies (simplistically defined as those with adverse macroeconomic conditions). 

 

Principle 3: Stay disciplined through market mania

When it comes to investment performance, avoiding mistakes is just as important as selecting potential winners. During late 2020 and through 2021, there was a frenzy of initial public offerings (IPOs), most of which had dubious business models and sketchy financials. Meanwhile, valuations lost all relation with fundamentals as companies that were beneficiaries of Covid-induced work-from-home strictures were bid up to stratospheric levels.

Most of the “stars” of this time were businesses that we call “Growth Traps”. They are characterised by a business model wherein a constant supply of capital is needed to fuel growth despite mounting operating losses. There is no evidence yet of such companies being able to capture the profit pool they have destroyed in their quest for scale.

In these phases, it is important to stay disciplined and not be enticed into overpaying for stocks. Our team helps us stay grounded and avoid mistakes in times like these. We have not participated in any IPOs for the GEM strategy over the past few years, most of which are now languishing below the listing price. Nor have we bought into flawed business models that promise a “path to profitability”. 

 

Principle 4: Conviction comes from thinking long term

The Covid-19 pandemic has dominated most aspects of life and business for nearly three years now, with places like China still battling the spread of the virus. Several of our holdings were also significantly challenged during the pandemic as the unprecedented lockdowns took its toll on their businesses. 

For instance, a Mexican coffee shop operator had never experienced same-store sales declines of more than 4% prior to the pandemic, but during the second quarter of 2020, sales declined by 60-70%! For some of our travel-related companies, like a Mexican airport operator, or Latin America’s leading online travel agent, the year-on-year sales decline was even greater, at 95%.

At this point, we took a step back and conducted a deep-dive review of our holdings. We had calls with management teams and re-evaluated their businesses. This gave us greater conviction in the longer-term trajectory of our holdings. The majority of them are market leaders and we realised that if they were struggling, their competitors would be even worse off. It became increasingly clear that when the lockdowns eventually ended, our holdings should have even higher market share and face less competition. 

As such, even though the early stages of the pandemic were particularly challenging, we tried to look beyond the immediate situation — and we found some very attractive bargains.

 

Principle 5: Stick to the process

In seeking companies to invest in, we apply our competitive advantage framework on prospective holdings, looking for those with good governance, strong business models, solid long-term prospects, clearly-defined competitive advantages and high cash generation. Our fundamental company analysis incorporates both qualitative and quantitative research that is designed to assess a company’s ability to compound cash flows sustainably and at high rates over the medium to long term.

As a team, we are all generalists with a focus on certain countries/regions. We travel together and conduct company meetings in small groups with people from different offices and nationalities. This means that several team members will analyse the same company over time, which provides different perspectives on the investment case.

Our process is designed to identify portfolio opportunities and reduce risk. The idea is to draw upon the experience of the whole team so that we can achieve our goal of preserving our clients’ capital and growing it sustainably. Over the more-than-30 years since the establishment of the FSSA team, the investment process has been honed continually, learning from (sometimes painful) lessons along the way.

 

Conclusion

To sum up, investing can be deeply frustrating in the short term, but highly rewarding over the years. It takes patience, a strong team culture and process, a focus on evaluating great management teams, and investing in companies with clearly-defined competitive advantages and sustainable and predictable growth.

We believe these core principles remain as relevant today as they did 30 years ago with the founding of the FSSA team, and we strive to apply them systematically on a daily basis. The result is a portfolio of high-quality companies from across emerging markets that offers attractive growth compounding opportunities. Our analysis suggests that our group of companies can grow earnings at 13-15% CAGR2 on a weighted average basis over the medium term, while aggregate valuations, at around 5% FCF yield3 and a PER4 of around 21x prospective earnings, seem reasonable (and sustainable) to us. 

 

2 Compound annual growth rate

3 Free cash flow yield

4 Price-to-earnings ratio

Investment insights

Since we last wrote, roughly three months ago, investors in emerging markets have had to reconcile themselves to a stream of disappointing headlines from several key countries. We are often asked about our own views on politics and macroeconomics, and how we incorporate them into our investment process.
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Source: Company data retrieved from company annual reports or other such investor reports. Financial metrics and valuations are from FactSet and Bloomberg. As at 30 November 2022 or otherwise noted.

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