- “In the past, the index was a very poor guide on where to invest during the next 25 years. And, it is very likely that currently it’s also a poor guide for knowing where to invest”
- The team starts with a blank sheet of paper when building the fund and judges each company on its own merits
- Many of the companies in which the fund invests will be beneficiaries of growing on domestic consumption in emerging markets
- As the rule of law is weak in many of the countries the team invests in, the investment philosophy focuses on finding high quality companies
During the “Janus Henderson Knowledge Exchange”, the first Janus Henderson Investors event after completing its merger process, Glen Finegan, Head of the Emerging Markets Equity team, reminded attendees that a market index is not always the best option for finding investment opportunities and detailed the criteria they take into account when selecting and including a stock in the Henderson Gartmore Emerging Markets fund.
Based on the historical composition of the MSCI Emerging Markets index, he explained that in 1992 the index invested 30% in Mexico, around 20% in Malaysia and about 12% in Brazil. However, China and South Africa, two of the economies with the greatest potential at that time, lacked representation. “In the past, the index was a very poor guide on where to invest during the next 25 years. And, it is very likely, that currently it’s also a poor guide for knowing where to invest, so one wonders whether 25% should be allocated to China, as suggested by the index at present. That’s why we don’t take it into account when building the portfolio and we follow a bottom-up philosophy when selecting stocks," said Finegan.
He also pointed out that the index also fails to both where people lives today and the expectations of population growth, a determining factor in creating opportunities in emerging markets: “In ten years, the population in Africa is likely to double and this is going to bring a series of very interesting changes, especially for those companies that are dedicated to the sale of detergents, or the ones that run a chain of supermarkets, as they will benefit from a fascinating trend in the long term. While the index focuses on identifying where companies with the largest stock market capitalization are, we are more interested in locating the secular trends that will determine the earnings and profits of companies in emerging markets.”
Finegan explained that an index does not correctly reflect the investment universe because it is only a list of large capitalization companies, something that in emerging markets is frequently linked to companies with state ownership and management, that do not necessarily take into account the interests of minority shareholders. Instead, he said, there are companies domiciled in the United Kingdom and the Netherlands that are not included in the emerging markets index, but which have a strong appeal due to their position in these markets. He cited PZ Cussoms, a company based in Manchester which produces soap and baby products, as an example. “Created in Sierra Leone 135 years ago, they have built an extensive detergent business in Africa, of baby care products in Indonesia, and more than half of their income comes from the emerging markets business.”
He also mentioned Unilever, a firm with a strong brand that currently obtains 60% of its profits from emerging markets, and which has a strong presence in India and Indonesia, Cairn Energy, an Edinburgh-based oil company that recently made an enormous discovery in Senegal and which has an excellent track record in emerging markets, and Heineken, Nigeria's largest brewery and one of the largest in India and Latin America.
Henderson's emerging markets’ equity team has spent years looking for investment opportunities among companies with good corporate governance practices, those that respect the interests of minority shareholders. During this time, they have built a list of approximately 350 companies with sufficient quality to invest in them, that any of these companies is finally included in the portfolio depends mainly on a good price, which is not necessarily cheap, but reasonable.
Another concern with emerging markets is that, normally, minority shareholders are not protected by the rule of law.“News headlines in recent years in China, Russia, Indonesia, Turkey and Brazil show that the companies linked to the governments of these emerging countries usually have an agenda which differs greatly from good corporate governance, very often including corruption schemes. That is why we try to find businesses managed by individuals or family groups that seek to manage their business in a sustainable way and are less likely to generate environmental or social problems," added Finegan, for whom knowing who manages the business, and how their interests are aligned with those of the shareholders, is essential.
“We look for companies that have generated strong returns over the long term, with a strong financial track record, but we’re tremendously concerned about how these financial results have been achieved. Many companies in emerging markets have built their franchises taking excessive risks. However, we like those companies that have built their franchises over time in a slow and secure way, reinvesting their profits. The demographic trend pointing to a new emerging middle class will serve as a tailwind and competitive advantage for many companies, so it will not be necessary to take big risks. An example of this type of company is Shoprite, a leading supermarket chain based in South Africa, which has spent the last 20 years expanding into the rest of the African continent without a significant debt volume on the balance sheet, only reinvesting part of its cash flows in its expansion project. Building a powerful franchise that will continue to grow in the coming years.”
Although the fund is not labeled as the “Sustainability” type fund, it does tend to take environmental, social and governance (ESG) factors into account when determining the integrity of a company’s management team: “If the company’s control group has taken advantage of any of the other parties involved in the company, why would it be expected to treat minority shareholders differently? For example, the fact that, at present, a manufacturing company in China obtains good profit margins by not treating its waste does not mean that in the future it does not have to face the shutdown of its company, investing millions of dollars in remodeling its manufacturing plant, or having to pay a huge fine. All these possibilities result in bad news for the minority shareholder.”
In addition, Finegan stressed the importance of investing in solid franchises, since only these have a strong purchasing power. So, if inflation is high in the country in which they have presence, they are able to push through price increases.
“There is often talk of the large size of the technology sector in emerging markets, but we do not think so, because the vast majority of so-called technology companies in emerging markets are companies with a low technological component. For example, a Taiwanese company that claims to belong to the technology sector, but which actually builds keyboards for Apple. If Apple's margins fell, they would stop producing their keyboards and would most likely shutdown. That is why we are looking for companies that have demonstrated that they can generate returns above inflation, counteracting the effects of the devaluation.”
To ascertain the quality of the management teams of the companies in which they invest, they study their behavior during past crises, which in emerging markets tend to be more frequent over time, especially in the case of Latin America. “Brazil has experienced several crises in recent years, specifically in 2009 and 2015; in order to know whether the people who run the company are as conservative as they claim to be, you just have to observe how they managed to navigate through these last episodes.”
Finally, on the financial fundamentals side, they look for companies with low debt levels, investing in indebted companies only when they are backed by a strong business group. In addition, they carefully examine the cash flows generated by the company, because in many cases, the company's income statement is quite fictitious. “We prioritize the preservation of capital when investing in emerging markets. We try to find companies that manage their businesses with a contrary view, allocating capital at the right moments. An example of this would be the Chilean company Antofagasta, dedicated to copper extraction. Antofagasta usually maintains lower debt levels than its competitors, because they know that the only way to acquire good assets at a good price is to be able to buy when the rest of the competitors are forced to sell,” concluded Finegan.