> Specialist Outlook> Discovering gems in emerging markets
In recent years, developing economies have enjoyed robust economic growth and their share of the global economy has increased dramatically. While a strong economy is undoubtedly beneficial for companies, research shows that there is actually little correlation between a country's GDP growth and the performance of its stock market. In fact, countries with the fastest economic growth have tended to deliver the worst returns.
We see the attractive macroeconomic environment in emerging markets merely as a positive tailwind. In our view, what really matters for investors is individual companies and their ability to generate returns for shareholders. We believe that the most successful way for investors to benefit from the opportunities in emerging markets is to focus on value creation, namely the profitable use of capital by companies, rather than economic growth. Over the long term, we consider value creation to be the key determinant of share prices and, consequently, investor wealth.
Focus on return on capital
Our investment approach therefore focuses on return on capital. We look for companies across the emerging markets universe that are improving their return on capital, or have the ability to sustain high returns for a long period of time. As bottom-up investors we pay close attention to company fundamentals such as assets and business models. This helps us identify companies with assets that can generate cashflows for shareholders in the future.
We are long-term investors and seek to align our interests with the value-creating strategic decisions that company management teams are making. Over the short-term, many factors are out of their control. However, over a period of years, the decisions senior managers make are hugely important and should be reflected in the share price.
Trust is essential
In our view, many emerging market companies are not sufficiently focused on profitable growth and delivering returns for shareholders. Corporate governance standards in emerging markets are often not equal to those in developed markets. One of the main reasons for this is the widespread influence of controlling shareholders. In markets such as China, Russia and South Korea many companies are run by dominant shareholders such as the state or families. In many cases these businesses are arguably run for the benefit of the state or owners rather than private investors or minority shareholders.
Before investing in a company we want to be sure that our rights as minority shareholders will be respected. This means that trust is essential. We want company management to allocate investors' capital efficiently and run the company in the best interests of minority shareholders. As a result we attach great importance to meeting company management and visiting operations to truly understand the culture of a company and determine whether the values that management teams champion permeate the business. This helps us to gain confidence in a company's future strategy and to determine whether they are focused on creating long-term value for shareholders.
Strict valuation discipline
The final element of our investment strategy is valuation. This ensures that we focus on good investments and not just good companies. We seek to identify businesses where investors are underestimating the potential returns that they can generate. In addition, by taking a long-term investment horizon, we can exploit pricing anomalies that arise from the short-term nature of emerging market investors.
World class companies
While many investors have been attracted to emerging markets by rapid growth rates, we believe that the real story is the emergence of dynamic, well-managed, value creating companies. Traditionally, emerging market firms competed with their peers in developed economies on the basis of cost, but an increasing number are now world-class companies in their own right. For example, Mindray Medical, a Chinese medical equipment manufacturer, has transformed itself from a low-cost producer into a leading technology company.
Mindray's management realised that simply being the lowest cost producer was not a sustainable competitive advantage and so they invested heavily in R&D. The company now produces technologically innovative products such as heart-rate monitors, in vitro diagnostic products and medical imaging. Mindray is the market leader in China with a strong brand and an extensive distribution network, but also successfully competes against the likes of General Electric and Siemens, on a global basis.
South African telecommunications group MTN is another high-quality, emerging market company. As the leading wireless operator in Africa and the Middle East, MTN has a strong brand and established presence in under-penetrated markets, which give it access to huge numbers of potential customers. What is impressive about MTN is the sophistication of its software and its services – for example, customers can use their phones for mobile banking. We believe it is an extremely well-managed company with a significantly better return profile than many of its developed market peers.
Harnessing long-term trends
There is undoubtedly enormous growth potential in emerging markets and we are convinced that the best way to profit from these trends is to look beyond economic growth and focus on what matters: well-managed companies that are committed to delivering sustainable returns above the cost of capital.
Encouragingly, we believe that corporate governance practices are improving across emerging markets. Management teams are increasingly aware of the need to create value for shareholders rather than simply indulging in the blind pursuit of growth. Growth is of no benefit to shareholders unless that growth creates value – a basic principle that many emerging market companies have chosen to ignore in the past. Higher standards of corporate governance and more efficient use of investors' capital should lead to structural improvements in company returns and, in turn, create wealth for shareholders.
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