Three lessons from 12 months of turbulence in emerging markets

A year in financial markets is usually not considered a long time. Certainly, as value investors, our approach is very focused on the long term; we are partial to long statistical data series and analyse markets through a lens of 100+ years of financial history.

But, as Lenin famously said, there are decades when nothing happens and there are weeks when decades happen. We certainly feel that the last 12 months fall into the latter camp.

We’ve rounded up three crucial lessons that we, as value investors in emerging markets, have drawn from the past year.

1. Conviction in your approach is key

As a fund manager, you must believe in what you do and why you do it. A quote that is often attributed to Alexander Hamilton, one of the founding fathers of the US, goes: “When you stand for nothing, you fall for everything”. We know what we stand for. Our process has been honed over the years and is laser-focused on finding the best opportunities in the most unloved parts of the investment universe.

We’ve had our discipline and resolve challenged on many occasions. A year ago, we struggled with finding investment ideas in Latin America. Mexico and Chile are some of the most developed constituents of the MSCI Emerging Markets (EM) Index. They have strong domestic pension funds that act as buyers of last resort and provide a floor to valuations, making those markets structurally expensive. Brazil, the other big component of the Latin American universe, had performed very strongly, providing limited hunting ground for a value investor.

Try as we might, we found only three Latin American stocks that fitted our strict value criteria; a tiny number given there are 100 stocks from the region in the MSCI EM index. That didn’t feel comfortable. But compromising on our approach and relaxing the rigorous criteria we apply to stock selection felt even more uncomfortable.

However, the EM world never stands still and the fortunes of both Chile and Brazil were about to change.

In Brazil, President Bolsonaro ordered the removal of the CEO of Petrobras, the state oil company, and replaced him with a military man with no expertise in either management or oil and gas.

The move helped to send the Brazilian stock market down by around 10% in February 2021, highlighting the importance of our earlier valuation discipline.

A sell-off does bring opportunities. As more Brazilian stocks came through our valuation screen, we reviewed the market: analysing the stocks, building financial models, following our process step by step.

Yet, even after that, we couldn’t get comfortable with the risk/reward profile of these opportunities. “Cheaper” may still not be cheap enough. However, we now have a lot of work in the bank. Should there be another downward move in Brazilian share prices, we will be able to move fast.

2. Be ready for sudden political change

Later on in the year, Chile experienced some of the most significant political upheaval it had seen in decades. The elections for the Constituent Assembly resulted in a selection of MPs which was vastly different to market expectations – and suddenly the prospect of full-scale constitutional change beckoned.

Chile is a market that some index providers classify as developed, not emerging. However, it was now facing huge uncertainty that no one was prepared for, and the local index fell by 12% over just a few days.

This opened up opportunities for us. Having struggled to find any suitable investments a year ago, there were now high quality companies – examples include a bank, a beverages group, and a utility – that fit our stringent criteria.

3. The biggest risk may not be what you think

Valuation discipline is not a panacea against making mistakes; for example, when it comes to state-owned enterprises (SOEs). How to treat SOEs is a question that is often debated in emerging markets investing.

Many investors are of the view that when a company does not control its own destiny, it becomes uninvestable. Unfortunately, we had a chance to experience what happens when this risk materialises.   

The stock in question was part of the cheapest quintile of the EM universe. The valuation looked compelling and it had a very strong balance sheet with a lot of cash – providing that protection we look for in case things get challenging for the company. However, it was also 73% owned by the Chinese state.

We were well aware that having the state as the majority shareholder was a risk. However, we felt that the most likely way in which this risk would materialise was through capital misallocation. We were therefore completely blindsided by President Trump’s executive order in November 2020 stipulating that the stock was on the black list – and thus no US investor could own it.

In short, we had interpreted the SOE risk in a very narrow way: insufficient cash distribution. We’d missed the wood for the trees – the ‘known unknown’ of large-scale political fallout between China and the US resulting in sanctions on listed companies.

Does this mean we’re swearing off SOEs for good? We think a blunt black and white approach isn’t helpful in this case – or in EM in general - and risks oversimplifying a complex reality. Deep value investors such as ourselves should be able to take on the risks emanating from SOEs provided we’re compensated for them.

Moreover, we don’t want to use a single example to reach wide-ranging conclusions that could impact our investable universe.

Returning to our earlier definition of SOE risk as ‘not being in control of your destiny as a firm’, recent months have brought a stark reminder that one does not have to be owned by the state to be subject to that.

We are, of course, talking about the ongoing regulatory crackdown on technology companies in China. Those enterprises are fully private. Until not long ago they were deemed unassailable – performing crucial roles in China’s ‘new economy’, beloved by their users as well as investors. But they’ve experienced a stark reversal in fortunes when the state made it clear that, SOE or not, it can step in at any time.

Such companies have generally been “market darlings” rather than the deep value opportunities that we seek out. But we think their plight helps to demonstrate that issues such as state influence in EM are very complex and one needs a more nuanced view than a blunt separation of the universe into SOEs and private companies.

The past year has been quite a journey but absorbing these lessons should, we hope, stand us in good stead for the coming 12 months and beyond.