Podcast - Finding investment opportunities in emerging markets

08 April 2024

The content and podcast below is an extract from the Netwealth Portfolio Construction Series, published on 4 April 2024. Northcape Capital is the underlying investment manager for the Warakirri Global Emerging Markets Fund.

For some, emerging markets remain one of the most mispriced asset classes globally, providing ample opportunities for outperformance, but it is important to properly evaluate the risks before investing.

In this episode of the Portfolio Construction podcast, Paul O’Connor, Head of Investment at Netwealth interviews Ross Cameron, Portfolio Manager, Emerging Markets at Northcape Capital, they discuss emerging markets and which ones have his attention this year and why, and those he’s avoiding in 2024.

Read transcript >

Paul O’Connor:

Good morning and welcome again to another Netwealth Portfolio Construction podcast. My name’s Paul O’Connor and I’m the head of strategy and development for the investment options offered by Netwealth.

Joining us for today’s podcast is Ross Cameron from Northcape Capital, who’s a portfolio manager analyst covering emerging market equities.

Northcape Capital are a boutique fund manager managing in excess of 12 billion in funds under management across Australian, global, and emerging market strategies and are fully owned by staff with offices in Melbourne and Sydney.

Warakirri Asset Management is the exclusive retail distributor of Northcape’s emerging markets capability by the Warakirri Global Emerging Markets Fund.

Good morning, Ross, and thanks for joining us on today’s podcast.

Ross Cameron:

Thank you. Pleasure to be here.

Paul O’Connor:

Today’s podcast topic will obviously cover emerging market equities, so it’ll be an interesting discussion and I’ll be keen to hear Ross’s insights and views on a sector that’s extremely diverse and what his outlook for returns are.

Ross has over 14 years investment experience and joined Northcape in 2009 and since then, has worked in Melbourne, Tokyo, and Sydney. Before joining Northcape, Ross spent three years working with Capital Partners now CP2. During his time as an analyst for Capital Partners’ concentrated international equities fund, Ross covered a broad range of sectors including financials, industrials, and infrastructure.

Prior to joining the investment industry, Ross taught decision analysis in the School of Operations Management and Econometrics at the University of Sydney. Ross holds a bachelor of commerce majoring in finance and Japanese studies from the University of Sydney and worked for six years in Tokyo in addition to roles in London and Australia.

Ross also speaks in fluent Japanese, but I suspect we won’t need to test your Japanese fluency this morning, Ross.

Warakirri, Northcape’s distribution partner in the wealth management, were established in 1993 and are 100% owned by directors and employees and provide specialist investment vehicles to charities, super funds, and individual investors across Australian, global, emerging market equities, cash, Australian agricultural, currency management, and U.S. real estate.

The Netwealth super and IDPs investment menus includes two funds managed by Northcape being the Warakirri Global Emerging Markets fund that Ross works on and the Warakirri Ethical Australian Equity Fund.

Warakirri also distribute the Flinders Emerging Companies Fund that’s also available on the investment menu.

Emerging market equities have long held appeal to investors as a growth allocation in a diversified portfolio, but returns have at times been volatile and disappointing, but I know returns have differed significantly across different active managers. It certainly highlights the importance of selecting a quality active manager.

The difference in returns really is due to the sector being so diverse, covering Central and Eastern Europe, Latin America, and Asia, and each region obviously has different economies and industries.

For example, Asian economies have a focus on manufacturing, agriculture, and a growing middle class. Whilst Latin America offers exposure to commodities such as soya beans, copper, iron ore, crude oil, and beef. Whilst Central and Eastern European countries offer exposure to the services of manufacturing sectors and some resources.

As I mentioned, whilst returns from emerging market equities have been volatile, emerging markets do now appear to be one of the most mispriced asset classes globally and hence could provide attractive returns over the next few years, but we’ll allow Ross to share his expert views on this topic.

Maybe to start with, Ross, can you provide a few comments on your career journey and how you came to today being a portfolio manager of the Northcape emerging markets fund?

Ross Cameron:

Yeah. So I’ve always been interested in Asia. You’ve got this fantastic history. For a long time, China was the leading civilization world and then we saw from the Meiji Restoration in Japan from the late 1800s through incredible development and we’ve seen that echoed in South Korea and Taiwan.

I think it was natural I started to do more and more work in Asian equities at Capital Partners and then Northcape was a business that I had tremendous respect for. I knew several of the founders. When they decided to launch an emerging markets fund, it was this beautiful combination of able to be part of Northcape, and I can talk a little bit more about why I think the culture is so unique here, but also while still being able to do Asia and expand that outside of Asia, as you said, to equally exciting opportunities in Latin America and elsewhere.

Paul O’Connor:

Yes. Asia I think is obviously on Australia’s doorstep. We are part of Asia, so I think I share your interest in the region and I’ve always enjoyed travelling through it and it’s been amazing the development and the growth of the different Asian economies, so certainly share that interest there, Ross.

For starters, can you tell us about Northcape’s emerging markets capability, your investment approach, and what’s driven your team’s strong performance track record?

Ross Cameron:

Yeah. So we started the fund on the 1st of July 2008. Over the 15 years since then, we’ve seen all manner of external events. We’ve seen a once in a century pandemic, we obviously saw the GFC in the early stages, the taper tantrum 2013, the election of Donald Trump 2016, Putin’s invasion for Ukraine. So the strategy’s been well and truly tested.

And what we’ve been able to achieve over those 15 years very consistent double digit, absolute returns, so very attractive absolute returns, and also we’ve significantly beat the benchmark since inception.

What is the… And I should add that’s under significant funds under management, so it’s not a case some of these funds you see where you start small and you’re investing in some small caps and then the performance dips away. Our performance… We had a very strong year last year, so performances remain pretty consistent. That’s something we focus on is the consistency of performance delivery.

The fundamental reason why we’ve been able to do it, in fact, you stole the punch line with your introduction, I think it’s the staff ownership.

I think there is a tendency… If you think about managers in emerging market equities, most of them are either listed companies or they are part of big financial services groups. And this is important. If we contrast with developed markets where you’ve got just ample liquidity, you can run a hundred billion dollars in global equities, no problem, but emerging markets, the liquidity drops pretty quickly. And if you look at the composition of the index, you don’t want to be pushed into those EM mega caps.

So if you look at the index, it’s 30% China. We argue that’s far too high that the best opportunities in emerging markets are outside of China, and also the mega caps are dominated by SOEs, state-owned enterprises. You’ve got some big oil and gas companies, mining companies. So the real sweet spot for emerging markets is in the mid-cap space.

Problem with that is if you want to have… Let’s say you want to run a high conviction fund focused on the very best ideas and emerging markets, the multi-baggers, addressing those beautiful structural trends that you talked about, demographics, infrastructure, and so on, your capacity caps out at a pretty conservative level.

Once you have that in the listed space or within a financial services group, you get this conflict where you become what we call an asset gatherer. You grow your business by growing the corpus of funds under management. Very quickly, those returns… Well, one of two things happens.

You end up owning the EM mega caps and in the long run, your returns will drop and you won’t be able to generate performance. You necessarily have to own a lot of China because it’s a big part of the index or, and we’ve seen this with some of peers, you end up owning a bunch of developed market stocks in your EM portfolio because you’ve run out as liquidity in the EM and so you’re not really giving your investments the diversification, the exposure to the asset costs they want.

We don’t have that pressure. This fund is capped at 6 billion US, very conservative level of capacity.

And we took a long time to come to that number. That’s the number where we are absolutely confident that we can continue to generate exceptional performance. And that’s probably the most conservative cap in emerging markets, but that gives us a big advantage in generating performance.

Paul O’Connor:

Yeah. I think you make a couple of very salient points there, Ross, that you do find that fund managers typically have a strong performance in their early days with low funds under management, and then it becomes a… I guess tracking error tends to reduce a little bit as business risk takes over, but having the staff align through that pure ownership model I do think further motivates and incentivizes. So I certainly would agree with your comments there.

Possibly not for now, but I would imagine trading would be a key point you would need to focus on given your comments around liquidity. Moving in and out of the stocks would require a lot of patience, I would guess.

Ross Cameron:

Exactly right. And so that again goes with having the high conviction concentrated approach, because the best opportunities in emerging markets is in multi-year opportunities. It’s not an asset class where you want to be frenetically trading in and out.

You’d mentioned about the neighbours on our border. Let’s take Indonesia as an example. Indonesia’s 270 million people. We can’t forget here based in Australia, there’s a lot of people in Asia, a very… And particularly a lot of young people. So you’ve got 270 million in Indonesia, a hundred million in the Philippines, a hundred million in Vietnam just to get started, and yet this is an asset class we still want and investors don’t have direct exposure.

In Indonesia, we own one of the leading banks there. We’ve had it for 10 years in the portfolio. Less than half of the population have a bank account mortgage credit to GDP in Indonesia, it’s 5%.

Now, if we think of that in an Australian context, that’s about where mortgage credit to GDP was in Australia in 1968. And you say Commonwealth Bank today trades are $116, thereabouts. In 1991, I think five or $6 from memory. So if you bought it 1968, you’d be buying it for 10 cents, 20 cents, and today it’s $160.

So those structural growth opportunities, whether they’re in healthcare, information technology, selective banks, consumer staples, if you find these great companies, as long as the valuation doesn’t get stretched, takes a lot… It’s 25 countries. The big asset class takes a lot of effort to find the real gems, but once you find them, you just want to put capital in front of these businesses.

And so our average holding period’s about four years. We’re not in the business of trading in and out of positions rather than finding truly great companies and owning them for the long run. And obviously, that’s beneficial from a tax perspective as well.

Paul O’Connor:

It’s interesting you mentioned the Indonesian bank. As I mentioned in my opening there that the growing middle class in Asia, not only banking, but the potential growth of credit right across consumer staples and discretionary must be great opportunity, but it does also resonate that it’s a buy and hold. You get the right business and you’re not waiting for the next earnings upgrade or what have you. It’s a three, four, five, six-year investment there.

Moving on, what’s your general outlook for emerging markets over the year ahead, Ross?

Ross Cameron:

Let me take this year and then let me take more broadly the outlook for medium perspective, as I mentioned our time horizons, that comes three, four plus years.

So for this calendar year, two things to note. First, this is a big year for elections. We already saw the election in Indonesia, India. The world’s largest democracy will go to the polls in a couple of months’ time. We have upper house election in South Korea. We have Taiwan’s election earlier in the year. Mexico has an election this year. And of course, we’ve got the U.S. election, which has an impact on emerging markets.

What we’ve seen, and you touched on this very well in your introduction, there’s 25 countries in the EM index and it is a vast diverse group of countries.

So you’ve got countries like India and the Philippines that are domestically driven where the median age is in the twenties, domestically driven, internally funded economies, not really dependent on external trade with beautiful high single digit nominal GDP growth. India, this year, the economy will grow in real terms about 6%. And that’s where the global economy that’s barely sputtering along.

But in the same index, you also have countries like China, which China has a lower fertility rate than Japan. The poster child for bad fertility. It has very, very high credit. Total credit to GDP chart is 300%.

So you’ve got a wide range of countries in the index, and that means that in any given year, this is a key difference between emerging markets and developed markets. With any given year, the dispersion between the performance of those countries is enormous. This is an asset class where if you’re in the wrong market, doesn’t matter how good a stock picker you are, your performance will suffer.

That extreme example of that is Russia. When Putin invaded Ukraine now two years ago, can you believe? You could have been the best stock picker in the world and you still lost all your capital if you were in Russia. We, by the way, were not in Russia five years ahead of that.

But in Turkey over the last 10 years, all of the equity gains you’ve made in Turkey have been confiscated by the currency.

The flip side of that, in Mexico over the last two years, you’ve had a currency tailwind in addition to the stock.

So if you pick the countries right, you get the double whammy. You get the stock price performance and you get the currency tail.

So this year will be no different. We will see a wide range of outcomes for different countries in emerging markets. I suspect that we’re going to have a year pretty soft global trade. I actually think structurally trade is a share of GDP. It declines.

Globalisation is a structural decline, and as a consequence, those economies that are domestically driven, that are insulated from global trade will fare better than the economies that are very exposed to global trade.

I think that one exception is North Asia. By that, I mean Korea and Taiwan, South Korea and Taiwan. That’s because of a very specific situation in AI. That’s the odd one out when it comes to global trade. And South Korea and Taiwan’s exports of semiconductor chips will likely be very, very strong because that’s not economically sensitive. That counts as cyclical. Other than that, I think you want to be in economies like India, Indonesia, Mexico that are less dependent on global trade. And I think again underweight China. It’s hard to see how China performs well this year.

Paul O’Connor:

Yeah. It’s interesting the way emerging markets, I guess the way I see it, their economic cycles also aren’t as correlated as the developed world’s economies are. So I think that in itself provides opportunity there. Just the different themes and the different structures of the economies right across the EM universe I think should always provide some opportunity, some risk, but some opportunity.

As mentioned in the opening, emerging market equities do appear mispriced and even outright cheap based on some fundamental valuations. So how do you see emerging market valuations relative to developed markets and what’s the opportunity today for investors?

Ross Cameron:

I think whether you look in terms of absolute valuation or relative valuation, EM equities are extraordinarily cheap. I would always be cynical about a fund manager saying that his or their asset class was good value, but the reality is we’ve been doing this for 15 years and this has not been the story.

We’ve always been confident in our ability to generate strong performance, but that’s been during a period where the asset clients has been, as you mentioned, our favour.

favour a different scenario when we look forward today that EM equities are very, very cheap. So if we look at relative valuation first, this data comes from Bank of America Merrill Lynch’s, it’s not data that I’ve put together. EM equities are in terms of valuation relative to DM equities, the cheapest we’ve seen in half a century, in 50 years. The last time EM equities were on this kind of discount compared to DM equities was in 1969.

And then if we look at absolute terms the last time… The best broad measure of absolute valuation, be it emerging market equities, is free cash flow yield. So we’re taking away the accounting distortion of PE, which is subject to all kinds of non-cash out outcomes. So just look at the free cash flow yield available to share in orders from EM equities. The current level, we only reached that once before in history. That was in late 2003 just for a short time. What happened then? The EM equity index rallied 230%.

So we’ve got a valuation where whether you look at it from a relative basis or absolute basis, it’s very extreme relative history. And we know that when we look at valuation multiples, that means reverting in the long run on this good data. In the long run, PEs are reverting and so on. So if we just see a mean reversion in the emerging market equity valuations, you would see very, very strong performance.

And certainly, that’s the case when we look at our portfolio. We’ve got companies that are trading on less than half of our intrinsic value, which is very, very unusual.

If I think of my career back before Northcape, one of the South Korean companies in the portfolio, very, very high quality company, it’s trading on a bigger discount to our intrinsic value than I’ve ever seen in my career. So it’s unusual. And so I think…

When we think about it, we’ve delivered good double-digit performance over a time period where the asset class has really been at favour. And if I look for the next five to 10 years, I suspect the pendulum will swing back. The asset class will be back in favour. So we would expect to do better than that in terms of performance going forward.

Paul O’Connor:

Which emerging markets are you favouring for the portfolio this year? Where are the overweights in terms of countries and regions?

Ross Cameron:

I like Mexico. We have a very large overweight position to Mexico.

If we think of the U.S.-China relationship as being a structural decline, there’s a number of reasons for that, but the easiest way to think about this is we’ve got very high political polarisation in the U.S. There’s almost nothing that the Republicans and the Democrats agree on, but China is the one issue where there’s bipartisan support for a tougher start. So we’ll see that in the lead up to the U.S. presidential election this year. It’ll be a competition between the two candidates to see who’s tougher on China.

But anyway, that ship has sailed. Every company we speak to is trying to rebalance its supply chain away from China, and Mexico is one of the purest beneficiaries. Excellent logistics to the U.S., wage rates that are 20% of the U.S. Some advantages relative to China, not only the logistics in terms of rail and road linkage, but also intellectual property protection, which was always a grievance for companies operating in China.

We saw Trump come in 2016. People were worried about Mexico in the end, the revisions to NAFTA were very high, and that’s why you see Tesla purchased an enormous block of land in Monterrey to build the next gigafactory there, and we see huge investment through global companies to supply the U.S. market. So that’s going to continue to underpin strong economic growth in Mexico.

And it’s just not priced in although the Mexican equity market, as I said, it’s been a very strong performer still trading on 12 and half times forward earnings. It’s about one standard deviation below its historic average.

So I think there you have the clearest example of solid fundamentals but not priced in. The Australian equity market would be trading like big premium even though most of the Mexican companies that we’re investing in offering high teens earnings growth potential, the trading as a market of 12 and a half times earnings.

The other two which look I think good and where we have overweight exposure is Indonesia and India for the reasons I spoke about.

Modi’s been very, very good for the economy and the share market in India. It’s very likely he’ll be reelected. BJP, his party, will regain the election for the next couple of months. Some of the reforms that we’ve seen, which really underpin stronger economic growth for India, GST normalisation, infrastructure spend, the daily mobile high speed rail corridor, these are going to underpin… We take a cyclical upswing in the Indian economy, which is already growing at 6% in real terms.

Just to finish on that, the key here is being very selective. There’s 25 countries in emerging markets, vast asset classes, two-thirds of the world’s population, 50% of global GDP, but it’s not an asset class where you want to have a scatter gun approach where you just want exposure because you buy the ETF or buy an index fund then you end up [inaudible 00:23:43].

Instead, you want a very, very selective approach, which is benchmarking out of where with constant country selection.

Indonesia, it’s a great opportunity, but it’s 1% of the benchmark, but you want maybe 10% today. It’s a highly selective approach and it’s going to yield the best results. And has yielded the best results in the past as well.

Paul O’Connor:

You’ve highlighted, Ross, the varying opportunities in the different countries and regions in emerging markets, Indonesia and India and Mexico.

Back to Northcape, how do you actually cover the EM equity regions and are there any emerging market countries you’re currently avoiding at the moment? I guess you’ve spoken about underweighting China there and I guess as a corollary to countries you’re avoiding, is that centred around geopolitical and sovereign risk?

Ross Cameron:

You’re exactly right.

The best way to think about it is you want to have research coverage of the broadest possible selection of countries. If we take a step back, we have a very tight definition of the kind of companies that we want to invest in, structural growth companies that have the ability to earn structural high returns on capitals.

By structurally, I mean not for a couple of years, but through the cycle returns significantly above their cost of capital combined with the ability to grow their asset base. If you get that combination that’s nirvana for investors, that’s where you create serious share value. And those companies are spread across emerging markets.

So the first thing is you want to have coverage across markets, but given the prevailing politics, economics, you may only want to be invested in certain countries at any point in time. How do you combine those two factors?

Well, we have something, three things, very unique where we have a Northcape sovereign risk discount rate. So for each of the countries in emerging markets, each of the 25 countries, we have a bespoke discount rate, which we think captures both the qualitative and quantitative risks associated with investing in that country.

Ten years ago, had you used the standard approach with China, you would’ve used the bond rate, which is very low because bonds are domestically owned largely at China. Put an equity risk premium on the top and you would’ve had a low discount rate for China 10 years ago. And Chinese stocks would’ve looked cheap. And so you would’ve been overweight China and over 10 years, that’s cost you significant performance because China’s significantly underperformed.

Our argument, and this has been in place really since inception, is that the bond rate doesn’t capture the risks of investing in each market.

And so we have and had a discount rate in China, much higher than bond rate to take into consideration things like the rule of law, corporate governance, accounting, reliability, the fact that basically no private companies in China, every company in China really is an SOE when you really dig down.

And so there’s capital allocation decisions are not made purely to maximise shareholder value. They’re also… You’ve got competing interests from national goals, provincial goals, strategic goals, the government. And so it’s a neat way for us to capture that risk.

And to give you a concrete example, we had very low exposure to India until 2014, but we’d had research coverage of a number of Indian companies. Under the previous government, the congress, we had a high discount rate for India because we thought that the policies of that government were not in the best interest of shareholders or the economy.

When Modi became elected and then in 2014, we’d had a very strong opinion of Modi. We’d followed him since his days running Gujarat state where that was one of the leading states in India for both foreign direct investment and GDP growth. It was also where Tata, after considering all the states of India, Tata decided to build the nanofactory for their micro carves considered to be the most business friendly state.

And so when Modi became prime minister, we had a high conviction view that he was going to be good for the economy and good for shareholders. As a consequence, we adjusted our discount rate down for India and all those Indian companies that we covered so their valuation weighed up if you think of discounting those cash flows using a lower discount rate.

And so today, we have research coverage of companies in South Africa, for example, decent companies, but there’s no South Africa companies in the portfolio because our sovereign discount factor is very high for South Africa to reflect all of the issues with the current government, the AAC.

But that could change. And so it’s why you need to have a specialist approach to emerging markets. This is not an asset class you want to have exposure to through an acqui manager because there’s no way they’re going to be on top of the ins and outs of the next Indian election or so on. You have to be able to be flexible in your country allocations.

We may get a renegade result in one of the elections this year, and we have to be in a position where we understand the candidate so we can pivot before that’s reflected in equity valuation, to make sure we have the best possible risk return dynamic for the portfolio.

Paul O’Connor:

Well, it certainly makes sense there, Ross.

I guess my take of that is that the higher the sovereign risk, the higher the return hurdle you are going to demand out of a corporate before you’d consider putting it in a portfolio. So it certainly just makes common sense in how you’d approach risk in EM markets.

Emerging markets are perceived… We’ve touched on the whole risk factors in the market. So how do you go about protecting capital? Can you even protect capital when it comes to investing in this asset class? And is corporate governance risk still a major risk across the sector or I’m assuming it’s going to be a country by country issue looking at governance risk.

Ross Cameron:

I would say it’s not a question of whether can protect capital, you must. It’s the first commandment to all… One of the investing commandments for emerging markets is do not lose capital. First, lose no capital.

So that’s very, very important to us philosophically, has been since inception. So we look at a metric called downside protection, which is when the stock market, the emerging market index falls 1%, a hundred basis points on average, what does our portfolio do. And since inception, our downside protection is 50 basis points, which we think is the best that we’ve seen in the industry.

So that means on average when the index falls 1%, we’re only falling half a percent. We’re protecting capital on the downside. And that is not by the way because we have a very high cash exposure, we’re fully invested because investors want us to be invested in emerging markets. That’s why they choose us. It’s because of the kind of businesses that we invest in.

And you’re exactly right. This is an asset class where if you protect capital on the downside, that’s more than half the value. So our aim is protect capital on the downside and give exposure to the upside as well.

And so even when as we expect some point EM equities will go on an extended rally as they did in that period between 2003 and 2008, it’s on a straight line. It’ll still be drawn out. So that’s why it’s absolutely critical to protect capital.

First thing is we very rarely invest with companies that are indebted. So most of the companies, let’s leave the banks assigned different with banks, but if you look at non-banks in the portfolio, virtually, all the net cash, very important because in those markets when you have an external shock, credit markets close because it’s very, very difficult to refinance debt. You end up making assets sales, selling your best assets to the bottom market. We want to be on the other side of that track. So we’ve seen it time and time again.

EM companies with lazy balance sheets, net cash positions where there are external shocks, there are the acquirers of high quality assets at discount valuations creating significant channel that value in the process.

Sovereign risk which we spoke about, that’s a key element of downside protection. If you’re in the right markets or right countries, you’ve done your homework on the politics and the sovereign risk, you will protect capital.

Russia is the example of that as I’ve mentioned. Our discount rate on Russia was so high that we had nothing in the portfolio for five years before preservation of Ukraine.

That’s very important because Russian equities looked cheap and in fact JPMorgan did a fund manager survey right on the eve of preservation of Ukraine. Russia was the number one overweight market for EM managers certainly because Russian equities effectively were on a low p and a lot of investors were bullish on oil and gas.

But you’ve got to take… If you want to protect capital, you’ve going to be in the right sovereign. Russia was just a bridge too far.

If you get that right, if you invest in those companies that have defensive business models or competitive advantage with clean balance sheets and in the right markets, you will take capital.

Paul O’Connor:

And corporate governance?

Ross Cameron:

Varies a lot by country.

So it’s very difficult to make broad statements about it across the whole of emerging markets. There are some emerging markets where the quality of the corporate governance is on par with the best that you would see in Europe, but then you also have this long tail of very poor corporate governance, particularly China.

A shares, so these are the shares that are traded in Shanghai, weak corporate governance.

Even within a market like India, there’s a very wide range between the very best companies in India, which are fantastic, good corporate citizens, and then you’ve got this tail of weak corporate governance.

The key is research.

And it comes back to your original question. We are very much driven by fundamental research. Everybody in the team comes with strong research background.

I should add that it’s the same team. That’s another differentiating fact. Lots of these managers you see have good track record but it’s a totally different team today than it was 10 years ago. We are the Hotel California of emerging markets. And so we’ve built up over that time among the whole team more than a hundred years best experience.

Because our portfolios count at 40 companies across this big universe, we’re looking for the very best because that means we can devote a lot of time to understanding these businesses.

The very first thing we do when we look at a company is do an internal ESG report. Governance is a big part of that and that’s about capital protection as well. If the governance doesn’t smell right, we don’t proceed. We just don’t need to. We could set the bar high enough. It never needs to be margined.

A really good case study that is Chinese internet partners. We never owned them. Never very fashionable five years ago. There’s a lot of pressure because a lot of our peers were very long Alibaba, Tencent, so on, but we could never, ever bring ourselves to put our capital, our investors’ capital in that VIA structure, variable interest agency structure. There’s still very poor understanding of the industry.

Chinese law prohibits foreigners from investing in the internet sector. That’s why there’s no Facebook, Amazon, eBay in China.

So we did buy shares in Alibaba or Tencent, whether it’s listed in the US or Hong Kong. In fact, you’re buying shares in a Cayman Islands incorporated VIA, which has a completely opaque relationship with the real Alibaba, the real Tencent in China.

And this is a structure that’s never been formally recognised by Beijing. And so that’s just not a structure that…

Talking corporate governance, doesn’t matter how attractive the growth that appeared in Chinese internet capital in front of. And over time, that’s proven to be the right policy.

Paul O’Connor:

No. Interesting there, Ross.

I guess as you’re talking, I’m thinking about it’s not only a country and rule of law and having appropriate structures and governance in place as a country, but also company by company, you need to look at to actually understand your corporate governance risk.

But I’d also add that it’s not unique to emerging markets, that certainly developed markets at times has its issues with corporate governance. So I think it’s just a common sense part of the analysis of any active management.

The next question I was going to talk about being that we’ve seen the growth of I guess EM exposure being gained through passive funds and ETFs. Now I was going to ask, what do you believe that an actively managed dedicated exposure? Well, why do you think that’s necessary when it comes to investing in emerging markets? But I think we’ve almost covered that in our discussion so far.

But is there anything further you’d like to add about why you believe the importance of active management, which I think you have highlighted in terms of understanding the governance, understanding the governments, understanding just each individual corporate, but anything further or comment you’d like to make about the importance of active management in this sector?

Ross Cameron:

EM has a really lousy benchmark. China, 30%, that’s too high. Everybody knows it. Wall Street Journal did an expose a couple of years ago. The reason China’s weight in the index is so high is because Beijing pushed MSCI, basically told MSCI didn’t include more China shares.

And you see not just in China but elsewhere, their benchmark weighting is arbitrary. There’s a very high share in SOEs, government-run companies in the benchmark.

If you’re going to use an active manager in any asset cost, this is the work to do. We see that. We have about a billion dollars of our client base is in North America. We have clients also in Europe as well. But we see with the North American clients, some of those clients, their philosophy is passive. So they go passive in every single asset class except emerging markets. Emerging markets is the one asset class where they have acumen.

So I think that’s the way to think about. This is absolute. It doesn’t matter whether you have a philosophical preference for passive. This is one place where you don’t want to go passive.

And that’s one of the reasons you mentioned returns for the index in the long run. Pretty underwhelmed given the growth of the underlying economies and so on is because the benchmark is lousy and the benchmark is not really giving you exposure to the best investment opportunities in emerging markets.

Paul O’Connor:

Funny you do mention the benchmark there because only yesterday I was sitting down with the investment team at Netwealth and we run governance over the investment menu every quarter. And I was saying to the team point number one is the benchmark of each strategy that we offer to our clients understand the relevance and the quality of that benchmark before you start blindly saying, “Oh, well, this fund or strategy is underperformed or outperform the benchmark.” So interesting comments there about the EM index there.

To round out the podcast this morning, Ross, how do you think about currency exposure given the high volatility of many EM countries currencies that you own in your portfolio? And I would add that I think our own currency is probably as volatile as most of them as well.

Ross Cameron:

Yeah. Certainly, Aussie dollar trade is much like an emerging market currency.

One of the reasons people give for that is because can’t really trade the Chinese currency. It’s really a peg to the U.S. dollar. So people trade the Aussie as a proxy for the Chinese currency.

It’s very difficult to hedge in this asset class. Hedging is prohibitively expensive for most emerging currencies. But if you get your country selection right, if you get the sovereign risk right, you don’t want to hedge because you’re going to make money at the currency in addition to stock.

So as I mentioned Mexico, that’s been a really good example. We saw last year it was king dollar. Certainly, the year before we’ve had this blow off at the U.S. dollar and yet over the last couple of years the Mexican pesos actually appreciated. It’s outperformed the U.S. dollar and massively outperformed the Aussie dollar.

So there’s been a big component of returns for an Australian investors investing in Mexican equities. And that’s the key. If you’re exposed to the really good economies, you should expect to make money on the currency.

The way to avoid currency depreciations, as we’ve seen in Turkey, really is not to hedge because the cost is so low that you confiscate your equity returns. It’s really just to avoid those sovereigns.

It’s a big enough universe. You don’t need to invest in low quality sovereigns.

Paul O’Connor:

And I guess to add to that, one of the benefits of investing offshore is to get currency diversification into your portfolio so it’s not all exposed to a dollar movements there. Yeah.

Ross Cameron:

I think that’s a really important point.

As I said, we’ve done since inception in 2008, solid double digit on a performance year in, year out. And the very important thing is it’s uncorrelated with the performance of the local market or the U.S. market.

And so investors thinking about an overall portfolio perspective… First of all, EM’s really which we spoke about [inaudible 00:42:08], from a diversification perspective, given that this is half of the global economy, I think it makes sense for investors to have exposure here in terms of not putting all their eggs in one basket.

And I think the U.S. dollar looks very overvalued and I think the U.S. equity market is trading on historically high valuation.

So if your time horizon is three, five years, that’s something to ponder. I think that exposure to such overvalued currency in the U.S. dollar.

Paul O’Connor:

We better draw the podcast to an end.

But firstly, I’d like to thank you very much for joining us this morning on the Netwealth Portfolio Construction podcast to talk about EM markets, the different countries, and how Northcape actually approach this active management across this region. But certainly some fascinating comments there I’ve found around the various governments, how you think about sovereign risk and governance risk and manage that in your portfolio.

And it’s been a really interesting journey across the varying countries of emerging markets from Mexico learning that they do more than Corona and tequila through to Indonesian banks and the investment opportunity there. So we do appreciate your time this morning, Ross. Thank you.

Ross Cameron:

Thank you very much. I enjoyed the discussion.

Paul O’Connor:

And to the listener, thank you again for joining us on the Netwealth Portfolio Construction podcast series. I hope you’ve enjoyed today’s discussion with Ross from Northcape.

And just to, I guess, emphasise again this strategy is available on the Netwealth super and IDPS investment menus as the Warakirri Emerging Markets Fund.

So thank you again for joining us. Have a great week everyone, and I look forward to you joining us on the next instalment of the podcast series.

Northcape Capital

Northcape Capital
Expert Investment Partner