Mon, 17 Jun 2013
Emerging-markets consumer stocks are one of the few areas of long-term growth as the people are buying, eating, and drinking better, says Virtus Foreign Opportunities manager Rajiv Jain.
Bridget Hughes: Hi. I'm Bridget Hughes. I'm part of the analyst group here at Morningstar. I'm here at the Morningstar Investment Conference with Rajiv Jain of Vontobel Asset Management. He just joined us for our international panel, so thank you for being here and participating in that panel.
Rajiv Jain: Thanks for having me here.
Hughes: When we look at your portfolio, which is a compact portfolio of fewer than 50 stocks in the foreign specific portfolio, there is a heavy concentration in consumer-oriented, more staples type of names. Can you maybe talk a little bit about how you think about that part of the portfolio, and given the performance of some of those companies over the past three years or so, what do you think about their valuations today?
Jain: I think if you look at our consumer staples exposure over a very long period, it's not always that it is this size. Generally, we have had a significant position, but not this high. For last four-odd years, we've had a significant position because we feel that that's where we're getting sustainable secular growth because earnings growth in general in most of the world is going to be lot more difficult to get.
European problems are going to be with us for a while. It may just get worse, if you look at what's happening in Italy and Spain; Greece was, as you know, just downgraded to emerging-markets [status] again. Japan we feel the whole massive amount of quantitative easing may not be the solution, especially because it's an extremely leveraged country. A third of their government revenue, give-and-take, already going for debt service, and interest rates are under 1%. So, if they're successfully in raising inflation, the question is what happens to interest rates and what happens with debt service? The United States, as you know, has massive amount of quantitative easing with zero interest rates, and how would the economy react once they sort of start tapering off? We have already started seeing some implications.
So, one of the few areas of secular longer-term growth we feel is coming from emerging-markets consumers, whether it's beer, whether it's toothpaste, and so on and so forth. So, that's where we found opportunities, and we feel, again, it's a very small group of companies which we feel can execute, whether it's Unilever, which is now in almost 60% emerging markets and extremely well-positioned. It has done a much better job than Procter & Gamble, for example, or better than Kraft. Or you can look at Nestle, which is a perennial in our portfolio, and names like that.
Hughes: One of the things that came up at the panel was that profit margins are at peak levels. Do you find this to be the case for the companies in your portfolio, and is it something that you worry about? Or is it something that you think that they can, sort of, sustain these impressive margins?
Jain: I think I do feel that, in general, the margins are at record levels and will be difficult to sustain, and that's why we are actually very conscious of that issue. In fact, if you look at companies like BHP, Rio Tinto, and a bunch of other commodity names, we feel that the margins can actually come under significant pressure. These companies have gone from some cases making 20% to 50% margins, the top line is slowing down now, and there's cost pressures. When truck drivers in Australia are getting $150,000, the cost pressures are getting worse, not getting better.
So, having said that, if you look at the emerging-markets-oriented or even the developed-markets-oriented consumer staples, we feel that with margin expansion, while not sustaining forever, you talk about 15-20 basis points, and most of that is coming from better management, shutting down factories, consolidation, or just running the system better. So it has to be more efficiency-led rather than pricing-led because if you look at the pricing environment, it's not that they are charging more and more for the same stuff, which is why we feel that the margins are sustainable in these few names more than the other areas.
Hughes: Just from a valuation perspective, are they cheap, fairly valued, expensive?
Jain: I think they are sort of in no-man's territory. We feel when it's in no-man's territory, it probably would be difficult to get midteen returns from these names. But I think we should still be able to get higher-single-digit, lower-double-digit sort of compounding over a five-year horizon. I mean, as you know, some of these names have actually come off sharply in last couple of months, because emerging-markets currencies have backed off. So, it's not going to be straight-line. But if you look at SAB, which was called South African Breweries, 80% of their volume comes from emerging-markets countries, and beer consumption is still going to creep slowly higher, and that's actually people consuming more a legal product rather than illegal product, if you look at bunch of African countries or the cola bottling operations they have. Diageo [is another name that] can still increase its pricing as well as volume growth in bunch of countries, including the U.S., because there is a move toward scotch, for example, which is a very good portfolio.
So, I think these names, while multiples have sort of expanded a little bit in last few years, they are not expensive because you can almost value them like a bond at 6.0%-6.5% because they're trading at 16-17 times earnings with 7%-8% earnings-per-share growth and a 2%-3% dividend yield. So you get a double-digit return.
Hughes: You've mentioned, with the consumer staples companies, emerging markets a couple of times, that that's one of the attractions. You also invest in emerging-markets directly. When you invest in those emerging-markets stocks, are you looking for global emerging-markets companies, or are you looking for emerging-markets companies that are really tuned into their own local economies?
Jain: It's fascinating. It's a very good question because a lot of things are thrown into the same bucket when people talk of emerging markets, and say, steel exposure or car companies. We feel that the smaller-ticket items are what are truly emerging because if you're buying a steel company in Brazil, China, or the U.S., you're getting essentially the same exposure, which is steel prices. You don't really have to go that far for a haircut. You can buy a steel company here in the U.S.; the same goes for coal companies. So commodities companies you can rule them out.
[You can also say that for] a lot of automobile companies and even technology companies. If you look at Samsung, for example, it's hardly an emerging-markets play. The bulk of their earnings come from U.S. and Europe. As you know now, the Galaxy S4 is not doing well; we feel the stock is extremely overpriced here. It's essentially a commodity player, which has sort of done well on the back of a few products over last few years, but structurally we don't feel it will do well.
So [we] really sort of [look at] smaller-ticket items, and hence domestic names. It's companies which are dependent on people, such as the middle class buying better, eating better, drinking better, and those sort of things. You might get Unilever, which is a global company and all over, but it's unlikely you're going to get an emerging-markets company which is sort of global and has the barriers to entry. You will get a commoditylike company from the emerging markets which is global, like Samsung, for example, or technology companies in Taiwan, or Petrobras, Vale, Gazprom, Lukoil, those sort of names.
Hughes: Just to kind of broaden out and talk a little bit about your strategy more generally--because it's a very compact portfolio of fewer than 50 stocks so it takes something to clear the hurdle and make it into the portfolio--what are some of the things that you look for, the pieces that are important to you and your strategy?
Jain: Our objective is to compound at sort of the high single digits, low double digits over a market cycle. We also want to lose less. Now it's a fully invested portfolio. We typically don't have cash, and it's an equities-only portfolio with those caveats. What we want to do is have a diversified portfolio which will keep the volatility low. So if you look at, for example, 2011 or 2008, we typically have lost less than declining markets, but we don't necessarily always keep up in a rising market. So, diversification at the earnings level is important for us. You don't want to have the same exposure. It might be three different sectors, but the same underlying exposure.
Like, if you buy Samsung and Apple, the risk is actually pretty similar. You're not really diversifying in any big way. But if you are buying a beer company in Brazil and a beer company in China and a beer company in India, they have nothing in common. No one is going to quit drinking beer in Brazil because there is a problem in China, right?
But there are certain industries [where a problem in one region could create difficulty for a stock in another region]. So we want to make sure that the earnings levels of companies are diversified, and we want companies which should be able to grow, whether it is earnings or production in terms of more commodity-like businesses, but companies which we feel can grow earnings on a next-five-plus-year horizon, so a longer-term horizon, which means that it actually eliminates a lot of business which we feel don't have high enough barriers to entry to do well.
But we want to make sure that we mix enough in a way because I think one of the things which is not being appreciated still is the amount of quantitative easing that is going on, which basically means printing money. We don't know the impact of that. Yes, inflation hasn't shown up, but when people say inflation is not going to show up because there is high unemployment or too much slack in the economy--I have managed emerging-markets portfolio in countries which had high inflation. Turkey didn't have high inflation because of tight labor markets. They were at 25% unemployment and inflation went to triple digits.
So fiscal irresponsibility can lead to a lot of things, in which I think people are a little too complacent on the inflation side. So pricing power is important. We want to make sure that companies will be able to survive in an environment where it's going to get more tricky.
Hughes: When we spoke last week ahead of the conference, we talked a little bit about that trickiness. So as an investor investing around the world, what kind of expectations do you have for the intermediate term in terms of returns expectations or what you can expect from the companies?
Jain: I think, we feel our portfolio should be able to deliver sort of high-single-digit, low-double-digit EPS growth. On top of that they get a dividend, which is let's, say, 2.5%. So you get 12%-13%. Even if you get some multiple compression, you should be able to get a high-single-digit sort of return over a full cycle. That's our base case.
Now, it is a not a very optimistic scenario, but we feel that if we are able to get that, we should still be able to outperform the index by a reasonable margin. Why? Because the index earnings should probably gross in the mid-single-digits. Now, that's sort of a macro viewpoint. Because on a bottom-up basis, these are very high-quality defensible franchises which are not leveraged. They don't access to capital markets. If capital markets shut down, it doesn't really matter.
I think the best example is if you look at 2011, in the Virtus Foreign Opportunities portfolio we had close to 20% emerging markets, the bulk of them being in Brazil and India. Both of these markets are around 35%, give and take, the worst markets. It actually did not impact us that much because these companies are still growing. So they're not kind of dependent on Brazil doing very well or China doing very well, because I think these countries are sort of coming down to the normal growth rate.
If you look at Europe, we don't really have much exposure to domestic Europe. We really have exposure to much more of global multinationals, which are very diversified, and I think actually we want to be careful about taking too much of country-specific risk. If we take it, we really have to sort of like it to take the country risk. So, I think high single digits, low double digits, if we can achieve that over a full cycle, would be a pretty good return. And I think even with multiple compression we should be able to sort of get high single-digit compounding.
Hughes: Good. Thank you very much for your time and thanks for being here.
Jain: Thank you. Thanks for having me.