Tue, 10 Dec 2013
Louis Mendes of Silver-rated Columbia Acorn International says the fund has found value in niche industrial and tech companies, as well as consumer names, while steering clear of regulated companies and low-cost manufacturing.
Jason Stipp: I'm Jason Stipp for Morningstar. It's Emerging-Markets Week on Morningstar.com, and today we are checking with Louis Mendes, a manager on the Silver-Rated Columbia Acorn International Fund. He is here to talk about the issues and opportunities facing emerging markets investors today.
Louis, thanks for joining me.
Louis Mendes: Thank you.
Stipp: Your fund Acorn International, a Silver-rated fund by Morningstar analysts. It's a foreign small and mid-cap fund. You are looking for smaller companies. You have a decent stake in emerging markets.
Overall, why small and mid-caps; what advantage do those give you when you're doing international investing or emerging-markets investing?
Mendes: About 25% of the Acorn International Fund is in emerging-markets stocks. Similar to small-cap stocks anywhere in the world, some of the major reasons why you'd want to do that are: one, small-cap stocks by their nature tend to be more focused business models. They tend to have a niche that they are targeting. It's a simpler business model. It makes it easier for us as an investor to understand it.
Two, their managements have a much greater impact on the outcome of the company. Because the managements are involved in a smaller business, they tend to be able to drive its performance.
And three, most importantly is, when you look at a small-cap company, it's often overlooked by most investors. So if we're willing to go in and do the due diligence, get to know the company, find out it's a good investment, we can often acquire a stake in it at a valuation discount to most peers.
Stipp: And when you are thinking about diversification at the portfolio level, a small- or a mid-cap international fund might give you something different than you would see in a lot of the index funds, particularly in emerging markets, for instance.
Mendes: Correct. If you look at a lot of the emerging-markets funds, their top holdings are all the same. They tend to own the large petrochemical companies, the large electronics companies, the large financial institutions. Part of that is that the benchmark for emerging markets is dominated by maybe 15-20 large caps.
In small-cap land, there are no dominant companies. So every stock is an off-benchmark bet. Managers go out, and they are just trying to find great businesses to put in the portfolio.
Stipp: When you're looking specifically at emerging markets or elsewhere at the companies that you want to invest in, what kind of fundamental criteria are you looking for?
You mentioned earlier that management can have a bigger impact on a smaller-cap company. I am assuming that stewardship is going to be one of those.
Mendes: The first thing that we look at is, is it a model we can understand. Smaller-cap companies by their nature can be riskier, but we need to feel that we can understand the business model. So we walk through the business model. Do I understand how this company is going to make money over time. And if I can't understand it, we are not going to invest in it. That would be the first hurdle that we want to see.
Second would be the management. As we mentioned before, management is very important. Do I have access to management? Do I feel management is a stakeholder in it? Is their stake aligned with ours? Are we on the same page in terms of share ownership, share class, corporate governance?
Third, would be a valuation issue. Is the valuation justified for us to become an investor in that?
Stipp: And do you have any examples of companies that have hit on some of those points that are in your portfolio?
Mendes: One of the companies we have had for the last five or six years since it IPO'ed is a Brazilian company called Localiza. It is the largest car rental company in Brazil.
To understand Localiza, because they are the largest, they can buy their fleet at the lowest cost of anyone in the country, because they go to the major auto producers and they get the cheapest price. Their raw material is the cheapest. They use it for 12 to 18 months at the highest utilization rate, so they have better utilization of it. And then because they have their own used-car network, they can sell that car at the highest aftermarket price, so the depreciation is the lowest in the industry. It's a simple model. You buy cheap, you utilize it better than anyone else, and you control your cost of unloading the car. So that meets the first criteria. We can understand the business model.
Second, the financials are very clean. When I meet with the CFO, he brings out a stack of financials. I can go through every single aspect of the company. When I leave a meeting with him, I have no doubts about where the cash is in the company. And one of the things we want to know is, can we follow the cash?
Stipp: And you mentioned risks before; emerging markets can be risky. Smaller caps can be risky. When you are looking to control risks in this area, specifically in emerging markets, what kinds of controls do you put on to make sure that you are not getting into something that [will] have a bad unanticipated consequence?
Mendes: Yes. There are three kinds of risks that we want to look at.
The first is the business risk. Again that's back to the business model. Is it something you understand? Is the business, possible that it's going to go out of style, or its business model is no longer going to be effective five years from now. Do we understand the business?
The second is the management risk. Do we get access to management? Have they ever misled us? Have they had mistakes of their own? Is this a proven management?
Stipp: What about any country issues or policy issues? Do you have any concerns investing in smaller companies with the government coming in and doing something unexpected that you wouldn't see in the U.S., but you may see it in an emerging market?
Mendes: That's the third risk. The third risk is the one that you can't analyze. It's the macro risk of a country.
I'll give you an example. One of our holdings we have is a Cambodian-based casino operator listed in Hong Kong called NagaCorp. If you do the first criteria, do we understand what a casino is? Yes. We've invested successfully in casinos for many years. It's a simple business model.
Second, the management issue. We've visited the company at least three times in the last 18 months. I've met with the chairman, Dr. Chen, a very well renowned businessman, who's been an economic advisor to Hun Sen in Cambodia for many years. I meet with the CFO. Again, he'll walk me through all the financials. So, I come out feeling very comfortable. The chairman of the company is an ex-FBI investigator, who's had a lot of corporate governance experience in Hong Kong. And furthermore it's listed in Hong Kong, so I have corporate governance rules from Hong Kong.
So, my criteria are being checked there.
The third one would be the political risk. Well, we can't call whether there will be a major unrest in Cambodia, or the rights that they have, which is a long-term exclusive rights, would be abrogated. But we can gauge that, and we try to value the political risk into the model. So, again, company risk, management risk, and then you have this macro overlay risk.
Stipp: And you're mostly bottom-up investors. You're looking for good fundamental stories, good prices, but have any themes emerged in where you're finding value, or do you apply any themes in where you look for value?
Mendes: One easy way to do is, where do we not look first? We do not do low-cost manufacturing. We think that is a beggar-thy-neighbor strategy. So, what happened from Japan to Korea to Taiwan to China, it moves over to Bangladesh. We don't want to follow that theme.
We tend not to invest in regulated businesses. So, utilities, most telcos, where the government can come in, and if you make excessive returns, they're going to limit it. Emerging markets are very populist in general. You do not want to be in a place where your profitability can be constrained.
So, where does that leave us? That leaves us in niche industrial companies, like Localiza. It leaves us in some of the technology companies. It leaves us primarily in the consumer space.
One of the main reasons you invest in emerging markets is because you have this huge demographic of people who are rising up out of the lower middle-class and the middle- class, and are aspirational, and you want to find a way to partake in that. So, that's one of the main themes we have.
We have that through our gaming companies. We have it through retail stocks. We have a company called Biostime which makes high-end baby formula, exports it from France to China for the rising middle class in China, who wants to give their babies perfect infant formula. Those are the themes that we tend to focus on.
Stipp: You mentioned exporting there. Do you ever find that you can get good emerging-markets exposure by investing in a multinational or a company that's domiciled in a developed market but has good exposure to an emerging market?
Mendes: Yes. One of our holdings that we've had for many years is a Swedish company, it's called Hexagon. They make metrology equipment, which basically does measurement work in production lines. And they've been exporting to all the production lines that are being built in China, in India, and elsewhere. So you are downstream from an area where it may not give you good returns if you're in the manufacturing element, but if you have an input that is required by all these people expanding capacity, you can make good profit margins.
Stipp: Last thing: I'm going to ask you a question that fundamental investors don't necessarily like to answer, but I want to get your take on it anyway.
We saw emerging markets really take a hit when the Fed started to talk about tapering earlier this year. There is a lot of seemingly risk-on, risk-off, macro-oriented trading going on right now.
When you look at your portfolio, and I know you don't construct your portfolio that way, but when you look at it, and the impact of these kinds of decisions and macro events, how do you plan for that or how do you think about it as a fundamental investor, and the opportunities or the complications it brings?
Mendes: Well, first of all, we're not going to try and second-guess people like Bill Gross and other people who've done this for a living. And his argument is the 10-year bond will probably be somewhere between 2.5% and 3% over the next couple of years. So, we'll accept that as the U.S. default rate. What we can look at is, is a country like Brazil raising rates? Where is it in its cycle?
Brazil has been raising rates. It's had inflation kicking up. It's had wage costs. It's made it very difficult for a number of our operating companies there. We've actually trimmed our names in Brazil from six to three in the last year, because a number of companies were running up against margin pressure.
So we can do it at the local level. We tend not to invest that way. What we do is, it's more of a derivative of, are we seeing it at the corporate level that margins are getting squeezed? What are we seeing from wage costs, interest rates, whatever it may be?
I think what's important is, we tend not to buy highly levered companies as a rule. If you look at our portfolio, we are not buying deep value stocks that have a lot of debt that are hoping that interest rates stay low so they can rebound. We tend to buy very high-quality secular growth companies that manage that interest rate exposure.
Stipp: Louis Mendes from Columbia Acorn International. Thanks for joining me today and for your insights on international and emerging-markets investing.
Mendes: Thank you.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.