Emerging Markets: Not Quite at the Bottom Yet
The fundamentals of individual companies suggest emerging markets are still in a very difficult situation, but valuations overall look reasonable, says Seafarer CIO Andrew Foster.
Jason Stipp: I'm Jason Stipp for Morningstar. We're at the Morningstar Investment Conference, and I'm checking in today with Andrew Foster, CIO of Seafarer funds. He is going to tell us about where the emerging markets are today and how his funds are navigating that environment.
Andrew, thanks for joining me.
Andrew Foster: Thank you, Jason.
Stipp: Let's start off with the recent letter to your shareholders that you wrote. You identified two drivers that you think are at play in emerging markets. I'd like to talk briefly about both of them. The first one could be a positive, and that's that you say that central banks in developing countries might not have to be as tied to the Fed as they had been in the past. Meaning, they might have some freedom to lower rates where maybe the Fed in the past is raising rates. Why do you think that's possible? Why can central bank policies diverge at this time when they couldn't in the past?
Foster: Well, my idea is a contentious one, but I do think there is a form of decoupling taking place. This is a word that was in vogue a few years ago, and it had a lot of different meanings associated with it. The decoupling I see taking place is in the interest-rate policy-setting mechanisms of the central banks of the world, and maybe the currencies and how they float or move against each other as well.
What's really happened and changed in the emerging markets is that they borrow a lot less dollars than they once did. The emerging markets are still heavy borrowers from richer and more developed economies such as the United States and other developed countries. But the proportion of the debt that is denominated in dollars or euro or yen that the emerging markets borrow is much reduced. By our estimates, it's under 20% of the total. A lot more of their borrowing is happening in their local currency terms.
Why is this important? In the old days when they borrowed a lot more dollars and that begat some previous financial crises, the central banks of the emerging markets had to pay a lot of attention as to how their currencies were fixed versus the dollar or kept in tight parities. And that meant their freedom to set interest rates in their domestic markets was somewhat hampered because they had to pay so much attention about how their currencies were pegged or fixed to the dollar in order to pay back those debts. Now that the debts in dollars are less, they have more freedom to float, and more freedom to float means more room to set interest-rate policies based on domestic considerations, in this case, maybe cutting even as the Fed is raising.
Stipp: And given the economic environments in a lot of emerging markets, do you think that central banks should act aggressively to loosen policy because they're not seeing the growth that they want to see?
Foster: I don't know I'd use the word "aggressively." In fact, I'm a little worried if they move toward some sort of quantitative easing program--and that's a distinct possibility because growth is so weak at this moment in the emerging markets. I frankly had hoped in my own analysis, or my analysis had led me to believe, we might see some sort of bottoming in growth--in the deceleration in growth in the emerging markets. Unfortunately, we're not quite at the bottom yet as far as I can tell. And I do think it's probably the right thing to do for most emerging markets to cut rates to engage in a little bit of stimulus at this moment, mainly because inflationary conditions in most of the emerging markets warrant it. Inflation is not terribly high, growth is weak, and so standard monetary policy analysis would suggest there is room for some cuts. That might allow the central banks to stimulate a little bit of growth at this juncture.
Stipp: You alluded to the second driver, which is the fundamentals in a lot of emerging markets are weaker than we would like to see and you said that you thought maybe we were reaching a bottom but then also you wrote to your shareholders that in looking at the financial results recently, things could get worse. So, is it going to get darker before the dawn in the performance of economic fundamentals in emerging markets?
Foster: Yes. I think some of the more credible forecasts that I've seen for where the emerging markets might go would suggest a bit of a bottoming right now and a reacceleration in growth happening in 2017. But the problem is, I'm not necessarily seeing it yet in the fundamentals of the companies that I follow within my fund's portfolio or even companies that I follow outside of the portfolio. I think we're still in a very difficult condition, so that's why I think the prospect of interest-rate cuts in the emerging markets, maybe contrary to the Fed, is such an important thing at this juncture, the ability to maybe re-stimulate a little bit of growth countercyclically.
Stipp: When you look at valuations in emerging markets broadly, do you think that the market is appreciating the fact that we still could be in for some tough times on the fundamentals?
Foster: I do think the market has priced in a lot of the negative news. There are some very difficult conditions in China yet that could have broader import. But apart from China, I think the valuations in emerging markets are quite reasonable and priced in a lot of the negatives. The real question in my mind is, will the growth trajectory of corporate earnings recover and therefore maybe even make the valuations look outright attractive. I'm not at the juncture where I could say that yet, but I do think the valuations in a general sense are very reasonable and are not off-putting even given the difficult circumstances I described.
Stipp: I'd like to talk about your fund, Seafarer Overseas Growth and Income. It was recently rated Bronze by Morningstar analysts. It's an interesting strategy because you will invest outside of common stocks. You'll also own preferred stocks, convertibles and other types of bonds. It's still considered a diversified emerging-markets stock fund but you have those other asset classes. What role do they play in the portfolio?
Foster: I very much don't view this as a balanced or allocation-driven fund where I'm allocating between different asset classes. However, the fund, as you mentioned, does make use of non-common stock securities occasionally, such as preferred stock, convertible bonds and maybe even sometimes corporate fixed income. The reason I do this is, we research individual companies, what we call, issuers: They are issuing securities, and we start by researching their equities for normal equity investment.
But our mandate has two formal objectives; one is long-term capital appreciation; the second is to attempt to mitigate some of the adverse volatility in emerging markets. And sometimes, once we start researching the equity, we find instruments elsewhere in the capital structure of the issuer, the company, that we believe will provide us risk-adjusted preference versus the common stock. So, we get comfortable with the stock first, but then sometimes find something we think is even better that provides superior risk-adjusted returns versus the common stock, and that motivates the investment in non-stock. But most of the time we're in stock.
Stipp: So, it's pretty much coming from the bottom up. You get to know the company and the fundamentals first.
Foster: Very much so.
Stipp: Another interesting fact about your fund is that, because you're bottom-up sometimes that will lead to overweights in certain areas. So, you've had overweight to Brazil versus China versus the benchmark, for instance. When you're thinking about the risks of emerging markets, though, political risk comes into play and other risks. So, how do you manage risk if you're going to be pre-overweight in one area of the world? How do you think about the way that you're selecting securities so that you're not overexposed and get hit by a political risk in Brazil, for instance?
Foster: I do so in two ways. As you mentioned, I'm very much a stock-specific investor. I'm what the industry calls a bottom-up investor. I look at the political risks that might manifest themselves in a specific stock or the macro risks that might manifest themselves in a specific stock. So, first of all, my stock analysis hopefully insulates the fund from some of those macro risks.
The other piece that I try and analyze is actually currency risk. I figure that the returns that are generated by my portfolio are a function of the stocks that I hold in foreign markets--their returns times those of their currency movements versus the dollar. So, I have a working hypothesis that all the macro sins of a country, all the difficulties--politics, poor macroeconomic policies, etc.--will ultimately be visited on the currency. So, I try and spend some time analyzing those currencies that I think will be sharply weak or have real problems against the dollar. I look at both their valuation and just their general fragility or lack thereof as two separate dimensions, and I make some assessments of currencies, and I use that to budget my portfolio. I don't necessarily hedge currency. In fact, I don't hedge currencies. But what I do is try and limit the exposure to individual currency buckets like the Brazilian real so that I don't overindulge in my bottom-up stock picks. I try and balance maximum currency exposure versus my bottom-up ideas.
Stipp: Besides the fact that you're finding lots of opportunities, or you had found more opportunities in Brazil, does that say anything about an overall take on those regions, like Latin America versus China where you're underweight versus the benchmark?
Foster: For me, it's very much a bottom-up view. I suppose the fact that we had a fairly substantial overweight into Brazil at the beginning of the year was just a measure of the sheer raw cheapness of that market that we were finding at that juncture. But the market in Brazil and the currency have both rallied a fair bit since January of this year. And consequently, that raw cheapness has somewhat dissipated, and it's happened because there is a very major change in the political environment in Brazil and that's led the market, the currency market, and the stock market to speculate on better times ahead. I don't see it from the fundamental level. So, for the time being I have been trimming that overweight I had to Brazil, not exiting, but trimming it back because frankly, I had fundamental cheapness before; I have now more expensive positions and no fundamental underpinnings to support those higher valuations--or not much of an underpinning--so I'm trimming that exposure.
Stipp: Sometimes a sell-off in a region will create that value, but again you're going in and picking individual stocks. So, I'd like to learn about your bottom-up approach knowing that you might have region exposure, political exposure, what are the things about a company that allow you to go into a place like Brazil but say, this is a company that's going to not only survive but also thrive. What do you look for fundamentally company-by-company that can overcome those higher-level risks?
Foster: I'd just take a quick step back, and I would say one of the things that's most overrated in the emerging markets is growth prospects. Growth exists, but it's far more challenging to produce than most people believe, and what's underrated is survivorship. The emerging markets are constantly hit by crises, and companies that can survive actually have a better chance of realizing the growth.
What do I use to identify survivorship? For me, the dividend or the ability to service some form of current income. It could be a dividend or maybe a coupon on a bond or on a preferred stock is probably the best proof positive of a company's liquidity and solvency, its ability to survive some sort of external exogenous macro shock.
When you peel back the layers to the onion about what gives rise to a company's ability to pay a consistent dividend, I would say that I look a lot at what are known as the EBIT margins, the earnings before interest and taxes, and just sort of a raw metric that measures the profitability of a company. The wider that margin is, often the more cash flow there is at the company to pay a consistent dividend. And second, and very importantly, having a balance sheet that's not excessively leveraged or indebted. Indebtedness is not a problem in and of itself, but it does severely limit a company's strategic options during a time of crisis, and as those strategic options dwindle at a time of crisis, you may face some sort of difficulty at the company or some sort of shortfall of its ability to meet its growth targets. That hampers the company quite severely. So, again, it's really dividend, EBIT margins, and hopefully, a healthy balance sheet.
Stipp: Andrew Foster of Seafarer Funds, it was great to get your insights on emerging markets today. Thanks for joining me.
Foster: It's my pleasure. Thank you.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.