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Seeking Sustainable Growth in Emerging Markets

Jason Stipp

Note: This video is part of Morningstar's May 2015 International Investing Week special report.

Jason Stipp: I'm Jason Stipp for Morningstar. Seafarer Overseas Growth and Income Fund (SFGIX) is a three-year-old diversified emerging-markets fund helmed by Andrew Foster, who has spent some time at Matthews Asia funds prior. The 5-star fund is off to a great start, and Andrew is on our fund analyst short list of managers to watch. He is joining me today to give his take on emerging markets and where he is seeing some opportunity.

Andrew, thanks for dialing in today.

Andrew Foster: It's my pleasure.

Stipp: Andrew, your three-year-old fund is having a good start; you are in the top 2% of the diversified emerging-markets category during the trailing three years. You wrote something interesting in a recent manager letter to your investors, and I wanted to start there. You said that everyone at Seafarer is proud of the fund's performance but that you are acutely aware that such performance is unlikely to persist. I thought that was refreshingly candid, but I want to unpack that a little bit. Let's just start with diversified emerging markets, overall, as a category. What have been some of the headwinds for funds and for the stocks in those regions?

Foster: Over the last three years, the index--through the end of March--hadn't moved much. It was basically flat or slightly up during the last three years, and I think that's surprised people. What was underlying that was the very anemic growth of the emerging markets. The macroeconomic models of the emerging world, probably best exemplified by China, were really starting to hit some limits to their growth capacities about three years ago. And most of these economies, because of those limits, were basically bound to decelerate. So, the real question on our minds three years ago when we launched our fund was whether or not some of these economies would retool themselves, reform themselves, because in the absence of that, it meant that growth was going to be very weak and well below people's expectation. And unfortunately, for the most part, that's what unfolded.

The growth was anemic. It wasn't zero and it wasn't negative, but it was much, much lower than what people were forecasting and what people were arguably paying for in fairly high valuations three years ago. And what we've seen is the index sort of tread water, digesting the fact that valuations were high and growth was low. That, in my mind, drives what we saw in the last three years.

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Stipp: Do you expect some of those trends to persist, or do you see that it might be time for the category, at large, to bounce back some?

Foster: I think the question going forward is really one of individual economies having different experiences. The nomenclature "emerging markets" is tricky because all of these markets are at different stages of their development and, therefore, in different stages of what they're doing to retool their economies. The good news is that probably the most important market and the biggest market, China, is moving the most aggressively to reform itself and I think, thereby, unlock new growth potential.

I think most of the other major emerging markets sit on a spectrum where some have done more and some of have done less. I would say Russia has done the least, Brazil and India are somewhere in the middle, and many of the smaller markets are also somewhere in the middle. What I think that means going forward is that some of these economies are going to perform better in the next few years--or at least they have the prospect to. So, I think there is a decent prospect of change, and I think earnings growth could, for the first time in many years, reaccelerate from admittedly modest levels at the current time.

Stipp: Your fund has done quite a bit better than the index in the diversified emerging-markets region. How do you chalk up your fund's outperformance? What was it about the way you invest and the companies that you invested in that allowed you to do so well in what, overall, was an anemic environment?

Foster: Well, there were two main things. One is that the hallmark of what we try to aim for is the pursuit of stable and sustainable growth in revenues and earnings for the companies in which we invest. And part of that is looking for companies that we think will be able to sustain their growth independently of the macroeconomic cycle. And I think the good news is we found some companies that ostensibly did that over the past few years.

The second reason why I think we did a bit better than the index is because we did have an eye to currency risk in the portfolio. We do not hedge currency risk, but we measure and pay attention to it. And we were not--I guess you could say--fooled by the premise that was really prevalent three to four years ago that the dollar was going to always be weak and get weaker still and that emerging-markets currencies would actually outperform. It's hard to remember that, but that was the case. That was really the prevalent mode of thought three to four years ago. And we were cognizant of the risk that was inherent to some of the emerging-markets currencies and tried to--I can't say we avoided it because we're fully invested and we don't hedge these risks--but we were cognizant of it and tried to measure it and manage it.

I would say, as a quick caveat, we're not, at the same time, fooled by the premise that exists today that the dollar will always be ascendant over emerging-markets currencies. The pendulum has swung really far in the opposite direction now, and I wonder if that will hold true, too, in the next five years. That's sort of a caveat. But anyway, those were the two factors that drove our outperformance. And just circling back to your original point of why we think our performance may not be sustained at the same level, that's because of what I said a moment ago--earnings growth may accelerate and people will get more excited about that. I think investors may get more excited about that and chase higher-value growth stocks. And the sustainable steady growers that we invest in may not do as well by comparison.

Stipp: I want to dig in to a couple of regions in emerging markets. You briefly mentioned China earlier and said some of the reforms there could unlock growth. We have seen, however, the Chinese stock market do quite well--much, much better than diversified emerging markets overall. So, when you're looking at China and the valuations, how do you factor in the fact that the market there has run up so much, even if the prospects for China have also run up? Are there opportunities left there?

Foster: It's challenging to interpret what's going on here. I think the most important thing for investors to focus on is to remember that the country is going through an enormous amount of reform and change at the present moment and not all of that reform and change is immediately visible to us or even comprehensible to us because we often filter it through the perception of the Western media. Some of that change is very, very positive, and some of it may be not so [positive]. But the amount of change is enormous, and I think that amount of change is begetting a lot of the short-term volatility and disruption in markets that we're witnessing.

In the short term, it's pushed stock markets rapidly higher in some cases--maybe unwarrantedly so. But underneath that is real change taking place, most of which I would grade as being quite positive for the long term. It's not easy for me to say the market is cheap on a price/book basis. China's markets are, in aggregate, trading at about 1.8 times price/book, which is in line with emerging markets. In terms of price/earnings ratios, they are, in fact, a little bit cheaper at about 10 times price/earnings versus about 12 times for emerging markets as a whole.

The challenge, though, is that those aggregate figures mask a lot of underlying disparity in valuations. There are some very, very expensive parts of the Chinese market and still some maybe more attractive ones. What this means for me is that I think it's a good time to be an individual-stock-picker because of two things. There are still parts of the market that I would deem cheap. And second, the change that's going on in China means that the things that people associated with success in Chinese investment in the past aren't necessarily those that will work in the future. And conversely, some of the things that haven't worked in the past might do so in the future. And it means that if you're a careful, patient, and observant bottom-up stock-picker, I think you can sometimes tease out the difference and maybe even get stocks that have good growth potential at low valuations.

Stipp: A quick follow-up there: You mention there are some areas of the market in China that are overheated and some areas that still look attractive. Are there any particular directions you can point to in that respect?

Foster: Well, one of the things I was alluding to a moment ago is the idea that there are a lot of companies that have large levels of government ownership; they are often called state-owned enterprises, or SOEs. These state-owned enterprises have generally been the bane of most investors because of that government ownership; they've been deemed as being not very efficiently run and not run necessarily for commercial or profit-seeking reason. I think that's generally been a good heuristic over the last decade or two; but I think things are changing and some of these state-owned enterprises are actually very well-positioned companies that are beginning to clean up their act with respect to their commercial orientation, their profit-seeking nature.

In other words, I think there is a reason to believe that some will deliver more to their shareholders over the long term. And because this sector has been overlooked mostly by foreign investors, in some cases it offers some good bargains.

Stipp: I want to swing over to Brazil. You also mentioned Brazil in your recent manager letter, and you said that it's emerging as a potential area of opportunity. What are some of the factors driving that?

Foster: Well, it's really valuations at the end of the day. I think that valuations have gotten quite a bit cheaper in the last three years in local-currency terms as the stock market itself in Brazil has deflated--and even more so, the currency has tumbled dramatically. From the time when my fund launched, the currency has fallen by more than 50%. I think that has left a lot of people sort of fleeing the currency, and I understand why; but in my mind, that means there are more bargains from a dollar investor's perspective than there were three years ago.

So actually, ironically, that currency weakness makes us pay more attention because what we're really looking for are companies that can produce larger and sustained U.S.-dollar-term capitalizations over long periods of time. And suddenly, we have some good companies trading at lower valuations that, in dollar terms, look very depressed. They are midsize companies that suddenly look very small, just because of the currency effect. Those, to us, seem quite attractive at this juncture, and we are paying attention to that segment of the market.

Stipp: So, as an individual-stock-picker, a lot of times you can find opportunities when broad themes are painting all companies with a certain brush. Would you say, then, that currency themes or short-term currency volatility is something that can create opportunity for you?

Foster: Currency risk can create opportunity, but it's also a tough risk for anyone to manage--including professional investors. I think all investors struggle to get the macro picture correct--the big picture correct. And within the big picture, the single hardest component is currency risk. There is no one I know--and I pay a great deal of attention--there is no one I know that consistently gets currency risk right.

What I would say is this: Our own analysis suggests that currency, for a patient and diversified long-term investor--and that's really someone who is willing to hold their international and especially emerging-markets portfolio for three- or especially five-year horizons and not necessarily panic over this risk in the short run--the drag that currency risk imposes on your portfolio is negative, but it's not terribly material compared with the potential return from equities.

So, I think that the point of this is to say if you are diversified and patient, currency risk shouldn't impose a huge risk on your portfolio. Individual currencies may have real challenges, but the basket of currencies that you might hold through your portfolio should do OK, and the cost of hedging it is far greater than the value that you would derive from doing so. So, I think the best means of managing this risk, as ever, is being patience and letting time and diversification work to your advantage rather than doing anything particularly costly or fancy with respect to hedging.

Stipp: Last question for you, Andrew, and you touched on this a few times. Reforms in the emerging markets have created enthusiasm for some of these regions. As a fundamental investor looking bottom-up for opportunity, how do you account for the effect of reform--whether it could be real and actually add value--how do you think about it in your analytical process?

Foster: It's so funny because people do get so excited about the term "reform," and it sometimes pushes markets rapidly higher, in aggregate--as was the case in India over the last year or so. I think there are a couple of things you've got to do. You really have to pay attention to whether or not the reform is real and meaningful as opposed to a buzzword that is being pushed around among investors as a reason to get excited over a market. So, you really have to identify what is the nature of the reform and its cause and effect.

I think the second thing you've got to consider when reform takes places is that it usually means a change from, and a departure from, the past economic model of the economy. It means that yesterday's winners won't necessarily be tomorrow's winners. And ironically, a lot of times when investors get excited about reform, they tend to push the whole market higher at the same time on the premise that every company is going to do better.

In fact, often, what happens is that only selected companies do better, and companies whose business models were maybe sensitively attuned to the old way of doing things might actually start to struggle in the new economic environment. So, that's some of the irony; investors push valuations up in sort of a nondiscriminate way. And so, I think those moments of reforms are when you have to really pay attention to the change and what it means for individual companies, as opposed to getting excited for a market as a whole.

Stipp: Andrew, I always get a new take on the emerging markets when I speak with you. Thanks so much for joining me today and for your insights.

Foster: It's my pleasure, again, Jason. Thank you for the opportunity.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.