Finding the best of emerging markets – COVID or not

Finding the best of emerging markets – COVID or not

Gokce Bulut, Portfolio Manager, LGM Investments, shares his unique insights on the sheer innovation taking place in emerging markets (EM), as well as what growth trends to watch – and what sets EM companies apart.

Is EM positioned to recover stronger than ever?

The impact of COVID-19 has been vast and hard-hitting. But in emerging markets, it has also been unequal. While China, Taiwan and South Korea have been recovering relatively swiftly based on their history with SARS, other regions including Brazil, the Philippines, India and South Africa have struggled with inadequate infrastructure, among other factors. We used this opportunity to increase the position sizes of our highest conviction names – companies with strong social purposes that are contributing to their societies.

We have also focused on secular trends that were growing before the pandemic and are set to accelerate even further now, virus or not. For example, the semiconductor space has been an attractive area for EM investment, particularly as more people are working from home. This shift has necessitated an increase in devices, while online communication and e-commerce have grown massively in the last year.

Importantly, we have also seen an incredible amount of human ingenuity across EM despite the strict restrictions, with companies tapping into innovation and benefiting from their ability to stay nimble. There are pockets of new revenue growth areas that did not exist in the region four years ago, from automation to telemedicine. As a result, while there may be volatility in the short term, there are many companies that will benefit regardless of COVID’s presence and are emerging as globally competitive businesses, offering exciting opportunities for investors.

Maximising returns

An example from our Responsible Global Emerging Markets Strategy is Raia Drogasil, an established pharmacy distributer in Brazil, which is being tested today with rising COVID cases. While its business model is solid due to the ongoing demand for drug distribution, the company has pivoted toward wellness and healthcare and has even started providing online doctor consultations as a result of local hospital overflows. Raia has risen to the occasion, taking its social responsibility seriously and stepping up to societal challenges. The pharmacy chain has expanded its social license to operate by providing more services for its stakeholders (consumers and healthcare operators) in times of need, which will automatically reflect in profit generation for shareholders for years to come.

An important part of our responsible investment approach – and our high conviction holdings – is the expertise we bring. It is not something we stumbled into but rather have been practicing for more than a decade within EMs, combined with Columbia Threadneedle Investments 35+ years legacy. Incorporating ESG factors into our investment process and decision-making also means we are truly active investors, not swayed by the benchmark. Time and again it has been proven that ESG factors drive value creation and greatly mitigate future risk. That is critical because we are not just long-term on paper: four of our five top holdings have been in our portfolio for more than eight years. We have decided against investing in the likes of Alibaba and Samsung for corporate governance reasons because ultimately, we are quality investors who believe in partnering with owners we can trust. Trust is built through many years of conversations with key stakeholders, and historical and background analysis of key decision makers to understand and ensure alignment. To sustain our approach, we seek strong cash flow-generating companies with a higher social purpose, offering a product or service that at the end of the day provides value—with the ability to grow that value over time.

Our goal is to identify companies that have strong environmental and social management practices, allocate financial capital wisely, and, ideally, provide products and services that promote long-term social, economic and personal well-being for the emerging consumer base.

Studying history: tried, tested and true

While EMs are filled with investment opportunities, they also come with risk – much of which is visible, and some of which is not, such as COVID-19. This means being equipped with a comprehensive risk management process, where considerable time is spent delving back in time to ensure that the businesses in which we invest have not only endured previous crises with success, but they also have pricing power and are providing a service or product that drives demand.

An investor can easily lose capital in EMs if the respective company is highly leveraged, and we see repeated examples of firms earning local currencies by acquiring US dollar debt, which becomes difficult if their business model is weak. That is why we target holdings with a strong balance sheet that have a cash cushion in case markets turn. For example, one of our holdings, India’s HDFC Bank, has been tested across many different cycles, and each time it is becoming more resilient, benefiting from its lending decisions. The private bank is also positioned to benefit from the country’s rising middle class and increasing access, as well as demand, for formalised banking.

In terms of other criteria, we look for companies that are first and foremost operating in structural growth areas, where product penetration is relatively low yet adoption is increasing. It could be a simple product such as toothpaste, or even the concept of financial inclusion, for example, whereby as people have increased savings in semi-urban to rural areas, they will want to improve their lifestyle, invest and borrow. Financial institutions that provide the access in a way that is fair and clear will be the winners over the long-term.

We are also extremely prudent with investing in state-owned enterprises, confirming alignment of interest, and digging deeper into how they handled challenging periods in the past. While it is not a perfect solution, it is a reliable indicator for how they will behave during the next crisis and whether minority interests are considered in important decisions.

Make sure the scenarios that you use are realistic and effective. It is hard to assess if the risk profile is suitable if all the scenarios shown are positive. It is much more effective to stress test people’s reactions to a negative scenario.

Studying history: tried, tested and true

India is an area where we see long-term growth potential, with companies that are both domestically and internationally capable. This region, along with Northeast Asia, are where most of our holdings are located because they are examples of what can be achieved with the right policies in place in terms of bringing people up from poverty into the middle class, particularly in Greater China. We observe and invest in this growth element that does not exist in the developed world any longer, and therefore offers a tremendous advantage for investors with a long-term time horizon.

Another theme to watch within EM is the fast adoption, or leapfrogging, of technology. 15 to 20 years ago in China, the nation had the reputation of producing copycats of Western brands, but today the opposite is true, with certain industries ahead of their global peers and many more continuing to make inroads into the global space. In fact, some of the world’s largest semiconductor manufacturers that power our PCs and technological advancement in the West are based in Asia, as is Tencent, one of the most successful global tech companies with stakes in various innovative businesses outside of its home market. More EM companies are set to follow in this path of capturing the global market because many have large, well-educated domestic consumer bases they can leverage off and are based in regions that are extremely entrepreneurial and competitive, which will translate into world-class innovation over time.

Investing in EMs also offers exposure to local champions who know their markets inside and out and have proven their ability to shift priorities when necessary, quickly acting based on societal needs instead of having to overcome layers of corporate bureaucracy at distant headquarters. The marketplace can be ruthless, but if a company is adding value by responsibly addressing stakeholder challenges, then it in turn will be rewarded, as will portfolio performance.

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Risk warnings

The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

Investing in emerging markets is generally considered to involve more risk than developed markets.

Views and opinions have been arrived at by Columbia Threadneedle and should not be considered to be a recommendation or solicitation to buy or sell any stocks or products that may be mentioned.

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