Ahead of the Curve in Emerging Markets
Principal International Emerging Markets Fund
Author: Ticker Magazine
Last Update: Dec 06, 10:48 AM EST
|A process focused on identifying positive change requires disciplined research, especially when it comes to fully understanding the capital allocation model of a business. Mohammed Zaidi explains how the portfolio managers of the Principal International Emerging Markets Fund and a team of analysts combine fundamental analysis and behavioral finance disciplines in detecting and selecting companies undergoing change not recognized by the market.
ďWe are fundamental investors focused on earnings and cash flows. We have a systematic approach leveraging technology and focused fundamental research to identify where positive change might offer relative value, and itís sustainable.Ē
Q: What is the history of the fund?
Principal Funds launched its first international fund in 1987, and even early on, this included emerging market investments. Then, in 1995, we established our first dedicated emerging markets fund, followed by this mutual fund, which debuted in 2000. It is managed by a team of emerging market specialists.
The International Emerging Markets Fund provides core exposure to emerging market equities through rigorous research and bottom-up stock selection. Our goal is to achieve competitive risk-adjusted results. A majority of our client base consists of retirement plans, including defined benefit, defined-contribution and individual retirement accounts.
Q: What core beliefs drive your investment philosophy?
We believe that the market is slow to recognize change, especially positive change, leaving expectation gaps we can exploit. For instance, investors tend to react swiftly to negative news, but slowly and skeptically to improvements in a companyís earnings. We endeavor to take advantage of these types of mispricing. If we identify positive trends and catalysts earlier than the market consensus, we can purchase that investment at a relatively attractive price.
We are fundamental investors. We have a systematic approach leveraging proprietary technology to identify where positive change might offer relative value, whether in the profit-and-loss or the cash-flow statement, and whether itís sustainable. Thatís the keyóweíre not looking for change in the short term. It has to be a fundamentally sound business whose value the market is overlooking.
We donít find specific price targets particularly useful. To us, valuation is a moving target, relative to competition and peers, and to the market itself, and depends on the growth expectations and monetary conditions.
Q: How do you assess if a company is mispriced?
One example is a company in Brazil, called Magazine Luiza SA, a retailer of light and electronic goods with about 800 stores and a $1.2 billion market cap that has grown its Brazil footprint through acquisitions. They went through a fairly difficult period about three years ago where, operationally, they had overextended themselves and ran up losses for a year, and the market devalued their stock. But the company was moving in the right direction, entering the e-commerce business and increasing its channels of sales, adding credit business which is now about a quarter of their revenue line. It was a blip, not a sustained situation.
When things get worse, the market overextends and prices at the bottom of the cycle, and when things look good, like they do now, the market overextends and may overprice. The question then becomes less about valuation more focused on our buy and sell discipline. We want to buy when the market is pricing downward. We want to sell when the market prices upward, or if we see extended exuberant growth that looks unsustainable, or an acquisition strategy that might push them to become the largest retailer in Brazil, where too much is priced into the stock.
We are not only students of fundamental analysis but of behavioral finance. The pillars of our philosophy and process is how we align those two skill sets. We distinguish between a generally good company and one thatís undergoing positive, unrecognized change, and being disciplined in avoiding common behavioral traps that can trip up even the most experienced professional investor.
Q: What is your investment process?
Ours is strictly a bottom-up process. Our quantitative screen filters roughly 3,000 investable companies within emerging markets, looking the highest alpha opportunities, roughly the top 20%, and we single out 70 or 80 companies with the strongest potential for an expectations gap in relative value that looks sustainable.
Our 10-analyst team, which is organized by global emerging markets sector, conducts analysis on the top 20% focus list (each has roughly 200 companies to analyze, at any point in time). As industry specialists, we know many of these companies well already and understand key industry drivers, political and economic impact. We evaluate specifically where any change is coming from: earnings, cash flow, balance sheet, or management. We talk to management and conduct industry, channel, and competitive analysis along with the necessary financial statement analysis.
We model out the key earnings drivers of a company to make our case, present it, and input the case thesis into our online Portfolio Manager Workbench system, which is accessible to all team members around the globe. Within the emerging markets team, we debate whether this investment thesis is a relevant and compelling investment for the portfolios. If the thesis is accepted, we buy a position. Analysts and portfolio managers talk daily, reviewing existing and potential positions.
The daily discussion amongst the portfolio managers centers on risk and portfolio construction. We run three different buckets of strategiesóglobal emerging markets, Asian regional, and China related fundsóso for each stock we assess our conviction and risk considerations, and which strategy itís most relevant to, by reviewing each strategyís risk parameters and existing portfolio composition. Deciding to buy or sell a stock, and how much of it, boils down to three pillars: conviction, risk perspective, and the stockís liquidity profile. While we are benchmark aware from a risk management perspective, we are not driven by the benchmarkís weighting as much as by those three pillars.
One of the biggest pitfalls investors fall into is the view that a good company is always a good investment. Itís not just the level of profitability but the direction of profitability that determines our success.
Q: How do you analyze the operations business?
We follow the money. We evaluate the strategy and direction of a business by how it deploys capital, by understanding what drives the business owners in terms of capital needs. A fundamental question one should always answer is who owns the company, what drives them, and what do they demand from this asset.
For example, if the owner prioritizes capital return, whether itís the government or an individual or family, one can expect to see a capital return model, either buying back shares or paying dividends, with less emphasis on reinvestment, and their business would suffer as a result.
If the company is largely publicly owned, in which case management is focused on maximizing shareholder value, then we expect that company to invest for growth and return less capital, until it reaches a point of saturation and capital spending starts to decrease.
A business either relies on cash flow or capital deployment to grow. Itís not just about profit and loss, itís not just the cash flow statement or balance sheetóitís putting all of that together and following the flow of money to determine whether the company is doing what it said it would do, how well itís doing it, and how the market values it.
Q: Can you provide some examples?
If we look at the IT sector, the market effectively values such companies as long-duration assets. Alibaba Group Holding Ltd., for example, has been increasingly investing in its balance sheet and overall investment. Alibabaís balance sheet has grown about four-fold in the past three or four years. Half of that increase is investment, while the other half is cash and investment in their operations. The market pays a fairly high multiple for the capital the business deploys in future growth. The market isnít paying for current earnings because the company is investing as much in its current business as it is accumulating cash. Itís investing in the future.
On the other extreme, mining companies are busy deleveraging, and their capital expenditure plans have disappeared. The market is valuing them based on how much capital they return to shareholders and how much they deleverage their balance sheet. For both those extremes the market is willing to pay a higher multiple because management is doing what the market wants.