Earnings Compounders in Emerging Markets
BMO LGM Emerging Markets Equity Fund
Author: Ticker Magazine
Last Update: Aug 08, 1:31 PM EDT
|With incomes steadily growing in emerging markets, discretionary consumer spending has been on the rise as well. Portfolio manager Irina Hunter explains how the BMO LGM Emerging Markets Equity Fund scours these markets in search of companies that benefit not only from the growth in spending but also from compounding earnings at a steady pace.
ďWe tend to find more quality companies among domestically oriented businesses in consumer discretionary, consumer staples and financial services. We donít target these sectors, but we tend to favor them, because they display the ability to generate cash and returns.Ē
Q: What differentiates this fund from other emerging markets funds?
The fund was established in 2012 as part of the BMO Financial Group, which believed in our approach to investing in emerging markets. LGM Investments, which is the sub-adviser of the fund, has over $5 billion under management, with about $2.5 billion of the assets in the Global Emerging Market fund. The strategy has about 10 different vehicles and the BMO LGM Emerging Markets Equity Fund is one of them.
A differentiating feature of the fund is that we do what we say we do. We invest in quality companies and our return metrics substantiate that statement. The return on invested capital of the companies in our portfolio is twice higher than that of the benchmark. These companies are not levered at all and that is a substantial difference.
We do not follow the benchmark. Constructing the portfolio with the sight of the benchmark has never been our ambition. For example, we donít have any exposure to Chinese banks, Samsung or TSMC. Our set of holdings is different, because for us the main decision is not whether to overweight or underweight something, but whether we invest in a quality company. I believe that this approach distinguishes us from other managers.
Another differentiator is that our portfolios tend to behave more defensively in different market conditions. While we do not aspire to perform great in all market conditions, we tend to outperform when the markets are flat to down.
Q: What core beliefs guide your investment philosophy?
We view ourselves as business owners. We donít just buy shares on the stock market; we buy stakes in business, because we aim to compound our clientsí capital in the long term without taking unnecessary risks. With this objective in mind, we invest in companies that can compound their intrinsic value over the long term. These companies are typically high-quality companies with dominant businesses, which have high moats and generate high returns and a lot of cash flow.
The key point is that they allocate capital in a way that allows them to continue to generate high returns. When there is extra cash, they share it with minority shareholders and that makes us fully aligned with their capital allocation. We never compromise on that factor and we also never overpay for the companies that we hold.
We also believe that it is important to recognize the company culture. That factor is often overlooked, but the distance from philosophy to outcome is reinforced by culture. I believe that our culture distinguishes us as an organization. We are driven by conviction and not by coverage. That means that we attract enormous talent that is self-motivated, bright and driven. It also means that we have disrespect for hierarchy in organization. Our structure is flat; everyone is an analyst and is empowered to bring the best ideas forward.
We have a focus on quality, but that focus is derived from our objective to compound our clientsí capital. We invest with an absolute mindset since we are not a relative-performance manager.
Q: How does your philosophy translate into your investment process?
Because we are a conviction-driven fund, we donít need to have a view on every stock in the universe. We take a large universe of over 20,000 stocks and distill it to something that we can understand. The majority of our ideas are generated by our travels and interactions with companies. We like to see companies showing strong metrics like return on invested capital, balance sheet strength, margins, profitability, free cash flow generation, etc.
We also do some filtering of the universe based on some of the mentioned factors and we take a note if something looks interesting, like a company that is a dominant franchise that sold off for some reason. On our next trip, we include that company in our travels. We need to understand the competitive dynamics, so we talk to competitors and industry consultants; we perform channel checks and visit stores and factories. During these trips we need to achieve not only an understanding of the potential company, but we also need to form a holistic and independent view.
If we like what we see and hear on the trip, we would do further due diligence and analyze how the business generates its returns or cash flow and whether the returns are sustainable.
We build an understanding of the market and the industry and we ask ourselves where the industry would be in 10 years and what is its growth potential. We also assess the culture of the company because thatís an insight on future capital allocation. Is the management likely to use capital in a value-destroying acquisition? Is it prudent with money? If there are no projects that need financing, would they release the capital to the shareholders? Thatís a big part of the qualitative analysis. Then, of course, we understand how much we are paying for the business.
Before we make an investment, there are three things that need to be done Ė the investment documentation, the discounted cash flow (DCF) model as a way to value the business, and the environmental, social, and governance (ESG) analysis. DCFs give us an idea of how much the business is worth. We take a long-term view of the business and aim to understand the drivers behind the ability of the company to generate a lot of cash. That process is necessary to understand how much we will be paying for the business.
The ESG analysis is integrated in our process, because corporate governance is paramount for understanding capital allocation. If we cannot trust the company in allocating capital, then we wouldnít invest.
Q: How is the team organized and who makes the final investment decisions?
Ultimately, the portfolio managers decide what goes into the portfolio, but prior to the decision, we discuss it at the investment board. Thatís the best way to make sure that we invest only in high-quality companies. In fact, if the board discusses has a positive view on a company, there are good chances that it will be included in more than one portfolio.
Although we have a small team, there are many people involved in the process. We travel together; we have follow up conference calls with the managements and discussion within the team. When the idea is presented to the investment board, it is open to all the 20 people in the company and that leads to a productive discussion. The board makes sure that the process and the selection criteria are followed. Only then we can be certain that our objective of owning high compounders is achieved.
Because we own the businesses for many years, we look for companies with a clean balance sheet. When we buy and hold a company over five to ten years, its debt on the balance sheet, particularly if it is in the wrong currency, could hurt our franchise. And the quality businesses typically donít have any need for levered balance sheets.
Q: What is your investment universe in terms of geography and sectors?
In our view, the best companies that were able to compound their intrinsic value over the years, have a domestic focus and are located in markets where the consumer is coming off low economic base. In markets like India, Indonesia, and Vietnam, the consumers get richer every day and spend their cash on branded products. Typically, these are the businesses that we own. They may be simple businesses that support the livelihood of consumers in emerging markets.
Overall, we tend to find more quality companies among domestically oriented businesses in consumer discretionary, consumer staples and financial services. We donít target these sectors, but we tend to favor them, because they display higher-quality characteristics and ability to generate cash and returns.
Q: Do you have specific requirements for the scope of compounding earnings?