Senior Portfolio Manager, Invesco Hong Kong Ltd. (IHKL)
Senior Portfolio Manager, Invesco
CIO: We’ve seen a decade of emerging market equity underperformance relative to developed international markets. Could you briefly recap the headwinds the sector has faced and what you expect over the next 5 to 10 years?
Jeff Feng: Three major factors contributed to underperformance. First was the crash in commodities prices, which squeezed budgets in emerging market economies that are highly dependent on exporting commodities. That slowed infrastructure spending and consumer spending alike. At the same time, quantitative easing measures implemented by central banks in the U.S., the European Union and Japan eroded the purchasing power of the foreign exchange reserves of emerging market countries, sending capital flowing into hard assets in developed markets. Finally, a strong U.S. dollar reduced real returns on emerging market investments and increased the risk premium for investing there.
We think some of these headwinds are poised to disappear or be overshadowed by other factors. With low interest rates expected to prevail in developed markets for at least the next few years, there is little meaningful yield available from most traditional assets. That makes growth more important, and leading emerging market economies offer better growth potential than developed economies. There are a variety of reasons for this, including demographic trends and the fact that many industries in emerging markets are less saturated than they are in developed economies. In addition, the continued strength of the dollar looks questionable over the next few years given the U.S. political situation, big U.S. budget deficits, and shifts in the global geopolitical landscape. Finally, commodities prices are already low, suggesting they don’t have room to fall much further.
CIO: How does Invesco approach investing in these markets?
Feng: We have a differentiated take, and it starts with our team of analysts and portfolio managers—either we were born in an emerging market or grew up there, or our families did, and we speak its language. That deep-rooted familiarity contributes to our insights. There are eight professionals on our international team, with five of us specializing in emerging markets. Each of us on that team of five has more than 10 years of experience investing in emerging markets, as well as a direct personal connection to these markets.
In terms of our investment philosophy, we emphasize high-quality companies, meaning companies that are generating a high return on capital and have strong growth prospects and a capable and honest management team. Those traits are important everywhere but particularly critical in emerging markets, where there often are no strong corporate governance structures and even the legal systems can be challenging to understand.
Perhaps our most distinguishing feature, though, is that we run a highly concentrated portfolio—typically owning just over 30 names—allowing us to do very thorough research. In a normal year we visit dozens of countries and conduct at least 500 meetings with companies in which we hold a stake or are considering investing. While travel has been limited this year due to COVID-19, we’re managing interactions though Zoom and Skype. Research definitely doesn’t stop because of the pandemic. Again, this is important for emerging markets because disclosure practices are not as strong there as they are in developed markets.
CIO: You’re a bottoms-up shop, but where in general have you been finding the best opportunities lately, whether by geography, industry, market cap or some other factor?
Matt Peden: One area is in the small- and mid-cap space. That’s been driven, in part, by recent strong inflows of passive money into large-caps that are the underlying constituents of major indexes. We find that many of the smaller and mid-cap companies seem to have been overlooked as investors tried to gain equity exposure during the rebound that followed the market’s bottoming out in March, at what was then the peak of the COVID-19 crisis and lockdowns. This holds true in both emerging and developed economies. Overall, though, we are seeing more attractive opportunities in emerging markets, not just because their economies and companies have higher growth potential, but also because extremely low interest rates in developed economies have helped drive valuations higher in those markets. We have close to one-third of our international strategy invested in emerging market equities.
CIO: Within emerging markets, are you seeing a preponderance of opportunities in any particular country or region?
Feng: China is certainly one place where we see a lot of opportunities. It’s clear China has done a good job of bringing the COVID-19 pandemic under control within its borders in the last few months, which certainly helps consumer confidence and economic activity. China’s government is also employing various means to stimulate the country’s economy, which has forced it to focus more on internal demand. Luckily, it’s a huge market and, like the U.S., can support a tremendous amount of businesses on its own.
CIO: What types of companies stand to benefit most from the disruptions and structural changes that have been accelerated by COVID-19?
Peden: A lot of e-commerce and online platform businesses have already benefited as COVID-19 has accelerated some long-term trends, such as consumers purchasing products online and acquiring services through online platforms. Social interactions through multiplayer and group games also has become more popular. We view these as permanent shifts and something we’ll focus on long-term.
Feng: Similar to Matt, we believe we’re at the beginning stage of shopping activities shifting online in many emerging markets, which is why we also have exposure to dominant e-commerce companies in Southeast Asia and Latin America, as well as in Europe. Another area where we see opportunity is in the digital payments space, where innovative companies are making it easier and faster to process payments, including online and mobile payments. Again, this is in the earlier stages in many countries outside of China.
—Matt Peden, Senior Portfolio Manager, Invesco
CIO: Let’s go back to the topic of concentrated portfolios. How do you manage risk in a highly concentrated portfolio? And, do you actually see some risk-related benefits in your approach?
Peden: We do see some benefits. One reason is that in addition to having a highly concentrated portfolio we take an unconstrained approach to security selection in terms of sector or geographic restrictions. That allows us to avoid some sectors and industries we feel are not conducive to long-term value creation. We also have strong risk-management tools and processes in place specific to our approach. For example, we look at risk correlations and concentration across our entire portfolio and particularly among the top 10 or so positions. Our emphasis is on ensuring low correlations across the different underlying performance drivers within the portfolio, including underlying geographic exposure. In terms of geography, we believe that where companies generate their revenue is much more important than where they are domiciled.
Feng: To further illustrate Matt’s point, imagine you invested in two beer producers, one in Brazil and one in Vietnam. While a traditional risk assessment tool may say you’re overly concentrated in beer companies, a look at the underlying drivers of their performance would show you there’s actually very little correlation between the two. Brazil has a younger population, which drives higher beer consumption, and its economy is heavily influenced by commodities prices. Vietnam’s economy is driven by exports, particularly electronics and apparel. Not only does owning two beer companies not increase risk in this scenario, it diversifies your risk. If you compare the correlations of the 30 positions in our portfolio against the correlations of our benchmark, which includes over 100 companies, our correlations are actually lower.
CIO: If you could leave readers with one last thought, what in your opinion do people tend to misunderstand about the investment opportunity in emerging markets?
Peden: It’s important to consider that despite the underperformance of emerging markets over the past 5 or 10 years there were many companies in which we invested that vastly outperformed any individual market globally. So, to some extent, the real story here is in stock selection, not simply market selection.
This article is for US Institutional Investor Use. In Canada, this document is restricted to accredited Investors as defined under National Instrument 45-106. It is not intended for and should not be distributed, or relied upon, by the public. Content was developed in October 2020. This is for informational purposes only and is not an offer to buy or sell any financial instruments. As with all investments there are associated inherent risks. This should not be considered a recommendation to purchase any investment product. Please obtain and review all financial material carefully before investing. The opinions expressed in this article are those of the authors and are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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