Strong contributions from the two key performance drivers – country allocation and stock selection – have enabled the fund to stay successful over these twenty-five years. The head of Robeco’s EM team, Wim-Hein Pals talks about the focus on the consumer discretionary theme and emerging names.
The fund’s starting point for the investment process is country allocation. Stock selection then follows. This reflects the portfolio managers’ philosophy that fundamental differences between emerging countries remain an important source of alpha. “Our peers start with stock selection and then apply the country overlay,” says Pals.
“The beauty of the EM space is its dynamic nature,” explains Pals. “Countries come and go. Saudi Arabia, for example, has just joined while Israel has just left, having been upgraded to a DM.”
The fund’s bottom-up stock selection is based on a unique blend of fundamental, quantitative and ESG research. For the stock selection process, “the huge benefit of EM investments is the attractive valuations of emerging countries compared to developed ones,” says Pals. “The portfolio is therefore tilted towards value stocks in combination with above-average returns on equity. Our in-depth company analysis is based on fundamental, ESG and quantitative research.
Outperformance is driven by both country allocation and stock selection
Since its launch in 1994, the Emerging Markets Equities fund has reached two crucial milestones. The first was quantitative enhancement – the application of a quantitative model to the stock selection process – in 2001. “This added stability to the stock selection results, with fewer outliers and less volatility, says Pals.
The second was ESG integration. Benefitting from data provided by Zurich-based RobecoSAM, we started this in 2001 and by 2011 it was an integral part of the process. This has also helped enhance returns for our clients in various ways, adds Pals.
“All things EM consumer are the bright spot,” says Pals. “Within this space, the fund focuses on the consumer discretionary theme rather than consumer staples. We are fairly underweight in consumer staples, which tend to be pretty expensive. The consumer discretionary sector, on the other hand, has been a structural overweight for years, which results in much more attractive price-to-earnings and price-to-book ratios,” says Pals.
On the flipside are the producers. “The old heavy industries have never been of interest to us. Paper mills or heavy machinery producers in China – we are underweight those. China used to be the factory of the world, but the growing overcapacity means all that’s changing.”
Apart from the consumer focus, the fund also concentrates on pure emerging names and not on multinational companies. As Pals puts it, “We prefer domestic exposure in countries like India and China. In India, for example, we would rather invest in a local food company than in a multinational, because multinationals would also give you exposure to developed markets, which we generally don’t like.”
We prefer pure emerging names
With country allocation as the starting point, the strategy is primarily oriented towards Asia, which accounts for two-thirds of the portfolio. Of the Asian countries, China dominates. Pals believes that the recent partial inclusion of Chinese A-shares in the MSCI EM Index means that the country’s relative weight will only grow.
In February, the MSCI announced that it would increase the weight of China A-shares from 5% to 20% in three steps. As a result, China will account for roughly 40% of index in the not-so-distant future, he thinks. “We are currently overweight China, and this is not going to change. We started investing in A-shares in 2009 – a decade before the MSCI decided to include them in its benchmark. India will also continue to grow, but at a slower pace.”
Over the years, the key strategic change has been to increase the weight of the IT sector. “IT has become one of the most important themes in the emerging markets,” says Pals. The IT sector has also evolved, particularly in China, where the focus has shifted away from hardware and more towards software and e-commerce. The sector has also grown considerably in countries such as Taiwan and Korea. IT is now second to financials in terms of importance for EM investors, believes Pals.
According to Pals, the current environment makes emerging markets particularly beneficial for investors due to the unique combination of earnings growth, undervalued stocks and solid fundamentals.
The EM universe currently shows superior GDP growth compared to that of developed markets – but that’s not the only factor. It also shows better earnings growth, which Pals believes offers very positive prospects. In many emerging countries, earnings growth increasingly correlates with GDP growth. “Take China, where companies now have a much better understanding of how to generate shareholder returns.”
The third driver of EM attractiveness is the valuation angle. “EMs now offer a 30% discount to DMs,” says Pals, adding that the current situation is truly unique. “This difference is unsustainably high, as historically the average discount has been around 10%. But this will come down to the levels we have seen in the past.”
And as far as macro fundamentals are concerned, many countries in the EM universe are currently on a strong footing – whether in terms of high foreign reserves, large budget surpluses, high bank reserve build-ups or high savings ratios. “Overall, fundamentals in EMs are stronger than in DMs,” says Pals, “which will dawn on more investors at some point!”