Five key insights on emerging markets equities

In 1994 Robeco launched its Emerging Markets Equities strategy to apply its expertise in the era of globalization. We believe that success depends on a consistent style and a stable team: portfolio manager Wim-Hein Pals has been managing the strategy since the beginning. Wim-Hein is joined by another Robeco veteran, multi-asset portfolio manager Arnout van Rijn, to share five of lessons learned in the past 30 tumultuous years.

Robeco entered emerging markets (EM) to invest in fast-growing global economies, but we quickly had to learn hard lessons about how to potentially beat a passive approach by being tactical and clearsighted. When the strategy was launched in 1994, we were in the so-called ‘tequila crisis’, when Mexico was still a big part of the EM index, and the peso crashed but worse was to follow later in the 1990s.

Before you invest in an emerging market, you have to be comfortable with currency risk, of which Thailand in 1997 was a great example. The Thai baht fell from 25 to 29 against the USD we decided to close the hedge, but the THB continued to fall until it bottomed finally in 1998, around 50.

Being aware of the risk of such a fall is important in positioning. The Thailand crisis taught us to avoid a common mistake in EM investing: entering or re-entering a market too soon after a crisis to try and get in ahead of a recovery. It’s probably better waiting a bit too long and losing a bit of the upside than being too early and going down another 20%. That was definitely a lesson learned. Today this informs our approach to countries like Turkey and Argentina. It’s important to be patient and wait for a period of stability in order to go neutral before going overweight, as these crises have tended to overhang asset prices for longer than you might think.

Beating the benchmark consistently was (and is) very much about active management with a disciplined investment process. The positive 30-year track record of the Robeco Emerging Markets Equities strategy against its benchmark rests to a large degree on companies we have owned throughout this period. Samsung Electronics and TSMC are two companies that have completely transformed over this period of time. We visited Samsung in the 1990s and it was a completely different company back then, but even then the company impressed with its technology focus. TSMC had visionary leadership and the consistent execution that builds trust, even through cyclically weak periods or when competition emerged.

We also followed structural themes like being long consumer discretionary combined with underweight consumer staples – that has been a consistent bias, but the exceptional companies still stand out. TSMC and Samsung are also emblematic of a key development – that the tech sector was basically non-existent in EM when we started. Materials, utilities and banking used to dominate, but now the tech sector is around 25% of the MSCI EM Index.

For active managers in EM, the global financial crisis was also a key turning point for region and country allocation and keeping a clear head. Just as in developed markets (DM), EM sold off at the end of 2008, with unprecedented collapses in some of the cyclical companies. Sticking to our investment process and strategy was crucial here. EM didn’t turn around until March 2009, when EM in general enjoyed one of its best years ever.

EM have always been characterized as more volatile than developed peers – but that has started to change recently. It wouldn’t be a surprise to us if the volatility of EM in the longer term declines below the DM level. This is because of improved economic fundamentals in EM and the fact that recent financial crises have originated in DM and not in the emerging world. The recurring crises in Latin America in the 1970s and 1980s, and the crisis of 1997 in Thailand and South East Asia, left EM banks much more cautious. That was not always ideal for minority shareholders, but it did leave lots of EM financial institutions better capitalized than DM peers. That caution also spilled into macroeconomic policy leaving EM economies with solid fundamentals and more policy flexibility.

Local interest has also had a very important influence on both volatility and returns. India, Thailand and Taiwan are great examples where domestic investors are key to the market dynamics. The increasing wealth in EM across the income distribution and rising level of financial inclusion is intensifying this effect. The fact that EM are being driven by domestic investors and institutions in the long run is a good sign, because it shows there is a connection between economic growth and stock market performance. The institutionalization of emerging equity markets has been a strong driver in India in recent years – a structural change where an increasingly wealthy population is sending inflows into the domestic stock market month on month. However, the reverse has been happening in China. Domestic confidence in equities has been a detractor there in the past year, so that needs to be restored before any recovery can be sustained.

We recently investigated the Korea discount – how Korean stocks have been trading at consistently lower valuations than comparable companies in similar markets. Well, it’s been down to governance and corporate strategy and this is a long-term issue. To highlight Samsung again in the early 1990s, we saw the merit of increasing our weight, but at the same time, we all knew that they were not focused on return on equity (ROE), nor on the minority shareholders. Back in those days, they were really targeting the number one position in market share, not making a nice return over their cost of capital. So that became a long-term theme and as the company matured we gradually started to enjoy the fruits of that change toward a focus on ROE.

Understanding a company’s management focus in EM and how much value there is to unlock is really important and is standing us in good stead wherever in the emerging world we invest. The research from the Robeco Sustainable Investing team has been instrumental in that regard and has helped us identify governance risks earlier in the investment process. This is where Asia has been playing catch-up. The number of IPOs coming from Asia has been phenomenal in the past two decades. In Latin America, the corporate culture was already basically Americanized and corporate behavior was more like US companies, potentially because many companies already had ADR listings.

We started in 1994 from a point where we were doing traditional fundamental analysis the Robeco way. We did lots of research on key factors back in the early 1990s, and we found out that in EM, value was a much better style, performance-wise, than growth. Over the whole three decades, this definitely helped us in terms of outperforming the benchmark. There’s also a general herd mentality in markets and that’s related to our comments about financial inclusion and institutionalization. In some markets retail investors would drive stocks to crazy levels, and we would take that as a signal to reduce our exposure. In addition, from very early on in our EM journey we leveraged Robeco’s quantitative rankings, which were value-focused as well, and that quant expertise has always given us discipline.

In the philosophical debate on being a growth or a value investor, we are clearly on the value side. That said, the debate didn’t exist until the 2000s, so it was more like we were not willing to overpay and we were always trying to go against short-term hypes and maintain a long-term focus. Momentum still plays a role in our EM process, and we understand you can run a long way past fundamentals, and that has to be respected. Going back to that Thailand experience in 1997 and 1998, we have also used charts to assess momentum. We believe that the more retail orientation you have in the market, the more momentum works. That puts us in a basket of ‘value with momentum’. We’re definitely not deep value managers. In the future, as we see EM getting more institutionalized, we will get fewer of those opportunities where retail investors do crazy things, both on the downside as well as on the upside. Whether that comes to pass or not, we are confidently looking forward to the next thirty years in emerging markets!