)takes a bottom-up approach to investing in the developing world, searching for the best relative values across market sectors. He starts by screening for the cheapest companies in this pure emerging markets portfolio, rarely taking more than a 2% position in a single issue.
Though the fund underperformed in 2000, falling 37% versus 28.9% for its peers, Garel-Jones is sticking to his strategy of owning mid- and small-size companies trading at a discount to their fair market value. One country where he has been finding some bargains: the Philippines.
Q: How do you go about investing in emerging markets?
A: Our aim is to make sure that our portfolio does not hold anything a client might otherwise hold in a global equity fund. So, we start out saying we will invest in anything that falls outside the MSCI World Index. When a client buys our product, he is clearly buying emerging markets, and nothing else. There are no developed world companies that have an element of emerging markets in the portfolio. It is pure emerging markets.
Q: How do you begin to select stocks?
A: We use a screening process, relying on our own data base and internal research.
We divide our universe of around 8,500 companies in the emerging markets into sectors, and then screen companies according to their sectors. The country factor is really ignored right until the last stage of the portfolio construction process. We really try to focus on companies from a bottom-up perspective, looking at valuation within the sector. Then we put a final screen on the portfolio to make sure we aren't taking any undo country risk. This really is a final decision.
We also ask: Is this a market in which foreign investors can operate freely? Can we put money in and take money out freely? Are there any taxes for investors? You can find cheap companies all over the world, but whether or not you can actually realize your profit in them is another matter.
Q: What kinds of companies are you looking to uncover in the screening process, and how do you sort through them?
A: We want to find companies that seem to be trading below their fair value. That is the first step. The second step is to say that the market is usually right - i.e. if a company is trading cheap, it is probably because it is rubbish, and the market is correctly pricing it below its fair value. Our job is to identify those companies trading below their fair value for the wrong reason, or for temporary reasons. It might be tied to the country, or to the sector.
We visit the companies we have short-listed, and try to tell from management whether there is really a temporary misevaluation of the company. When we find them, they are the ones that we buy. We are not interested in management that is simply there to earn its salary and nothing else. We want management to have a strategy in place that allows them to realize the value -- the embedded value if you like -- of those cheap assets.
Q: What kinds of valuation metrics do you use?
A: About 70% of our universe is made up of companies where the net tangible assets -- the fixed assets of the firm -- are where they derive their value. In other words, these are capital-intensive businesses where the replacement cost of the firm has an impact on valuation. Are we buying a company way below its replacement cost, or way below the average value at which those companies in that sector trade in the emerging markets? That is what we ask ourselves. Then we simply value them on the basis of what we know it costs to replace a unit of capacity in their industry -- the beverage industry, or the cement industry, or the steel industry -- depending on what the company does. Then we put them on a list, from the cheapest to the most expensive, based on how far away above or below the replacement value they are.
Q: What about the rest of the universe?
A: About 15% of it is made of companies increasingly into technology, so the value is not so much from fixed assets, but from intellectual property or services. Is this a company that generates enough cash to pay down its networking capital over time without constantly recurring to shareholders for more cash? The key ratio we use to find this out is the net net current assets (NNCA) of the business. It is basically our broad definition of networking capital. We take the current assets of the business and subtract all the liabilities of the firm, except for the equity. We deduce that any company that manages to pay down that ratio over time must be generating cash somewhere in the balance sheet.
Q: When do you decide to sell?
A: When a company reaches its fair value, it immediately goes on a sell list. We won't sell it all immediately, but we will start to sell and monitor trading and momentum in the stock very closely to make sure we are selling into demand for the company. We are always leaving something on the table for the next guy. We do this because emerging market companies -- on the way down and on the way up -- tend to overshoot their fair value. Companies often trade through and well above their fair value on the way up.
There can also be other reasons to sell -- reasons tied to management or a company's strategy. Occasionally, it may be a top-down or a country reason, but the most common reason is valuation based on our price target.
Q: What are some of the fund's top holdings?
A: Electrobras and Banco Itau, both in Brazil; OTE, the Greek telephone company; Bancomer, a Mexican bank; Pakistan Telecom; Bank Pekao, a Polish bank; Anglo-American Platinum in South Africa; and Anglo-American Gold.
If a stock is worth buying, basically, it is worth buying 1-2%. We don't have much less than that in each stock, but neither do we have more than 2%. We want to diversity away the absolute risk. We are diversified not only by sectors, but by country.
Q: Can you explain how Banco Itau reflects your investment strategy?
A: We have owned it before, but it was recently purchased after the Brazilian currency devaluation in January 1999. We don't just want a portfolio full of cheap banks, but banks that are cheap, highly profitable, and with a secure capital structure. Banco Itau fit all these conditions.
We didn't own it prior to the devaluation, since it is a bank that has always been quite expensive. The devaluation knocked every stock in Brazil out of bed for about two or three weeks, and gave us a chance to buy into the stock at something like 15 cents on the dollar, or 15% of deposits. That was substantially below the average for emerging markets at the time, which was around 24-25% of deposits.
Q: Telecom is another presence in your portfolio. Are you overweight the sector?
A: We are actually underweight telecom in our fund. Both Pakistan Telecom and OTE are the cheapest companies in what is still generally quite an expensive sector.
A lot of investors have de-emphasized telecom just because the sentiment is clearly against it. We haven't really de-emphasized it that much, I have to say. We have probably paid a little bit of a price for that, but we have stuck to our discipline of owning the cheapest ones within the sector.
Q: Can you talk about a position that was recently added?
A: Quite an interesting company would be in the Philippines, a country that has been in the news quite a lot recently. This is a market that has been in the doldrums since 1997, when the Asian crisis occurred. A large number of Philippine shares have been figuring quite prominently in our sort of cheap stocks list for the last six months. The president has finally been thrown out. With hope a new government is going to make things better.
One company we own there is San Miguel Corp., one of the biggest beverage companies in the world. They are bottlers of soft drinks and brewers of beer. They have state-of-the-art plants, and a rock-solid balance sheet. They also have between $800-$900 million in cash on the balance sheet. A lot of potential investors in this company are worried about what they are going to do with that cash. We think that at this price it doesn't really matter. They could almost throw it away, and the company would still be cheap.
Q: Does liquidity every present a problem for your emerging market shares?
A: It can be an issue, and we have to be careful. We set ourselves a target . We won't own so much of a position that we can't get in or out of our entire thing in more than five trading days. We limit ourselves to about a third of the weekly volume.
Sometimes, however, you have to take a little liquidity risk. That is part of our business. We wouldn't be doing our job properly if we didn't ferret out some of these undervalued opportunities. You really have to get down into the local markets and roll your sleeves up, and frankly get your hands dirty. You have to be a little bit of a pirate, to be honest with you.
Q: How do your sector weightings currently break down?
A: Generally, we don't take very big sector bets. We tend to buy all the sectors, but simply the best of the cheapest companies within every sector. Occasionally we will override this, when we have a very strong view on a sector, as is the case with the financial sector -- the banks -- our biggest weighting. We are about 27% in banks at the moment. The benchmark would be about 19%. The bank decision reflects our view that the Fed has shown its willingness to be aggressive in cutting rates.
Q: Emerging market funds as a group were down 28.9% in 2000, and your fund fell 37% for the year. Was this a result of market
conditions? How can you quantify the steeper decline?
A: Last year was our worst year. It wasn't market conditions. I think our investment style suffered quite badly. It was a very unusual year. We are certainly more relative value oriented, and tend to own sort of mid- and small-size companies, not so much the big caps. Basically, investors in emerging markets have sought safety in liquidity. The big, liquid shares are also the more expensive shares, and not the ones that we typically own. We found that the large expensive shares continued to outperform the broad index right up until October or even November of last year.
Last June, we were way behind our peers and the index, and spent much of the second half of the year recovering that. Most of the recovery actually happened in the last couple of months of the year, because finally those small, more value-oriented companies started to outperform. It was a bit late in the day, and it certainly came later than we expected. It was clearly a style issue for us, but this is also the style in which we have managed money for 10 years. It has produced very good returns for us. We are loath to change something that has worked well and that has served us well just because of one slightly odd year where we didn't think market conditions were normal. As long as market conditions normalize this year, we would expect our recovery to continue, and it has so far.
Q: Once Greenspan cut rates at the beginning of January, some emerging markets countries benefited. Have you seen more
investors coming back into emerging markets?
A: We actually saw flows into our fund in November/December last year, and that was clearly because investors anticipated the potential in 2001 for emerging markets to do the same as, if not better than, the developed world. I think Greenspan's move reflected what was already happening in the markets. People were basically getting out of the more developed expensive markets, and looking for alternative assets. They were casting their nets wider to make money. That contributed to the weakness in the main market, which probably contributed to Greenspan's decision to cut rates so aggressively.
Q: What's your outlook for emerging markets going forward?
A: For them to really perform, there has to be some idea that global growth is at least bottoming out, and won't be apparent until the US is clearly in a soft-landing scenario, and Europe and Japan are seen as a drag on growth. It probably won't happen until the middle of this year, perhaps the second half.
What is quite clear from Greenspan is that aggressive rate cutting is extremely positive for the more leveraged emerging markets -- countries like Turkey, Argentina, Brazil and Mexico, where there are big current account deficits. That is why we have seen those markets perform so well over the last two or three weeks. Further aggressive rate cutting in the U.S. or in Europe could well support these markets up until the middle of the year, when we would hope global growth will pick up again. In the past, when industrial production picks up in the G7, it has been a good forward indicator of good returns in emerging markets. From Standard & Poor's FundAdvisor