Earnings Growth Story for Emerging Markets Equities in 2018
GILLIAN KEMMERER: Welcome. I’m Gillian Kemmerer. Emerging markets have had a great run in 2017, but is there still room to rise? VanEck Portfolio Manager, David Semple is here to tell us more about his process and the broader macro picture. David, thanks for joining us.
DAVID SEMPLE: Pleasure to be here.
KEMMERER: Emerging markets, they've had a great year. If you're an investor who is sitting on the sidelines, did you miss all of the upside?
SEMPLE: I think there is a very good underpinning to what's been going on in emerging markets. We don't try to forecast particular amounts that the markets are going to go up. But I think if you look and break it down into various categories, like the big macro issues, some of those have moved off the table. People are not as concerned about the U.S. dollar strengthening rapidly, which is the worst scenario for emerging markets. Interest rates have gone up, and I suppose the conversation has turned a little bit to over-tightening and the effect that might have on the developed market economies, and therefore in emerging markets economies. But for the time being we've had the Federal Reserve raise interest rates, and that's fine. And that's typically a good environment for emerging markets, because it talks about better global growth. And then we continue to have news on protectionism and tariffs. But I think in this case the bark is worse than the bite and there's been a lot of talk about it. But the reality is that it would impact people in a bad way in emerging markets and in developed markets. So I think the reality will be a lot less.
And, then, when you look at the emerging markets macro itself, it is actually exceptionally benign just now. All the things that we traditionally look at as on the macro side, and bear in mind we're bottom-up stock pickers, so I'm really describing the environment that we're picking stocks in. These macro issues like fiscal deficits, current account deficits, amount of external debt a country has, all those sort of things, if you aggregate them all, it's pretty benign just now. We're in a pretty good place. And then China. China is the place which yet again hasn't collapsed, despite the worse prognostications of the hedge fund community in New York. It hasn't happened. China continues to do actually very, very well. Now, it probably will slow down this year, but the idea that it's all going to, in some way, fall apart, I think is wide of the mark, again. So that's been good. But the real story, and the one that excites us as bottom-up stock pickers, is on the micro side. Companies are actually delivering. From 2012 to 2015, companies failed to really deliver EPS [earnings per share] in any meaningful amount in emerging markets. And then this year, well, actually from the middle of last year, 2016, that all changed.
But there is more. I know I sound like an infomercial, but there is more, and the more is that the cash flow that the companies are generating is really turned up very nicely, because operating cash flows picked up nicely, and capex is flat to going down in many places. So it is spare cash, spare money that companies are generating. It is a high quality problem about what they do with it. We think that that's really what gives a lot of the emerging markets its legs. Then, on the other side, if you decompose what's actually happened this year and in fact what's happened in terms of the last few years – that it has not been a re-rating story for emerging markets. It has been much more, particularly this last year and the year before, an earnings growth story and a little bit of an FX story. So it is not that we are the most expensive place, far from it. We are, depending upon which measure you look at, broadly speaking, average in terms of valuations for emerging markets. But that certainly makes us the least dirty shirt in the laundry, when a lot of the other asset classes are pretty fully valued.
KEMMERER: Well, I was going to ask about the currencies, I think the last time I looked, every EM [emerging markets] currency was up this year, granted coming off of a low base. Could we see that continue to stabilize and strengthen, even if we see some pressure from the U.S. dollar moving forward?
SEMPLE: I think it's going to be a little bit more mixed going forward probably. I've learnt over many, many years, that predicting shorter-term FX movements is kind of a fool's game, because we can talk about valuations of currencies and what's cheap and what's expensive. And it can be cheap and expensive for years, and what really matters is flows. But from what I see, I think that it depends on what happens here. So it is as much a reflection of what happens here, how EM FX will do, rather than the fundamentals of their own making. But what has changed over the longer term for emerging markets, and this gives them a lot more flexibility, is that we've moved off from fixed exchange rates, crawling pegs, dirty floats, all that sort of stuff, to truly floating exchange rates. And that acts as a kind of escape valve, and allows emerging markets to develop their own monetary policy suitable for their own circumstances. It's not that they'll always get it right, but they actually have an opportunity to really be more tailored, rather than simply a reflection of what the Fed is doing. So that will help on their FX.
KEMMERER: Well, on the currency side actually it brings up another important point which is China. You alluded to it earlier. We saw some technical movements made in the renminbi earlier, I guess this year into late last year, and the Western World really panicked when they saw it. But you seem to think that we shouldn't be looking at China as a “Doomsday” situation.
SEMPLE: Well, certainly not for the whole economy. The trouble with China is that whatever preconception you have about China, you can find evidence for it. It's simultaneously the best place to invest, and the worst place to invest. We have always, with our strategy of structural growth, looked at those companies that are in the so-called new China. I don't think that's an elegant phrase about what's going on. But what we're talking about here is not the old smoke stack industry, the heavily cyclical state-owned part of the universe, a lot of the banks and so forth. They might have a moment in the sun simply because, as bad things getting slightly better, they can perform. But we'd rather invest in what people want to spend their money on going forward. And that's things like healthcare, it's things like education, it's things like travel, it's things like the internet. And some of the things that are happening in China, where they leapfrog what's happening here, is just truly amazing. Because they don't have a lot of the legacy costs of, let's say, a shopping mall to close down, or a bank on every corner. And they're able to leapfrog that, and they have a generation, which is very willing to accept new things like fintech. So, it's very exciting what's happening there. Of course there'll be accidents. Of course there'll be issues. But it's been a fabulous place for us to be investing. And it's actually one of the places that a lot of emerging markets managers have been underweight and yet it's been a persistent performer.
KEMMERER:So more an issue of turbulence rather than a hard landing?
SEMPLE: Well, I think the sort of negativism which comes, you know, principally, apparently from New York, about what happens in China creates fantastic opportunities for the rest of us to just go and invest in what the good parts are. It allows us the valuation opportunity to do that.
KEMMERER: Well, speaking of, you're early in on Tencent, how is it doing and do you think that there's still room to run?
SEMPLE: Well, they just reported their numbers, quarterly numbers, and it was a beat across the board. So, I think that probably answers your question. This year's scale of the opportunity to them has become apparent more and more to the company, to the investors, as time has gone on. And as they invest in front of that, clearly that depresses near-term earnings, so maybe optically it appears more expensive in a one year out, two years out, outlook. But the sheer benefit of having that huge community they have available to them, and their conservatism in monetizing it, means there's a lot more to come from Tencent.
EMMERER: Excellent. Now, you brought up another stock pick when we were speaking earlier, and it was in South Africa, it's a really interesting business. Tell us a bit more about that.
SEMPLE: We were talking about Transaction Capital. The main business that it's involved with is actually financing little minibus taxis in South Africa, which is a fundamental part of the transportation infrastructure. It's how, basically, people get to work. South Africa's quite spread out, and these buses follow fixed routes. When they fill up they go, and the next bus comes up and so forth. And this company finances these owner/operators, so I mean it's a great entrepreneurial type of thing. But they also use big data in what they do, which is not only to track where the collateral is, the bus, but also to track whether people are actually working and, if there's an issue, nip it in the bud, rather than wait till the guy doesn't pay. I.e., speak to them now and say: "What, are you ill? Is the bus broken?" Whatever it is. And if the bus is broken they have the full ability to refurbish it and if the guy's not going to work, he can take it back, sell it again. I mean it's an end-to-end type of thing. But it's a very nice little company. I mean it's not going to be a Tencent, it's very different, but it's structurally growing very nicely for us.
KEMMERER: Excellent. So finally, if you're a client that perhaps hasn't taken advantage of the emerging markets run but is looking at the headlines and thinking, I missed out. What would you say to them about the next year or so, looking ahead? Is it still a good place to be allocating more capital?
SEMPLE: Well, we think people should be persistent allocators there. I mean it's not, in my view, an optional asset class. Now, obviously I would say that because I'm an EM guy, and I've been an EM guy for a very long time. But here's the difference. A lot of the cyclicality has been taken out of emerging markets. We've talked about the currencies. It means that the countries can basically be masters of their own destiny. And some of that cyclicality which came from having to follow the Fed has been taken out. The composition of the universe, what we're actually investing in emerging markets, has become much less cyclical as time has gone on. So, the energy, and the materials, those types of cyclical sector have become much smaller, and you've had the rise of companies like Tencent and Alibaba, which have become very big.
Even cyclical companies like Samsung have become much more structural, if you think about their memory business. There used to be lots of people who made those products, and it went into very few applications, basically your PC. Now fewer people make it and it goes everywhere. It's in your PC, your phone, your car, and your refrigerator, whatever. So, there's a lot of different things there, and that's taken some of the cyclicality out of it. And I think the investor base for emerging markets has changed a lot over the years. It used to be sort of foreigners, growth tourists, all in and then all out. But now it's moved on where you have the rise of a lot of domestic institutional investors, life companies, pension funds, wealth managers, people who are natural buyers of equities on dips, and away from the self-investing, sort of mom and pop momentum-driven investing. It's still there, but over the years it becomes less. So a much wider range of people invest in the market, and again that takes some of the cyclicality out of the asset class.
KEMMERER: David, thanks so much for taking the time to chat with us and to share your view on where EM is going next.
SEMPLE: It's a pleasure. Thank you.
KEMMERER: And thank you for tuning in. For this and other insights from VanEck, please visit vaneck.com/ucits/subscribe.