In this interview, Edward Robertson from Somerset Capital Management, managers of the St. James’s Place Global Emerging Markets fund since early 2020, speaks with Darren Johnson, Senior Investment Consultant at St. James’s Place. Among other things, they discuss the market’s recent concerns about Chinese regulation, how to manage ESG considerations in emerging markets and the current inflation debate.
The fund aims to invest in around 40 emerging markets companies that demonstrate good growth potential and that trade at reasonable valuations. As well as having strong positions in their respective industries, the companies that it invests in typically also have competitive advantages, a good history of allocating capital wisely, and transparent management teams.
The Global Emerging Markets fund is included within the St. James’s Place Adventurous Portfolio and Strategic Growth Portfolio. It is one of our ‘High Risk’ funds, which makes it suitable for clients that want the potential for exceptional returns and accept that this comes with a high risk to capital.
Can you give us an overview of the investment philosophy that you adopt for the St. James’s Place Global Emerging Markets fund?
We run a relatively concentrated selection of around 40 stocks, focusing very much on the longer term. We have a slight growth tilt in the portfolio, which means we tend to favour companies that are growing relatively quickly but aim to purchase their stock at times when that growth is attractively valued.
We have a team of 26 analysts, including a specific China team, which reflects the fact that the portfolio has a lot invested there currently. The team is united by a focus on owning good companies over a three-to-five year-time horizon. The equity asset class is inherently volatile – we just have to accept that, but we try to manage that volatility through our due diligence process, which aims to identify robust businesses where the operational performance should be much more dependable.
We also have a focus on larger companies. There is some exposure to medium-sized companies, but we don’t really have much exposure to businesses that have a market capitalisation of less than $4bn. We like to see plenty of liquidity in the portfolio. This is something we always need to be conscious of, because although there is abundant liquidity in China, many other emerging markets do not enjoy the same level of activity.
How has the fund been performing so far this year?
We have been sailing through some challenging waters recently, with two particular headwinds. The first is the tilt to value that has been evident in markets for most of this year. Value investing, which in a nutshell, involves buying stocks trading for less than their intrinsic value, had endured several years of underperformance but is currently enjoying a renaissance. This is linked to all sorts of macroeconomic factors, such as the reopening of many economies, the return of inflation and the outlook for US interest rates. As mentioned previously, our investment process tends to result in a tilt towards growth companies within the portfolios and, inevitably, there will be periods when that is not in favour.
The second headwind comes from China, and in particular, the Chinese technology sector, which has been a relative laggard recently. We are big believers in China over the long run – we still think it’s a great place to be invested, but it hasn’t really worked so far this year.
What has caused the recent weakness in China?
There have been a couple of independent regulatory announcements, which have combined to unnerve investors and lead to questions about China’s attitude towards profitable business. One of these announcements concerns China’s education sector, which offers a lot of out-of-school tuition. This has become a significant problem for regulators and the government because some education companies have been aggressively targeting parents and making them feel guilty for not spending enough money on extra-curricular tuition to give their children the best chance of succeeding academically. This was also exacerbating inequality because not everybody can afford this additional tuition.
So, there were official concerns about this behaviour which have culminated with the regulator taking a very aggressive stance that essentially means that these education companies, some of which are listed, can no longer make a profit. This is a non-profit business activity from hereon and that is clearly an issue for investors in those stocks. Meanwhile, it has raised broader questions about whether China is becoming “anti-business”.
At the same time, a different regulator has started talking about the social policies of some of China’s big internet platforms. Are the people they employ receiving a fair deal, and are they playing an appropriate role in society more broadly?
In my view, it is entirely normal and right that a regulator should be thinking about these things and ensuring that the big internet companies are not abusing their positions and that they are looking after their people. The education thing too is a problem, and it is totally appropriate that it is looked at. Across the board, in fact, I think that Chinese regulators, in all the different things they look at, are heading more or less in the right direction.
However, this mix of “internet companies have to change and behave properly” and “education companies can no longer make a profit”, has caused a degree of short-term panic in the stock market. It shouldn’t be too much of a surprise that these things come along but, in this instance, investors took fright.
Part of the problem was in how the regulatory messages were delivered, which involved a series of draconian proclamations and a lot of a sensational global media headlines. The Chinese subsequently clarified a number of things to reassure markets that it was not turning anti-business, which suggests that its regulators are learning about this process and that they will hopefully improve.
Personally, I think a lot of the proposed activity is very necessary, and I certainly don’t think China is anti-business, or against the idea of people making money. But it does want people to act responsibly with that broader social conscience. Nevertheless, we hold stocks like TenCent and AliBaba in the portfolio, both of which were caught up in last week’s selling.
Have the tensions between the US and China played a role in this sell-off? The background tension between the US and China has probably contributed to the skittishness of markets. Whether it’s on trade or other issues, the rhetoric that was started by Trump but continued by Biden, has led to an unhelpful atmosphere between these two superpowers.
It is essential that both sides learn to live with each other and learn to live with the ascent of China. But for now, China is very out of favour with international investors. The long-term investment opportunity remains very positive, however. We are at the mercy of events in the short run, but we continue to add selectively to stocks that have been caught up in this sell-off. The current conditions will not last forever.
What’s your view for the technology sector over the next ten years?
COVID has accelerated some of important trends that were already simmering away: how we communicate, how we buy things, how businesses sell to us. I don’t think we are going back.
As a whole, though the technology sector has been out of favour for much of this year in emerging markets. Looking longer term, however, I think there’s still quite a lot of growing to do. If last week in China shows us anything, though, that growth has to come in a proper way. Indeed, that doesn’t just apply to China – we’re going to see regulatory scrutiny everywhere. In the US, Europe, Asia and other parts of emerging markets. That is the right way it should happen.
Overall, though, we think technology is a really interesting growth area. The opportunity on a three-to-five-year view is tremendous, which is why we have around a quarter of the portfolios exposed to it. However, there will inevitably be shorter periods when it is out of fashion – that’s just the way markets are.
How do you manage ESG considerations in emerging markets?
One of the advantages of being an active manager and discussing things regularly with management teams is that you are able to impress upon them a direction of travel when it comes to the issue of ESG considerations, whether that be climate, supply chains or governance.
It is important to recognise that this is a gradual process. You can’t expect a company that has done things in a certain way for years to change its behaviour overnight. The advantage for the long-term investor and someone who is speaking to management regularly is that you can keep the pressure on. We repeatedly ask what businesses are doing about their ESG issues and press them on the progress of their transitions.
For some economies such as China, there seems to be a belief that there is a reluctance to listen and change, but that is not true in my view. They are desperate to listen and desperate to learn. Obviously, many of the companies that we speak to are at a different stage of development than those in more mature economies, but as active managers, we can and must work with them to ensure best practice.
Is inflation currently causing a problem within emerging markets?
We try to own companies that have some degree of pricing power. That means that they can pass on price increases to their customers. If their input costs go up, so does the price that they charge their customers. Plenty of good emerging market businesses do possess this pricing power, which protects them to a degree from inflation. However, there does tend to be a lag between their costs rising and their prices going up, so there can be a temporary hit to profits, which we have seen a few examples of this year.
From a macroeconomic perspective, the outlook for US interest rates can be important for all assets, emerging markets included. We don’t tend to take strong views on these macro considerations – company fundamentals are far more important to us. Nevertheless, we will closely monitor what the US Federal Reserve is saying, and a lot will depend on whether the current bout of inflation in the US turns out to be transient or more enduring. I feel that a certain amount of inflation is inevitable as economies re-open post-COVID, but I am slightly more sceptical about the idea that it will turn into more persistent long-term inflation. If it does, clearly there will be implications for all asset classes.
Is the slower pace of vaccine programs in emerging markets an economic risk?
I don’t see this as an economic risk but there is a human side to it which is very bad. Emerging market nations have tended to be slower in rolling out the vaccination to their populations, but they are getting there. China should be 80% done by the end of the year, albeit about a fifth of the population has received the Chinese vaccine which is not as effective. Many other countries are not so far behind. Meanwhile, there is real urgency to ensure that we don’t go back to what happened when COVID first hit. Policymakers have kept things going much more effectively through the second and third waves, which has meant that the economic costs have been nothing like as severe as in the first wave.
What do you think is the biggest risk to markets going forward?
Clearly, the inflation debate is front-page currently and is likely to remain so. The tensions between the US and China are also likely to continue to create headlines. I do think, though, that a lot of that is political rhetoric – both sides will pander to their domestic audiences but, ultimately, I believe they understand the need to co-operate.
No matter how hard I think about the answer to this question, there will always be something else that emerges from nowhere to worry investors. To mitigate risks, be they known or unknown to us, we build our portfolios around companies that have balance sheet strength, strong cash generation and good management teams. These are characteristics that allow businesses to prosper over the long term. This doesn’t mean that returns from the portfolio won’t be volatile, but it does improve the probability of long-term success.
Somerset Capital Management is a fund manager for St. James’s Place.
Where the views and opinions of our fund managers have been quoted these are not necessarily held by St. James’s Place Wealth Management or other investment managers and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice.
The value of an investment with St. James’s Place will be directly linked to the performance of the funds selected and the value may fall as well as rise. You may get back less than the amount invested.
Some of the products and investment structures documented within this article will not be available to our clients in Asia. For information on the funds that are available please get in touch.