Q2 2022 CIO Review and Outlook
CIO Robert Horrocks, PhD, says well-managed companies, not inflation and interest-rate cycles, will determine long-term investment returns.
In the end, long-term investing is not really about timing economic cycles. Why? Well, for one thing, it’s hard to do. Our macroeconomic discussions also tend to focus less on the general environment. Gross domestic product (GDP), inflation and interest-rate cycles are not front and center of our considerations.
The issues we chew over are more tied to the prospects of companies themselves. Are we investing in countries which have policies supporting markets and the promotion of high-quality businesses? Are we able to find businesses with market power? Can they raise prices when the environment allows and maintain prices when the environment moves against them? Are they in a strong bargaining position with suppliers? Do they have a good or service that their clients will prioritize over other spending? Are they free from competition in providing these goods? And, finally, can we make a decent estimate of valuation?
A lot of this is about understanding companies and their management but also having the discipline to back up the analysis with some kind of fundamental assessment and metric. We don’t invest in fads, fashions and stories. That’s speculation. Growth investing is more concrete. We try to understand the economic environment as it relates to industrial ecosystems. So it’s in this sense that the macro most often enters our calculations.
Look beyond sentiment
It’s undoubtedly been the case that there have been some significant factors playing out within the economic environments and industrial ecosystems of certain markets recently. Take the regulatory initiatives in China, which triggered such a shock on the markets. Here was a government prepared to stand up to the monopolistic power of companies in the online retail trade. That seemed like a foreign concept to many Western investors and yet, we ourselves have the same issues around market power in some industries. Our governments also espouse the same ideals of intervention in the market, rhetorically at least.
But despite the adverse sentiment these policies caused, they did not render China “uninvestable’’ as some have claimed. It simply required an understanding of the motivations behind the government’s actions and a realization that there were other companies that might benefit from having a more level playing field or open architecture in the online retail space.
Similarly, the approach to regulation in the educational and health-care sectors in China was around trying to provide broader access for lower income families. Although there may have been some missteps and misunderstanding about how the price system would react to regulation, we have emerged with a rational market where low-cost providers will grab market share and highly innovative businesses will be allowed a certain amount of time to reap quasi-monopolistic profits in order to encourage continued research and development.
Staying with Asia, while China is a managed, growth economy with developed regulatory oversight, there are other markets that are struggling with the earlier stages of development and have very different environments and ecosystems. They’re figuring out how to build the appropriate infrastructure, and how to meet the challenge of creating a strong manufacturing base and if in fact that is still the best way to raise wages and living standards. Some have been more successful than others. We’ve always been complimentary about the advances Vietnam has made, for instance. On the other hand, we’ve tended to be skeptical that India could achieve the kind of progress in these areas that other less democratic regimes have achieved—at least at the pace they have achieved them. Now, however, India appears to be moving in the right direction.
And then there are the developed economies of North Asia. They are at another level of development stage having bred their own global champions, most notably in electronics and technology hardware. Their economies are more export-led and right now more exposed to the adverse sentiment building over slowing growth and the prospect of recession in the West.
Added value in Latin America
Looking across to Latin America, commodity price-inflation is usually seen to be a boon. It’s often a big reason for speculators to trade these markets. But while these countries are indeed resource rich, this strength can be a vulnerability and at times like these they can become caricatures. A rise in commodity prices will lift stocks but the subsequent fall in commodities will usually see these markets relegated to the sidelines once more.
But these caricatures are just that. The economies of Latin America are much more varied than this. One way to access their growth—and this apples to other areas of emerging markets too—is through investment in local banks. Their banking systems are often much more commercially run than one sees in Asia, particularly North Asia. It’s probably true that emerging market banks have benefitted perhaps even more than commodity producers in this inflationary episode and period of steepening of global yield curves.
Additionally, the opening up of Latin American economies to tourism as the pandemic subsides should be a further boost. We can access this growth directly through consumer businesses but also through travel infrastructures such as airports, which are often interesting businesses in that they are mini monopolies! And beyond the immediate beneficiaries of the return to normalcy, there are interesting franchises in the health-care sector, where we can invest for secular growth as societies both age and get wealthier.
So it would be wrong to buy into the caricature of emerging markets as inflationary trades. Even if inflation does subside quickly, there is much value to be had in Latin America, value that has only been increased by the recent strength of the U.S. dollar.
Business not inflation
If we stand back for a moment—while markets continue to fixate on the pressing problem of inflation in the U.S. economy and how the central banks will respond—we see that many emerging market economies are treading a relatively normal path. There’s no reason why these economies shouldn’t keep making advances in their own ways in terms of productivity, innovation and growth. Granted, some central banks around the world are hiking but not at the magnitude of the Fed. And those markets with large, strong domestic economies can mitigate slowing overseas consumer demand and the prospect of recession in Europe and the U.S. China’s counter-cyclical monetary stance even puts it in a position to inject stimulus and demand into its economy.
There are headwinds to be sure. China’s zero-COVID policy has hit the economy and sentiment much harder than I would have thought. And dollar strength has always been a problem for emerging markets. But at some point a strong dollar starts to make foreign purchases attractive and emerging market valuations are already relatively low compared to global peers.
We would contend that much like the magician’s sleight of hand that deceives the audience, investors in the West have been focused on inflation just as emerging markets companies have been focused on their businesses. And it is companies that we have been focused on—not rising prices. For what it is worth, I think inflation is peaking and the Fed is likely too tight than too loose. But in any case, we try to find the companies that can best navigate the future whatever the rate of increase in prices or whether or not the West enters recession.
Robert Horrocks, PhD
Chief Investment Officer