During January the fund outperformed the MSCI Emerging Markets by 3.6%.
The largest country contribution to relative performance was from India, where we have no exposure due to high valuations. Most markets where we are invested saw a strong rally during the month, led by Korea, Taiwan, Indonesia and Mexico. Stock selection was also a significant contributing factor, for example in China where it compensated for the modest underweight we still have.
During the month we continued to manage down exposure in Brazil while adding new ideas in China. We remain cautious on the structural issues facing the latter market but are still able to find deeply discounted stocks that should benefit from domestic growth drivers.
Unsurprisingly, as value investors, we constantly find ourselves repeating the mantra that valuations matter. This may not be obvious in the short term when momentum or catchy narratives (this newsletter has not been written by ChatGPT) may seem to drive asset prices. It is however incontrovertible that the price we pay for an asset will determine the returns on that investment, regardless of how wonderful it is. Imagine you were provided with a crystal ball at the end of 2001, about half way through a major bear market. You could buy shares in a very profitable US blue chip tech company that had more than halved from the peak. You were told it would build on its near monopolistic position to grow sales by double-digits every single year and more than double profits by 2007 with ROEs reaching 40%. You would then sell it at the next peak of the US equity market (September 2007, S&P500 returned +50% over the period). Would this investment have made you money? The company is Microsoft and the answer is no. Of course the question omits a key item – your starting valuation
was too high. Even though the business performed really well over the coming years, it still did not perform well enough to justify the price you paid for it in 2001.
While we cannot calculate it with certainty, every stock has an intrinsic and finite “fair value” – the sum of its future (unknown) cash flows discounted by an (uncertain) appropriate cost of capital. The market’s estimate of that figure will oscillate around the true number, sometimes significantly over- or under- shooting it. As there is a zero bound to valuations but no limit on the upside, the market can get overvalued by far more than it can be undervalued. Given the enormous uncertainties involved (which grow exponentially the further we try to peer into the future), a prudent investor should err on the side of caution and only buy assets whose “fair value” is likely to be higher than their market price under most future scenarios.
This is why we wrote in September that the expensive Indian stock market was risky. There were some plausible paths to justifying the historically high valuations in the market as “fair value” but the investor had to hope for a series of fortunate outcomes. We wrote about Adani Transmission trading on 330x earnings as representative of a broader valuation bubble. Since then the stock has collapsed by 67%, aided by short seller reports, but remains on over 100x earnings. The Indian market has underperformed the rest of our universe by a large margin too, but remains well above historic valuations. We are watching with interest but still find much more attractive opportunities in other markets with better odds.
