During Q2 2023 the fund outperformed the MSCI Emerging Markets index by 5.3%.
The largest contribution by some margin came from Brazil this quarter, confirming the market’s status as a high beta play. China also contributed positively relative to the index, with our positions outperforming. Korea, the UAE, Taiwan and some smaller markets also performed well. The largest drag relative to the index was India where we still have no direct exposure. During the quarter we have been adding to China, particularly to some of the larger internet companies. We also rotated some of the Brazilian portfolio and added further to the UAE. This was funded by trimming some of our commodity and energy exposures in Latin America alongside slightly reducing our Taiwanese overweight into AI driven strength.
Potential investors sometimes ask us, “Aren’t Emerging Markets all about growth? Why would you want to be a value investor?”, which is reasonable given the expected GDP catch-up that should in theory provide a tailwind to our companies.
Successful quality and growth investing are actually just a subset of value investing. We agree that high quality stocks with high growth prospects deserve a premium valuation: quality stocks because they are less risky and therefore enjoy a lower cost of capital and discount rate; growth stocks because of larger expected future cashflows.
North of South’s approach deals with both the challenge of determining how high this premium should be and ensuring we do not overpay for these great businesses, as if you overpay, you will do worse than the market since eventually valuations converge towards fair value.
Our tailored multi-factor cost of capital approach penalizes lower quality companies, operating in riskier countries with a higher cost of capital, meaning we are not willing to pay up for those businesses. Additionally, our valuation models always assume long term growth rates fade towards zero in real terms, meaning we cannot get carried away by highly uncertain distant growth prospects.
Demonstrably, many high growth stocks have provided very high returns and beaten the market over the years, actually reflecting a successful value investment. Many of these were originally undervalued given their quality and growth prospects at the time, whereas many others are a function of survivorship bias. Typically, these companies with then unproven business models ended up being successful, their high returns compensating for the other promising upstarts that failed. Overpaying for these stocks is very easy, evident in a series of high-profile futuristic growth stock ETFs in the US which overpaid for portfolios of unproven companies, generating huge losses for investors.
Coming back to Emerging Markets, the five largest active global EM funds focussed on growth manage US$165bn in AuM, compared to $45bn for the largest value funds. With such an imbalance of buyers, you expect growth stocks to be overvalued as a scarce commodity, making it difficult for growth investors to outperform. For value investors, there is far less competition to own attractively valued stocks that do not appear to have the desired levels of growth. Thankfully, this makes our job easier.
