Where are the investment risks and opportunities in emerging markets?

How did your portfolio fare through last year’s volatility?

2020 was clearly a tough year, but it was a year that worked broadly in our favour. The high-quality businesses that we have invested in tended to do well. One of the things we did while markets were reacting really negatively to the early stages of the pandemic was to stress test all the positions in our portfolio. We had learned some valuable lessons during the global financial crisis in 2008. We did not want to have to take difficult decisions at market extremes, but we knew we had to do the due diligence and stress test every single position to identify any companies that we thought would not survive. The stress tests were severe, cutting revenues by 30%, 50% and more, then forecasting out for a number of quarters to see how many of these companies would survive. The conclusion we drew was that most of our companies would not only survive but would actually thrive coming out of pandemic because they would be the ones left standing.

So, we knew we had a good hand. We did not have to make any changes. Then, the key was to be patient, which is often the hardest thing to do in our business. As a firm, the experiences of 1999 and 2008 helped us to navigate that. But in summary, the high-quality businesses that we owned did well last year, and that is what enabled us to deliver the kind of performance we did, and we’re extremely grateful for that.

What themes have been successful in your portfolio?

Last year we saw an acceleration of some of the themes we have been invested in for a while, such as the digitisation of corporate networks and the transition to accessing all sorts of services online. Regarding the first of these, we are all working from home and I expect we will continue to do so even after lockdowns have ended. There are some permanent changes to working practices. When we go back to work it will be a mix of working on site and working from home. People are questioning why they need to commute when they can deliver the same output remotely. So, I think there will be some permanent changes, but there are some interesting companies that have enabled corporations to get to this point.

Meanwhile, by some estimates, the adoption of ecommerce has been accelerated by between five and seven years in some parts of the world. Mercado Libre is a stock that we’ve owned for a number of years. It is the leading ecommerce provider in Latin America with 55% of its revenues coming from Brazil. It has been reporting revenue growth in excess of 100%, so that’s a trend that definitely benefited the portfolio. These are trends that will not reverse. Once people taste convenience and progress, it is hard to put the genie back in the bottle.

What do you think is the biggest threat to the portfolio in the short and medium term?

In emerging markets, the biggest risk is always geopolitics. An important question that hasn’t been completely answered is, what will China’s relationship with the rest of world – not just the US – look like? We have to consider the implications of the adjustments to global supply chains that are occurring. Part of this is a function of COVID. Governments and nations have realised that their supply chains cannot be as stretched as they were. The reliance on foreign countries to deliver product is something that will be re-examined. For example, President Biden last week passed a resolution saying that the US is going to examine its supply chain in areas such as pharmaceuticals, railroads and semiconductors. Meanwhile, China has been very vocal about its quest to achieve independence in semiconductors for the last couple of years. It has put things in place to achieve that goal. So, I think this is a shift that is going to occur. There will be more on-shoring or near-shoring by a number of countries.

You’ve talked before about how you see semiconductors as the new oil – can you explain what you mean by that?

It almost sounds like we’ve made a mistake in making that statement, because unlike oil, which is a finite commodity, you can keep building semiconductors provided you have access to the technology. But it’s worth stepping back and explaining why semiconductors are important.

Modern technology permeates every aspect of our life, whether it’s e-commerce, telemedicine, distance learning, or working from home and accessing all our professional resources remotely. All of this activity is processed through tiny silicon semiconductor devices.

Fifty years ago, the key factor of production was oil and everybody wanted to secure access to it. The choke point was the Strait of Hormuz in the Persian Gulf, which explains why oil was the source of so much geopolitical tension in the Middle East.

Today, the factor of production that is becoming increasingly important is access to semiconductors because, no matter what you do, it all ultimately gets implemented in silicon. Over the last fifteen years, we have seen a shift in the manufacturing of semiconductors from the West to the East, primarily led by Taiwan Semiconductors (TSMC) and Samsung. Six months ago, Intel announced that it is now effectively two technological generations behind TSMC. So, suddenly the choke point for the key factor of production is controlled by one island, Taiwan. It has shifted from the Persian Gulf to the South China Sea. This is a challenge that the world hasn’t yet fully appreciated.

Now, TSMC recognises this, which is why it is spending about $12bn to build a foundry in the US. It knows it is a geopolitical pawn that everybody is going to be talking about. China wants access to it. The US wants access to it. What does this mean for the world order? This is what we mean when we say semiconductors have become the new oil. It is the key factor of production for the modern economy. Everything grinds to a halt if you don’t have access to it. That means access to the people who make the picks and shovels as well as the devices themselves. It isn’t completely clear how all this will play out, but we think it presents opportunities as well as challenges.

How do you integrate ESG factors into your approach?

This is a challenge in all emerging markets, and it is one of the more important aspects that we must pay attention to. We must try and discern the behaviour of management teams over and above what is represented in their financial reports. Yes, management can deliver earnings, but we need to pay close attention to how they engage with all their stakeholders – whether it’s employees, suppliers, customers, how well do they treat all of them?

We have to investigate how companies adhere to strict standards of accounting and corporate governance. Standard practices vary from country to country. For example, insider trading is not frowned upon in some countries. We have had examples of companies where the CEO has engaged in insider trading on a stock. We sold the stock as a result, even though the underlying business was great. The company didn’t view that behaviour as wrong, because it was seen as par for the course. These are things that happen in emerging markets, but we take a dim view of behaviour like that.

Probably the most important things that we can do in emerging markets is pay attention to the balance sheet and focus on ESG aspects. We recognise that do we have to be careful, however. We can’t apply a strict Western lens. For instance, we can’t mandate that companies in Indonesia or India follow the same environmental standards as a company in the US, because it would be cost prohibitive.

Has COVID-19 changed the world forever?

I think the way we approach work has changed permanently. So, exposure to commercial real estate, and things tied to it, will perhaps have to be re-examined, because we don’t know what capacity utilisation will look like for office buildings when everything opens up.

Will travel come back? Ultimately, I expect travel to fully recover but the slope of that upward trend is unclear. A number of tourist destinations have also had to re-examine their approach. For example, where tourism was the main source of revenues, economies have seen a huge economic hit, but they’ve also seen the benefits of low levels of tourism. Only time will tell how far they will be willing to re-open their economies to tourism in the future. I think there will be some fundamental shifts.

How is the vaccination rollout progressing in emerging markets and what does it mean for growth?

Unfortunately, most emerging market countries have had to face really hard decisions. Countries like India, where our portfolio has significant exposure, have had to make the tough choice between losing lives as a result of COVID or because of a lack of livelihood. That is a gut-wrenching decision that governments should not have to make, but they have had to.

So, some economies have been opened before vaccines have been rolled out. Clearly, there is a significant risk attached to this policy decision but, if you look at the high frequency indicators of economic activity, you’ll see a significant uptick in things like consumption and auto sales. From a company fundamentals perspective, we are approaching the end of the reporting season, covering the last quarter of 2020. A number of companies are reporting sales and earnings above pre-pandemic levels, because they are now benefiting from a good degree of pent-up demand.

With vaccines being rolled out, things should only get better from this point. But even today, when looking across our key markets, we’re actually reasonably confident that things are moving along pretty well.

Wasatch advisers is a fund manager for St. James's Place.

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