MASTERCLASS: Disruption in International Investing - November 2017

Disruptive innovation is becoming a catalyst for increased productivity and economic growth. Although disruption often carries a negative connotation on Wall Street, it also presents a tremendous opportunity for investors. What is the definition of disruption, how is the current macro picture impacting the markets, and what kind of due diligence helps investors get on the right side of disruption? Asset TV’s Gillian Kemmerer spoke with financial experts from Thornburg Investment Management about disruptions within emerging markets, China, Europe, and ESG Investing.

  • Greg Dunn — Portfolio Manager at Thornburg Investment Management
  • Di Zhou — Portfolio Manager at Thornburg Investment Management
  • Ben Kirby — Portfolio Manager at Thornburg Investment Management
  • Rolf Kelly — Portfolio Manager at Thornburg Investment Management

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  • 56 mins 06 secs
Gillian: Welcome to Asset TV, I’m Gillian Kemmerer. The term ‘disruption’ often comes with negative connotations on Wall Street, whether it conjures images of volatility or a market correction, the word is one that many investors fear. Today four experts from Thornberg Investment Management will help us analyze global disruption from a different angle, one of innovation progress, an investment opportunity. Welcome to the Thornberg Exclusive Masterclass on international investing, poised for disruption. Thank you all so much for joining us here today. So we have an opportunity to go around the world and look at disruption. But, Greg, I’m going to start with you, can, from a very high level you give us a picture of what you’re looking at, at the world right now, what’s the macro picture right now?

Greg Dunn: [0:00:41] Yeah. I think, you know, one of the areas we’re paying attention to is Europe. And we’ve seen a nice resurgence in growth in Europe. So it’s been kind of a gradual pick up in growth, kind of a healthy pick up and a slight acceleration of GDP growth with unemployment continuing to come down, but without experiencing any wage pressure. So we think that kind of gives the economies in Europe room to continue to expand. And that’s leading to more opportunities on a stock level.

Gillian: [0:01:11] I don’t know if it’s a surprising story or not, but I feel like when we were looking at Brexit just a little over a year ago, we were thinking to ourselves is Europe really going to be the outperformer. But it’s turned out to be the one that I’ve heard maybe pitched the most this year.

Greg Dunn: [0:01:23] Yeah. You know, it really has worked out that way. And I think, you know, Brexit raised a lot of fears. But the reality of it is it’s taking a long time to happen, to be executed and it’s very complicated. And you know, what we’re seeing in Europe is, you know, what they have done with stimulus there is finally starting to have some effect. And they came to stimulus a few years after the US did. So they seem to be a few years behind the US in terms of the impact and starting to see that stimulate some growth. We still don’t have any inflation there, but the employment picture is getting better; the GDP growth picture is getting better. And we think there’s room to go there.

Gillian: [0:02:04] Okay. So Europe is looking good. Rolf, what about you, what do you see?

Rolf Kelly: [0:02:10] Focused a lot on the ESG trends around the world. So it’s a picture of growing interest from investors, a great acceleration of investment dollars flowing into that area. And then, you know, basically we’re taking a few different material factors, we’re finding in the ESG space to help us find better investments out there.

Gillian: [0:02:34] Now, ESG must be an interesting area to be focused on given the political climate. Do you find that investors are now increasingly voting with their wallets for example?

Rolf Kelly: [0:02:44] I guess I don’t have direct link or experience to that. But there is talk of that and with our clients there is frustration out there with the … where things have gone politically. And I do think a lot of those people are saying, “Well, if I can’t make a difference politically because these people don’t represent me, then I’m going to put my dollars where I think I can make an impact.”

Gillian: [0:03:08] Sure. Di, how do you see the world right now?

Di Zhou: [0:03:11] We definitely see the same way as Greg was saying in Europe. But if we look, you know, Asia’s perspective, say even for example, China compared to a year ago now China growth has stabilized. And we also see industrial companies’ revenue and margin has rebounded, and that even sort of the bank MPL formation has also slowed, right. So that has a lot to do with little bit pick up from demand side of, you know, coming from property and investments and also, you know, the SOE reform reducing excess supply, excess capacity really helped the SOE’s profitability. And going forward we think SOE reform will continue to help profitability and corporate earnings in the future.

Gillian: [0:04:02] And it’s interesting because in Europe last year was dominated by talks of Brexit and the picture has gotten rosier. I think last year we were talking a lot about Chinese debt but it appears that things have picked up.

Di Zhou: [0:04:11] Right, yeah, much more stabilized.

Gillian: [0:04:13] Perfect. And, Ben, last but not least, what do you see in emerging markets right now?

Ben Kirby: [0:04:17] Well, some emerging markets have been the best asset class for the past couple of years and they’re up about 65% from the bottom. What’s interesting is that from 2013 to 2015 outflows were about $150 billion from active and passive investors. And there’s been about 50 billion of inflows back into emerging markets. So roughly a third of the money that went out has come back into the emerging markets. So there’s potentially still room for investors to come back to the emerging markets. And similar to what we see in Europe, you know, we’re seeing a synchronized global expansion for the first time since the financial crisis. So many of the emerging market countries are on a different part of the economic cycle than the US, so the US is fairly late cycle, unemployment is low, wage pressure is probably likely to start building, many of the emerging markets are actually coming out of recession. So Brazil was in a recession of 15 and 16, Russia was in a recession of 15 and 16. And as they come out of recession they can actually grow above trend for a few more years. So we see pretty robust economic growth coming out of the emerging markets right now. And investors are still underweight, so emerging markets are half of global GDP and about 10% of global investor portfolios.

Gillian: [0:05:31] So a large divergence. Would you say that what you see coming down the pipeline in emerging markets is synonymous with political stability? Do you see, you know, increased stability in places like Brazil or Russia?

Ben Kirby: [0:05:41] And so each emerging markets are certainly a little bit different. Brazil seems to be on a path of reform and structural improvements. But that can be derailed at any moment in time. And Russia is Russia, so Putin remains firmly in control.

Di Zhou: [0:06:03] So I was in Brazil about six weeks ago, [inaudible] made the best comment. He said, “In Brazil we don’t have much natural disasters, only [inaudible] politicians.”

Gillian: [0:06:16] That’s fair, that’s certainly dominated the headlines, at least since the Olympics. I think one that I heard from someone in Brazil last year was, “Brazil’s the country of the future and it always will be.” So let’s talk a little bit about this theme of disruption. It’s a word that is really loaded with a lot of emotion and feelings, especially from investors. So I think, Ben, I’m going to start with you. When you think about the word disruption in financial markets, how do you define it?

Ben Kirby: [0:06:41] So I think creative disruption is a critical part of capital formation and over capitalist economies. So it’s flushing out the less efficient companies and replacing them with more efficient companies that can do more with less and typically provide value to consumers in the process. So in [inaudible] disruption you want to be on the right side of disruption from an investor standpoint. But they can be some of the best investment opportunities out there as those companies can often have secular or multi or growth opportunities that they’re taking market share from entrenched and established players.

Gillian: [0:07:14] Okay. So a positive in fact, Rolf, when you think about disruption, is it a positive or a negative word in your mind?

Rolf Kelly: [0:07:21] It depends if you own the companies that are being disrupted then, you know, if you happen to own the ones that are doing the disrupting then they can be very positive. The challenge is usually the companies that are doing the disrupting are very expensive. So if there … a lot of times excitement can build behind those companies. And then they may stumble or not have as big an impact as investors are expecting. And then you can end up losing a lot of money there too. So it can be challenging from an investment perspective.

Gillian: [0:07:57] Okay, Greg, how do you define disruption?

Greg Dunn: [0:07:59] Well, as a growth investor I love disruption. I love innovation driven disruption. I love if there’s secular drivers there that are driving that disruption. So it’s not purely company specific, but there’s something going on in the world that’s driving that. And that’s, you know, one of the things that we look for is secular driven disruptive patterns.

Gillian: [0:08:22] Okay. So secular driven disruption is something that we’re looking for, Di, how do you think about it?

Di Zhou: [0:08:26] Maybe just another way to think about disruption is in developed countries we might have say traditional business models and disruption could replace those business models. But if we move that to another market, say emerging market, they might not have existing, you know, business models, infrastructure already will be disrupted. So it will be just sort of leapfrogging that part of the business that we have in the developed market. So it’s very interesting, maybe we just kind of, you know, leapfrog over and they grow into something much bigger.

Gillian: [0:09:03] That’s a good point. So in some economies what maybe look like disruption here in the US is actually disruption that’s creating some of [inaudible]?

Di Zhou: [0:09:09] Exactly. Just meeting that demand.

Ben Kirby: [0:09:12] Yeah, and skipping an infrastructure step, you know, so if you think about telecom in emerging markets, they maybe never had a great wire line telecom system and they kind of skip that. And now they have great mobile. So it’s, you know, I think that’s something that you maybe don’t think about as disruption just because you’re leapfrogging that step of infrastructure.

Gillian: [0:09:37] Now, it’s interesting, Rolf, I want to come back to a point that you made, it’s a lot about being on the right side of disruption. So it will be interesting to hear a bit more about how you make decisions to figure out how to be on that right side and how you do due diligence on these types of opportunities.

Rolf Kelly: [0:09:53] I guess that’s where we just get down in the weeds and start digging and researching. And I think a lot of our work is done with the companies. So we’ll sit down with the companies and try to put together a mosaic of what things look like and determine which companies we want to back and which ones we want to stay clear of.

Gregg Dunn: [0:10:12] Yeah. And I think, you know, one of the things you want to do, especially when you’re thinking about disruption is looking at the big picture and thinking pretty long term. Because like Rolf said, in the early stages there’s a lot of growth but their evaluations can be very high as these trends are just starting. So it’s a risk because evaluations are high. But it’s also, you know, not necessarily a reason not to own these things, that may look expensive now, but when you think about it on a 5, 10, 15 year basis, all of a sudden that earnings potential out in the future can justify a high multiple today.

Gillian: [0:10:56] Yeah. So often we think about disruption in terms of the short term pain, but long term it could absolutely revolutionize an industry. And, Di, how do you think about getting on the right side of disruption?

Di Zhou: [0:11:05] So I think again, this goes back to really to the fundamental bottom up research and really compare to think about the long term potential versus evaluation. And be a long term investor, so we do have the luxury to be able to see longer term. And then, you know, if we can get comfortable with the bigger price out there and get into at the right valuation we’re happy to hold it for multiyear.

Gillian: [0:11:36] So timing is everything in these types of cases. And then, last but not least, Ben, how do you think about it?

Ben Kirby: [0:11:40] Yeah. I think a lot has to do with the business model of the company who’s doing the disrupting. So if it’s a business model that they’re able to generate high entry barriers or they have a recurring revenue business, or it’s a winner take all or a winner take most markets, then many times those can be the disruptive companies that have staying power. A disruptive company that’s just, you know, cutting costs or doing something marginally different they can themselves then be disrupted in a few years. But a company with a wide moat can have much more staying power. And you can feel more comfortable paying the higher multiple if you believe they can hold the market after they penetrated.

Gillian: [0:12:19] Excellent. So we’ve talked a bit about being on the right side of disruption, obviously that’s key, but if you are looking at the magnitude of that disruption and whether or not perhaps it’s a totally new entry point into a market, really interesting things to consider. So now that we’ve given a high level point of view on disruption, I’d really like to dive into each of your areas of expertise. So we’ll go region or in your case, Rolf, we’ll talk about ESG overall, and then afterward I want to talk about specific disruptors you see in each of these regions or sectors. So, I think, Di, I’m going to start off with you. We’ve been talking a lot about China, so let’s start with the growth picture. You mentioned that it was a little troubling earlier, let’s say last year, we saw slowing growth, falling corporate revenue. Has that overturned? And if it has, tell us a little bit about some of the drivers, more in depth.

Di Zhou: [0:13:02] Sure. So I think one thing we have been seeing this year in 2017 is the corporate revenue and margin rebounded. And that’s because of a couple of things. One is modest demand coming from property investments. And also really the supply side reform, the SOE reform we talked about. And we do see that excess capacity in those sectors, especially very troubled steel and coal sectors. And as a result we saw margins starting coming back and really help profitability of those companies. And going forward, especially after the 19th People’s Congress in the next week, we think there’s probably going to be more SOE reform initiative coming out. We can think about in the area like more mixed ownership reform, IPO in some of the companies, inviting private investment coming in to those companies and increased employee, share ownership. And also divestitures and if we think about the goal of SOE reform in China, it’s really to make those companies more efficient, right. So make them more efficient and be disciplined about cost, be disciplined about investment, reducing waste, reducing corruption and make them more competitive in the domestic and also global markets.

Gillian: [0:14:39] Now, it’s interesting timing of course because the party congress that you just referred to kicked off this morning, Xi Jinping addressing the public. What are some of the expectations you have coming out of this? You said SOE reform, are you expecting any further thoughts on China’s growth for example, moving forward?

Di Zhou: [0:14:52] So again he just opened up the congress last night. So the initial talks interestingly did not mention a growth target, right. So which means maybe the Chinese government a little bit more relaxed, the growth target per se, you know, very different from the previous years we’ve been seeing. And what we’re expecting, we’re probably still expecting more consolidation of power on his side and more towards reforms, not only SOE reforms, probably more financial reforms, [inaudible] reform, all that sort of reform initiative trying to rejuvenate the economy.

Gillian: [0:15:35] Are you at all concerned about the debt to GDP ratio? Or would you say that this is a conversation that we should put to bed finally?

Di Zhou: [0:15:42] Well, I think marginally it’s much more better spot we are today than even say a year ago, just because some of the results coming out of the SOE reform.

Gillian: [0:15:54] Now, broadening out and looking at the region, I think we’d be remiss not to talk a bit about North Korea, obviously it’s dominated the headlines here. What’s a potential scenario you see playing out? What’s a probable trajectory moving forward? I’ve heard some say that they didn’t think the Chinese government would think about North Korea until this party congress was over. But it’s soon to be over, so what can we expect?

Di Zhou: [0:16:12] So there is clearly there are a lot of rhetoric about it. And the US want China to do more about Korea. But as much as China wanting to control North Koreans weapon development program, but they are also concerned about refugee problems, especially the refugees coming to the northeast region of China, which the GDP growth is not as high as sort of the coastal cities. So there is a grand bargaining scenario which sort of involves South Korea, Japan, China and the US all work together, we unify North and South Korea. And therefore Japan will not be worried about North Korea developing nuclear weapons, so they don’t have to give up their own nuclear weapons. And China might be able to get US to drop their satellite program in South Korea, and therefore more incentivized to do that. So clearly we’re still far from that scenario. Things probably need to get worse and it will still need to take time to work that through, but there is a potential grand bargaining scenario for everybody to work together to solve that problem.

Gillian: [0:17:30] I was going to say it’s going to require quite a bit of compromise on our side. So it may have to intensify in order to bring them to the table. It’s interesting. So now I would like to move over to Europe with you Greg. And we’ve already touched on it a bit. But what’s driving some of the strong fundamentals in Europe right now? I think a year ago we were looking at it as one of the most politically fragmented pictures we could imagine.

Greg Dunn: [0:17:50] Yeah. It’s just I think a big part of it is just the nature of this recovery. And it’s just been a long cycle. And I think it’s just gradually gotten a little bit better. There’s higher employment. The consumers are in a better place. And it’s just been a number of things that have kind of come along. And some of the political turmoil has died down; Greece is very much in the rearview mirror. You had the political outcome in France was not as disruptive as some had feared. And there’s problems in Spain right now, but it doesn’t appear like that’s going to lead to some kind of contagion that spreads across the region. So they’re in an okay spot. And when we’re talking about disruption, when the consumers are in a little bit of a better spot than these kinds of disruptive secular trends that are happening, really have a chance to shine in an environment like that. So you know, we’re not talking about 4% GDP growth in Europe, we’re talking about 2. But when you’re talking about some of the areas that are being disrupted, the growth rates are much higher there.

Gillian: [0:19:07] Now, so we’re still seeing, to some degree, some political disruption in Europe, but nothing that’s impacting just the larger economic story?

Greg Dunn: [0:19:14] Not at the moment, yeah.

Gillian: [0:19:16] We’re waiting on a big ECB decision, anything you’re expecting to see there?

Greg Dunn: [0:19:20] They’ll start to taper. So the timing of that we’ll see. It’s been expected that it’ll be some time at the beginning of next year. Inflation has remained low so maybe they’ll delay that a bit. But you know, we’ve been through that in the US, and it didn’t derail growth. So I think there can be some expectation that they can manage through that tapering process and remove some of that stimulus and not derail the economies.

Gillian: [0:19:50] Now, much in the way that Ben alluded to earlier, that you can’t look at emerging markets as a block, obviously every country is different. When you look at Europe as a whole, do you feel the need to break out country by country or do you find that the positive trend is really pervasive across the continent?

Greg Dunn: [0:20:05] Well, as Ben mentioned we’re kind of seeing the synchronized global growth. And you see that across countries in Europe. And for us we really take a stock specific approach. So we don’t necessarily look country by country, we’re looking stock by stock. And for most of the companies that we own in Europe, they’re operating across the region. So they aren’t driven by just the German economy or the French economy or the Spanish economy. So that’s kind of the way we approach it.

Gillian: [0:20:33] I feel like earlier this year when I had portfolio managers in, the big refrain was Europe looks so cheap right now, so cheap compared to the United States. Is it still cheap compared to the US? And if so, kind of are we coming to a convergence?

Greg Dunn: [0:20:46] The gap in valuation between Europe and the United States really hasn’t changed over the last year. So Europe has outperformed. But it’s outperformed because earnings have been stronger, stronger than expected and stronger than the US. So you know, we haven’t seen, you know, it’s still at a discount to the US at about the same gap as it has been over the last several years. So I think there’s still room and there’s still opportunities to say, yeah, it looks cheap.

Gillian: [0:21:16] And of course we won’t have the outcome of Brexit until March of 2019. But when you talk about this…

Greg Dunn: [0:21:21] Or 20 or 21, who knows, yes.

Gillian: [0:21:23] Or never. But when we think about Europe as a whole are you counting the UK into this discussion or are you looking at them separately in terms of an economic outlook?

Greg Dunn: [0:21:32] We’re thinking about them separately. And, you know, the consumer in the UK is under a bit of pressure now. And, you know, the UK economy recovered at a faster rate than
Europe, more on the pace with the US. So they have been farther along. But there’s pressure there and it’s a result of the uncertainty around Brexit. So that’s a risk and a concern for us.

Gillian: [0:21:54] And of course the pound absolutely going through the floor I’m sure has resulted in some interesting inflationary picture there.

Greg Dunn: [0:21:59] Yeah. And that’s stabilized and actually recovered some. But that’s a risk too. So depending on how Brexit works out, you could see another step down if it ends up being a hard Brexit.

Gillian: [0:22:12] Okay. I’m going to move over to emerging markets and sort of around the world tour. So, Ben, coming back to you, you’ve already alluded to it, emerging markets have outperformed on virtually every measure this year, including the currencies. I think last time I checked, every EM currency was up this year. Does the picture still look good or are we slowing down?

Ben Kirby: [0:22:30] I think it has a lot to do with China. So China is about a third of the Emerging Market index. But it’s actually even more important than that because they are commodity importers. So they have trade channels with Southeast Asia, trade channels with Latin America. So the Chinese influence on emerging market growth is pervasive, it’s a huge influence. So stability in China is a huge deal for the emerging markets. If you can have China growing steadily or even slowing a little bit or even having a soft landing, then the emerging markets can continue to outgrow developed markets. So we see that continuing to happen. One thing that Di alluded to that I think is interesting is the supply side reform that China did in the past couple of years. So they had many industries in excess capacity. So steel, coal, aluminum, and they were producing more than was necessary. So they were flooding the market, prices were too low, that puts pressure on Indonesia, puts pressure on Brazil, it puts pressure on Chile. And then as they started to shutter some of that excess production then the prices go up. So that helps China because their MPL problem for the banking sector starts to look better. And it helps the rest of the emerging markets because there is a general inflation in commodity prices.
So those are all positive trends that are still continuing. I think it’ll have a lot to do with, going forward with a direction of growth and slowdown that China chooses. They have with the centralized government, the centralized planning they have the ability to slow growth or to accelerate growth a little bit. We’d like to see them slow it and not continue trying to grow at high 6s. We’d like to see them slow to a more sustainable rate. If they do, I actually think that’s good for a sustainability standpoint and it takes a lot of the tail risk off the table. If China keeps trying to grow at 6½ or 7%, then we’re going to worry about debt build up and we’re going to worry about the debt problem that you mentioned, MPLs eventually ballooning and causing some sort of a financial crisis. If they slow their growth they can gradually move towards 5% or 4% and they can do that for, you know, we think many more years.

Di Zhou: [0:24:45] Right. And less dependent on property or infrastructure investment and more organic growth.

Gillian: [0:24:50] Now, the whole world seems to be very sensitive to the growth rate in China. I mean even if you just look at small technical movements they make in the currency, it makes headline news all over the world. If they slowed do you see any kind of ensuing panic from that or do you think emerging markets will absorb that slowdown pretty well?

Ben Kirby: [0:25:04] I think we’d like to see the slowdown. I think the renminbi has actually been appreciating. So the big concern in 2015 was they’re going to devalue by 20%. Actually the currency has been appreciating versus the dollar and versus their trade partners. So that’s also a signal and a symptom of capital is wanting to flow back into China right now, not flow out of China.

Gillian: [0:25:24] So assuming that continued rosy picture for emerging markets, even if it slows down a little bit, which it has room to, what are some of the risks that we need to consider on the flipside? And how do you approach them?

Ben Kirby: [0:25:35] So I think one of the risks is definitely US monetary policy. So global liquidity conditions, the US is one factor in that. But if the ECB is tightening and the US is tightening, Japan is continuing to print money and aggregate if you get higher liquidity that tends to suck capital out of the emerging markets. And that can create, that can deflate multiples for stocks and it can create potentially, I wouldn’t say a panic, but if it gets severe enough then it could create a panic. In general when the US is raising rates, emerging markets tend to outperform because that’s symptomatic of a strong economy. So the US is a big trading partner for emerging markets, if the US is raising rates that typically means our economy is doing well, it’s hot, it’s performing well. So there’s really two sides to that coin and we’re watching liquidity. We’re also watching just to make sure that the US continues to grow well and demand those emerging market imports.

Gillian: [0:26:34] And, Fed Governor, Jerome Powell was just speaking earlier this week saying that he thinks emerging markets are maybe better able to absorb this kind of change in monetary policy than they would have before.

Ben Kirby: [0:26:43] Yeah. Certainly emerging markets, they went through … they kind of had their crisis in … with the Taper Tantrum 2013 to 2015. Many emerging markets went into recession and in that process they slowed their loan growth. So some countries they were growing loans at 20% are now growing loans at 10% or even 5%. And as they’ve slowed their loan growth they’ve essentially elongated, we think the duration of their expansion.

Gillian: [0:27:14] Now, we mentioned this earlier but the US dollar has been weakened, emerging market currencies have been strengthening. If you see a strengthening of the US dollar does it change your outlook at all?

Ben Kirby: [0:27:24] That would be a negative. But I think that given how much strength we’ve had, we could see a bit of a pullback in emerging market currencies without derailing the story. If we see extreme dollar strength then that would be indicative of a risk off environment. And I would expect emerging markets to underperform if that happens.

Gillian: [0:27:42] Now, let’s talk a little bit about a specific emerging market that you like. And when we last spoke it was Russia, tell us a little bit about your thesis there.

Ben Kirby: [0:27:49] So I think Russia’s interesting. It’s clearly a contrarian investment at this point. Many investors are actually forbidden from buying Russia. There are sanctions on Russian assets, and it’s in the news. But that means that Russian stocks are really cheap. And just the fact that many investors simply can’t buy them, so Russia is a country that’s coming out of a recession. So again, the US is nine years into an expansion, Russia is one year into an expansion. So coming off the bottom, Russian margins are low, unemployment is high. There’s no inflationary pressure, in fact, inflation in Russia is falling pretty substantially, where the US is raising rates, Russia is reducing rates. So those are all tailwinds for growth. Russia is just at a different point in the cycle. And we think that coupled with really low valuations and the ability to grow above trend for a couple of years, Russia looks pretty attractive.

Gillian: [0:28:43] Now, the ruble story has often been an oil story, is this predicated on some strength in commodities moving forward?

Ben Kirby: [0:28:49] That would help, certainly Russia is highly correlated to oil and the ruble highly correlated to oil. The oil prices is fairly low today by historical standards. So although we can’t predict the oil price, we see that demand is growing. And many of the international oil companies have actually reduced their CapEx budget. So they’re spending less to explore for new oil by, in many cases, half, in some cases, two-thirds. They have cut their budgets dramatically, as oil was at a 100 down to 50, the international oil companies actually have more free cash generation today than they did when oil was at a 100 because they have reduced their spending to find new oil, so we have demand growing and we have supply not growing as much. So eventually, you know, that should support the oil price which is bullish for Russia.

Gillian: [0:29:37] Yeah, continued good news for Russia. Rolf, I’m going to move to you, last but not least, you’re talking about ESG investments. So I want to start off with just a basic definition. I feel like there’s so many terms and acronyms we throw around in this space. How do you define ESG investment and what’s your process?

Rolf Kelly: [0:29:52] Yeah, this is a good question. It’s kind of the Wild West out there right now in ESG. So I think different investors have different philosophies. And it’s just important to align yourself as a buyer of those products with their philosophy, like if you like what you’re hearing and you see that they’re following through and actually acting on what they’re saying they’re doing, then that’s a good manager for you. For us, we’re kind of slowly and methodically selecting different factors that we see as material and important to finding a better investment out there. And we feel that can help enhance the return of our portfolio and reduce the risk on the other side.

Gillian: [0:30:35] What are some of those factors you’re considering?

Rolf Kelly: [0:30:38] So on the environmental side it’s efficiency, efficiency of things like water and waste and energy, for example. And it makes sense, right; a company that’s more efficient with something that’s as expensive as water is today can outperform their peers.

Gillian: [0:30:56] So just this month we’ve seen obviously some political changes and I alluded to them earlier. But we saw a reversal of the carbon emissions, the kind of flagship ESG piece of legislation passed under the Obama Administration. Do you see any legislative or political headwinds coming into this space or do you think that those that are operating and let’s say on an environmentally sustainable platform will continue to do so?

Rolf Kelly: [0:31:19] I think that could be a near term, call it hiccup, but it’s nothing more than that, that these trends are firmly established. Basically from a global scale people are concerned and very concerned about things like climate change. And those trends are firmly entrenched. You see some backtracking in the US unfortunately, out of either ignorance or stupidity, I’d say. But globally the majority of countries have come out saying, “No, humans are having a strong impact on climate change. And we want to do something about it.”

Gillian: [0:32:05] So you’ve talked about the step back in the US. But something that really interested me when we last spoke was China and India’s role in this ESG space. Tell me a little bit more about that.

Rolf Kelly: [0:32:15] So they’re becoming powerhouses call it, like if you look at the number of electric vehicles sold globally, Chinese, I guess, companies and consumers are buying more electric vehicles than any other country in the world. And that’s things like buses, forklifts and even consumer vehicles.

Gillian: [0:32:38] Now, when we think about industrialization which is something that these great economies are going through, that often is synonymous with extra pollution. Do you find that as these countries industrialize they’re doing so more responsibly?

Rolf Kelly: [0:32:49] I think they have to be. And going back to one of Greg’s points, of leapfrogging, if they were to reach penetration rates, for example, in the US, I think there’s one combustion auto per human being living in the US today. And I think it’s one combustion vehicle for every six people in China, that if they were to reach the penetration levels of the US, most cities you wouldn’t be breathing very well and you have cancer problems and all sorts of health issues and environmental issues that would arise from that. So I guess we’re already seeing that. So they’re going to try to preempt that I think and really make it from a consumer standpoint, individuals would be getting behind it. And I think with the government pressure or adding to that you can see a great uptake in the number of vehicles, call it, purchased that are electric. And maybe a good example is a place like Norway where they … so their GDP per capita is one of the highest in the world. So basically they can afford electric vehicles. And the government’s really gotten behind pushing electric vehicles out there, which is funny because they’re one of the biggest oil producers. So it’s like the crack dealers not using their own product. But I think they’re almost at the point where 50% of vehicle purchases are electric and hybrid. And they have a government target now, 2025 I think it is that all vehicles purchased in Norway will be electric or hybrid.

Gillian: [0:34:36] I like the analogy you just used there, that’s a good one that I have to remember. One of the questions about ESG, I find that, at least traditionally and perhaps it’s changed now, there’s been this assumption that you have to trade impact for performance. Do you find that this is something that you consistently have to defend? And how do you usually explain it to investors in this space?

Rolf Kelly: [0:34:56] We do have to defend it. And I think there’s a few reasons for that which we could go into. But really you don’t have to trade off performance if doing it properly. Now, if you invest too evangelically and just trying to make an impact and say go fill your portfolio with solar companies. Then I think, yeah, you will underperform, you’ll blow up at some point. But if you do it responsibly and just look at integrating all the factors, not just environmental, look at the social and the governance side of things, at the same time keeping strict rigor on maintaining the financial aspects you’re looking at. Like Ben talking about barriers to entry, that’s critical. We haven’t made a solar investment in our fund because of that. You really don’t have much for barriers to entry in that industry. It’s tough to say who the champions are going to be in that space. And you have very little pricing power, in fact you have pricing deflation at the rate of call it 20% a year.

Gillian: [0:36:01] So it’s not about throwing out your due diligence process in favor of making an impact, it’s including it?

Rolf Kelly: [0:36:06] Exactly.

Gillian: [0:36:07] Okay. So we’ve gotten a nice overall picture of the areas that you’re focused on. So now I want to move into the disruptors. So, Greg, I’m going to start with you, when you’re looking at Europe, what is the big disruption coming down the pipeline?

Greg Dunn: [0:36:18] Well, I think one of the sectors or industries that’s being disrupted the most in the world, not just Europe, but everywhere is retail by ecommerce. So you know, when you think about ecommerce, you think about how many people are online in the world, so about half the population of the world is online. And about half of that half is buying things online. And about 10% of all retail purchases are happening online. So there’s a lot of room to go. There’s a lot of disruption that’s happened. And you see it in the headlines of traditional brick and mortar retailers seemingly missing their earnings, going bankrupt on a weekly/monthly basis. You’re seeing these constant headlines, not just here but over in Europe as well. And one of the ways we’re benefitting from that, we’re trying drive performance from that is not just from pure ecommerce retailers but from some of the companies that are on the periphery of that who are enabling it. So one of our largest holdings and has been for a long time is Wirecard. And they’re an online payment processor. So they have about 20% share of payments, online payments processed in Europe. And so they’re benefitting from these secular trends and they’re the leader in that space. And at the end of the day what you get is a company that has secular growth drivers that are driving 20% growth in a high margin profile and a reasonable valuation, which we think is attractive.

Gillian: [0:38:02] So it’s interesting, you’re not necessarily playing the disruptor, you’re looking at businesses that are benefitting from that disruption.

Greg Dunn: [0:38:06] Yeah. And I think in some ways when you take it one step away, you get more attractive valuations because they’re not as associated as directly with the disruption that’s happening with that secular trend. I think in some ways kind of people miss it because, you know, they’re not clearly an ecommerce company. But at the end of the day they really are.

Gillian: [0:38:28] Excellent. Di, what’s a disruptor? I’m sorry, Rolf, did you have a point?

Rolf Kelly: [0:38:30] I had a question for Greg, I was actually asked yesterday. Sorry to put you on the spot, but.

Greg Dunn: [0:38:34] That’s okay.

Rolf Kelly: [0:38:36] Do you think it’s a point in the US?

Greg Dunn: [0:38:38] This is my real hair.

Gillian: [0:38:41] I was going to ask that next, [inaudible].

Rolf Kelly: [0:38:43] Do you think … I was asked this question yesterday, and I wasn’t sure about the answer. But do you think the government will step in at some point and break up an Amazon for example, because they get too powerful?

Greg Dunn: [0:38:54] Yeah, I think that’s one of the biggest risks for the very large internet companies, the Amazons, the Facebooks, the Googles, we’re seeing it already. And it tends to start in Europe from an antitrust level. And we saw it years ago with Microsoft. So I think that is a risk for them, for sure. I think at some point there is a high risk that governments around the world step in and basically claw back some of their profitability and try to limit some of their power. But at the same time these are trends that I don’t think we want to see disrupted. And Ben was mentioning earlier, the winner take all or the winner take most kind of way these things are developing, it doesn’t make sense for there to really be more than one Google or more than one Facebook, that’s part of their value proposition and part of what they bring to the table. So the government think is a risk but I don’t think it leads to multiple search engines or multiple social networks and things like that because the power in the search engine, the power in the social network is that it’s all consolidated. So I don’t think they’d totally derail it, but I think they’d take some of that profitability or they try.

Gillian: [0:40:21] That’s right; I think Alphabet was the big example of the antitrust violation in Europe. But it was concerned over their online retailing platform, if I’m not mistaken.

Greg Dunn: [0:40:28] Yeah.

Gillian: [0:40:28] And I think they’ve made the same argument for consolidating information; they’ve put themselves in the mix too.

Greg Dunn: [0:40:33] Yeah, absolutely.

Gillian: [0:40:35] Di, talk to me a little bit about disruptors you’re seeing.

Di Zhou: [0:40:37] Yeah. So same, along the same line Greg’s talking about. You can see that very pronouncedly in China. We talked about how emerging market could leapfrog existing infrastructure. And on the payment side, you saw that in China already. So when we look at in 2016 the mobile and online payment transaction volume was US $11 billion. That’s 16 times – 16 times what we had here in the US. So why China has been growing so fast from mobile and PC payment standpoint? It’s because a couple of things, one is their existing infrastructure has been weak. There are only 200 million people in China actually have credit cards. So there is a big population who has a need for using credit cards or a payment but don’t have the ability to do so. So online payment like Alipay and Tenpay comes in and fulfill this need. And also 4G smartphone penetration really helps that as well. And infrastructure building, say for example, Alibaba’s company, there’s an O2O called [inaudible], they have established a billion and half offline retail facility on their platform alone to accept [inaudible] pay. And that platform by itself facilitate 50 million daily transactions. So there’s 500 million currently, 500 million active payment users in China, and therefore generate a, you know, US $11 billion payment last year. And we think there’s still a lot of room to grow because there’s only still 15% of total payment in China, right. So the long term trajectory is still very, very huge for those companies. And then again, going back to the leader take most, leader takes all, the two most beneficiary here are Alibaba’s Alipay and Tencent’s Tenpay.

Gillian: [0:42:49] And it’s so interesting, because in the US so often we talk about why some of these payment systems can’t disrupt the system, it’s because they lack the distribution network that the big banks have. But in this case they’re replacing the bank that no one had access to in the first place, interesting point. So, Ben, coming to you, what’s the big disruptor in emerging markets that we should be looking out for?

Ben Kirby: [0:43:07] So there’s a few. I guess one that I would highlight is again, going back to Russia, so this is a company that we own and I like called the Yandex. So Yandex is disrupting two industries at the same time right now. They’re disrupting traditional advertising and they’re disrupting the taxi industry. So Yandex is an online search engine, so like Google, they compete with Google, and are ride-hailing, so they compete with Uber. And they recently combined with Uber in Russia. So on the search side, just like in the US, digital ads are displacing traditional legacy ads, so television, print, billboard, other forms of legacy ads are being pushed aside and more and more is going in digital. So that’s benefitting Yandex. And then on the taxi side only about 5% of rides today in Russia are via a ride-hailing service. And of those ride-hailing services, the combination of Yandex plus Uber, they recently merged, they have about 67% market share. Over time the 5% of rides that are being fulfilled by ride-hailing should double, maybe triple. And their market share should go, we think, from 67% into the low 80%. And as they do that they’re going to be able to reduce rebates. And we think that their revenues probably grow between 5 and 10 x over the next three years.

Gillian: [0:44:40] So driving the growth in that ride-hailing app, is it just accessibility, is it a consumer demographic shift, what do you see driving it?

Ben Kirby: [0:44:46] So mobile phone penetration is really high in Russia. And so most people have cell phones, I think as you get more 4G, more people have the ability to actually use and consume the service. And it’s really growing extremely fast right now, so really not much is inhibiting the growth except their ability to roll in to new regions. So today half of their revenues come from Moscow. But they’re rolling into new cities one after another; it’s expensive to do that. You have to subsidize drivers. So you actually lose money when you go into a new city, often for a few years. But then eventually getting back to the winner take all or winner take most model, once you’ve won that new city it’s really tough for somebody else to come in because you get a critical scale and a network effect and then you become a low cost provider. So they’re already the low cost provider in Moscow. We think that over the next few years they’re going to roll into other regions and become the national low cost provider.

Gillian: [0:45:42] And if you can commiserate, if anyone has ever hailed a traditional cab in Russia, it’s pretty good to have this being disrupted I would say. Did you have a point to add there?

Ben Kirby: [0:45:51] Yeah. One thing about these regional businesses that have dominant market share, when they do get someone that comes in and tries to compete with them, it actually just raises the awareness for the service, and in some cases it actually increases the incumbent market share. So that competition, sometimes it’s, you know, it just shows how defensive it is once you’re there and established as the leader for some of these business models.

Gillian: [0:46:20] It’s interesting, so competitors bringing attention to the new business, interesting. Rolf, talk to me a little bit about any disruptions you see in ESG, any particular technologies or sectors you think are really poised to take off.

Rolf Kelly: [0:46:31] Sure. I guess I touched on the auto industry. And I think [inaudible], well, so the combustion to electric vehicle shift and that has like vast implications for a number of different industries like the energy industry Ben mentioned, or utilities for example. And that’s, I guess on the utility and energy side you have oil right now in the US roughly 70% of oil demand is going into vehicles or transportation vehicles, and then the majority of that is personal transportation vehicles. So if that shifts to electric in a big way, you have a big, let’s call it falling of demand for oil. And that has vast implications for oil companies. It is a very tricky situation though, because to Ben’s point, you have CapEx being cut by most oil companies around the world. So supply looking out a few years doesn’t look good because companies are just not investing right now and not stimulated or incentivized to invest because of the prices. So it’s a, call it a tug-of-war between, I guess, supply and demand and investors saying, maybe telling you one thing by allowing, I guess, showing cheap stock prices in things like oil. And then we hear theses or investment pitches on, you know, buy oil because it’s cheap today. And just look what happens when the supply starts to run short prices will spike. But that’s not necessarily how it might play out if this electric vehicles pushes is pervasive and strong.

Gillian: [0:48:21] What do you think would be the tipping point for electric vehicles to really come out and make this thesis viable over the next five to ten years?

Rolf Kelly: [0:48:28] I think it’s just price, as I said with Norway and call it, all encompassing price, so the upfront cost but then the maintenance levels as well, taking that into account. So you don’t have to buy gasoline and then we’ve seen figures on combustion engines have 2,000 moving parts versus an electric vehicle has 20 or 30 moving parts. So you see these creative, I guess, programs offered by the car companies saying, “We offer a million mile warranty” for example, because there’s just such lower levels of maintenance involved there. So when a consumer starts taking that into account and the consumers are pretty sophisticated and they starting saying, this car now is, especially mainstream vehicles, if they’re equivalent to a combustion auto I think they’re going to make … and range keeps expanding out, so that you don’t have that range anxiety. So those are probably the two things, price and then the range of the vehicles gets to a certain point. And maybe a third I’ll add is the charging station network. But we see all those coming and in places like Norway where all those dominoes have lined up, they’re now falling for the combustion auto industry. And I think that’s going to happen around the world.

Gillian: [0:49:54] So when [inaudible] it might be a Tesla next time.

Rolf Kelly: [0:49:56] That’s right.

Gillian: [0:49:57] So let’s finish up by just giving a couple of high level points. We’ve talked about the macro picture. We’ve talked about some potential disruptors. But for anyone that’s watching at home, maybe each of you can summarize two or three points that you feel they really should take home about the region or area that you’ve discussed and how they can approach disruption, Greg, I’ll start with you.

Greg Dunn: [0:50:13] So I’ve been talking about Europe on this panel. And I think the thing to take away is that we’ve had modest synchronized growth across the region. There’s room for employment to continue to fall. And there’s room for that growth to continue. It’s been a region that’s been under-earning since the crisis. And there’s an opportunity to bring that back. And in terms of disruption, I talked about retail; I think that’s a big one and these guys have hit on some other points. I think the thing to take home about disruption is that it’s always happening somewhere. And it’s a big investment opportunity for us across different stocks. And that’s one of the things that we focus on at Thornberg.

Gillian: [0:50:56] Perfect, Rolf, what about you?

Rolf Kelly: [0:50:58] I guess the big takeaway for me would be to emphasize that ESG investing when done properly, doesn’t have to result in lower performance. So for those watching out there, if they go and find managers that are doing it thoughtfully they can actually invest with their values and have good performance experience, especially on the risk side, that ESG strategies tend to be lower risk and have lower volatility. So if you are like myself and concerned about valuation levels and fear we’re in little asset bubbles everywhere because of the central bank policies, then these funds might be a good place to position because you get equity exposure, but you’re protected somewhere on the downside.

Gillian: [0:51:45] So you can do well by doing good?

Rolf Kelly: [0:51:47] Yeah.

Gillian: [0:51:48] Di, give us your final thoughts.

Di Zhou: [0:51:48] One will be in China and so the 19th People’s Congress is one to watch because that sets the agenda for the next five years. And if we think the initiative to further push along reforms and that could have multiple benefits. One namely will be improving profitability in the SOE companies. And two is thinking about disruptors, there’s a lot of the new and emerging business in China. You know, we talked about, you know, mobile payment but there is others, you know, EVs and batteries, a lot of those are going on as well. It’s a market that really, you know, facilitates, you know, innovations. And then third point will be even though global market has been doing well in 2016, in terms of returns, we’re still seeing a lot of good attractive ideas, investing ideas globally. So we’re very excited of that.

Gillian: [0:52:54] Excellent. And, Ben, last but not least.

Ben Kirby: [0:52:56] So I would say that we’re still very optimistic on the long term outlook for the emerging markets. A lot of the long term secular drivers are still firmly in place, lower debt levels, better demographics, higher potential growth. So those are all there and we think that they persist for quite a few more years. On the near term things are going pretty well in the emerging markets. They’re coming out of recession in some cases; they’re stable in China’s case. And earnings revisions are positive, so companies are surprisingly positive whenever they report earnings, economic surprises are positive. So long term is still attractive, short term actually also looks pretty good. That being said, emerging markets is clearly a volatile space and it’s a space that can react with the beta to more developed markets. So we think it makes sense to have a portfolio that participates on the upside but especially protects on the downside. And we are very mindful of the potential for a drawdown in global markets, given valuations and in emerging markets given entire liquidity conditions coming. We achieve that a couple of ways. One is from good companies, so good balance sheets, good free cash flow. Those companies that are self-funding, they can survive whenever the liquidity gets withdrawn or pulled back, they can actually prosper in an entire liquidity environment. And then another idea, playing into the disruption, one way to transcend an economic slowdown is to own companies that are going to grow right through it. And I think Yandex is going to grow right through the next slowdown. And I think that, you know, some of the companies that we’ve mentioned here will grow right through the next slowdown. So that tends to be a way as the economy slows down for your equity investments to continue performing.

Gillian: [0:54:39] Excellent. So you’ve given us a very comprehensive global picture. You’ve defined disruption. And you’ve helped us understand in various specific examples how to get on the right side of it. So thank you all so much for taking the time to chat with me today. And thank you for tuning in. From our studios in New York, I'm Gillian Kemmerer, and this was Masterclass. We’re here with Thornberg Investment Management to take a closer look at Europe and what’s driving the growth in the market, particularly how much of that growth is due to disruption. Greg, thank you so much for joining us. Can you give us an overall picture; you’ve already alluded to it, to what exactly is happening in Europe? Do you see that the rosy picture that we’ve seen for the better part of this year is poised to continue? And thank you for your insights. We’re here with Thornberg Investment Management to discuss the current growth that they’re seeing in Asia and how much of that growth is coming from disruption. And thank you for joining us here today. We’re here with Thornberg Investment Management to discuss global expansion in emerging markets and where exactly the disruption is coming from. Thank you so much your insights. I’m here with Thornberg Investment Management to discuss ESG investing and how disruption in the environmental arena is impacting industries around the globe. Thank you so much for joining us here today.