Sector Spotlight: Emerging Markets

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  • 17 mins 22 secs
MFS Equity Research Analyst Deividas Seferis provides perspective — including the opportunities and challenges — on fundamental, bottom-up security selection in the emerging markets.
Channel: MFS Investment Management

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- Hi, I'm Jon Hubbard in the Investment Solutions Group here at MFS. I'm very pleased to be joined by London-based Equity Research Analyst Deividas Seferis. Welcome, Deividas!

- Hi there.

- Deividas has been with MFS since 2009 and within his coverage universe dedicates most of his time to equities within the emerging markets universe. He had previously covered US equities. Now we're going to spend some time discussing his views, both opportunities as well as some of the challenges of fundamental bottom-up security selection within emerging market equities, where the macro backdrop can play a really important role. Now it feels like right now we're in a period where the macro factors have been overwhelmingly the focus of investors' attention. From global GDP to inflation rates to central bank actions, these have been some of the key drivers that have captured both the minds and attention of investors today. Now as a bottom-up investment manager, our portfolios are constructed on a stock-by-stock basis with the merits of each individual company and their future prospects in mind. But this still requires a keen understanding of the macro economic environment in which these companies are operating within. So Deividas, let's start off with understanding — how does that big picture macro environment fit within your overall investment framework? So, in essence, how do you tie that macro to the micro?

- It's a great question to start with because I think it speaks to a lot of the work that we do here at MFS. And as you said at the beginning, we are fundamentally bottom-up stockpickers, so we try to find securities that are most attractive on their individual merit. But being an emerging markets investor, you inevitably have to incorporate the macro views of where those countries operate as well. And the framework, how we think about it, is fairly simple, and it starts with understanding what drives the fundamental value of any business. And there's really only two variables that matter. The first one is the free cash flow generation of the business in the future. So the value of any business is the sum of its future cash flows. And then also we need to discount those future cash flows into present value, and we need to find the appropriate discount rate to do that. And the macro analysis in emerging markets really come in play when we start thinking about what is that appropriate discount rate to use, when we, you know, present value of those cash flows. And there's lots of things that come into that equation, but ultimately the first building block of any discount rate that you sort of create for a company is to determine the country's credit risk and sort of understand what the country's underlying discount rate is, and then you add the company-specific premium on top of that. And then also in the cash flows, in some cases, we have to remember that the cash flows that we care about are dollar-base cash flows because we invest in dollar-basis. So we try to think about company's future earnings potential in dollar terms. A lot of it is related to understanding a company’s competitive position and the quality of its product because obviously a good company will tend to have pricing power. So even in an inflationary environment, which is usually present in most emerging market economies, a company that has pricing power will be able to pass on that inflation through earnings and grow real earnings power over time.

- Right, now, within that framework, as you think about the difference between selecting securities within the US for example, and within emerging markets, within emerging markets, you have lots of different countries, right? So you have country-specific risk. And then you also have the added element of foreign exchange and currency and the role that it plays in EM investing. So how do you incorporate that into your thinking?

- We start our analysis by reminding ourselves that our job is to generate returns in dollar terms, because we get capital from our investors to invest and generate dollar-based returns. So when we look at any business, we first analyze that business's sensitivity to different exchange rates. And if you are exporting business, obviously you would be benefiting from a weaker exchange rate and vice versa. If you are a locally based business that depends on local demand, you will not be generating foreign currency earnings. So if the currency depreciates, you know, the value of those free cash flows — and remember that coming back to that equation of what drives the real value of the business — it's a really the free cash flow. If you're not growing that free cash flow in dollar terms, you're not likely to have a stock price appreciation in dollar terms either. We're not really trying to predict where currencies are going to go. Our process is really more centered around understanding the risks around the currency so we can size the positions correctly. And maybe that's what I should have started earlier by saying, that when you make an investment decision, it's two decisions. First is which security you want to buy and second, what's the position size that you would want to have in that stock? Fundamental analysis ultimately drives which companies we want to invest in, but then the analysis of currencies and risks around the macro factors comes into play when we make a decision on how to size the security appropriately. And as an example, like some countries, we would see as a lot more vulnerable to currency depreciation, and even the best company in that environment, we will probably not make it a big position in the fund simply because there are certain exogenous risks that will impact the dollar returns for our investor.

- So Deividas, how do you think about foreign debt service? These sovereignties have debts, both internal and external debts to service, and there's another element of inflation that you have to fold in there. And again, these are very macro themes. I'm curious to see how you think about those, but also what tools and teams that you tend to leverage here within the overall investment team.

- At MFS, we have a very strong fixed-income emerging markets team who spend all of their time analyzing emerging market economies and making investment decisions based on their analysis. So we tend to leverage their work in making our decisions as well. We don't make investment decisions based on macro predictions, but we use their analytical work to understand where the potential risks are, and also using that to size the positions correctly in the equity funds. In terms of the second part of your question, about how inflation feeds into the analysis of fiscal sustainability and stockpicking, it comes through mainly the assessment of the discount rate at which we discount the free cash flows for the business because ultimately the first starting block in building the appropriate discount rate starts with a country risk, and the country risk is largely a function of the country's indebtedness and of the fiscal dynamics that the country is undergoing at that time. And usually inflation also has a strong link with fiscal dynamics in the country because in EM, governments are big economic players in the economy. So whenever a government, for example, tries to stimulate the economy through a fiscal expansion, that usually means more mone- printing and monetization of sovereign debt, which ultimately, if done incorrectly, can lead to significant currency depreciation, higher inflation and ultimately, higher rates.

- And it seems like, from a monetary standpoint, some of those emerging markets have actually started to remove some of the accommodation from the system.

- Yes, they are. I mean, every country is doing it slightly differently and at different pace, and it mostly reflects countries different starting positions because obviously if you are starting with low indebtedness levels prepandemic, you had a lot more room to stimulate. So you can sort of afford to wait longer to remove the stimulus. If you are a country like Brazil or South Africa, where your debt sustainability was already in question before the pandemic, you clearly have even less room after the shock of the pandemic. And that's why I think we're seeing different approaches to policymaking across EM. It's just a different starting condition that all of these countries have.

- So, Deividas, as you think about different countries, they're earning their sources of revenue from different revenue streams, and even within each country, those individual companies might have different revenue streams. So how do you first think of it at a country level? Why is it important where those countries are getting their overall revenue from? And then within the individual security that you're looking at, how do you think about either comparing or contrasting that with how revenue is coming in at the country level?

- So that's a good question. The starting point is really a basic economic equation of balance of payments. And when you look at how countries generate their dollar revenues, it mostly comes from exports and also portfolio inflow. So financial flows into the country. And even though these things are difficult to predict and base your investment decisions on, you can understand which current accounts are more cyclical and which ones are more sustainable and structural. So for example, a country that is exporting manufactured goods — more value-added goods— will have a much more sustainable export base and therefore much more sustainable foreign currency earnings than the country that, for example, is exporting a commodity such as iron or oil price, which can fluctuate in price every year by 50, 40%. And obviously that kind of country is just a lot more vulnerable to swings and moves in capital markets or swings in commodity prices. The other side of it, as you mentioned, is also company analysis. And typically, it's a bit tricky. Sometimes, portfolio managers and maybe other companies try to manage that risk by being country neutral. You say well, you can neutralize the country risk by just managing your benchmark weight with a portfolio. The problem is that some of the companies in the country can be exporting, so they will be benefiting from currency depreciation. And in the end, just by virtue of that, the company will do a lot better than a better business that only has domestic revenues. And a good example is in Turkey. We've seen a strong depreciation of a currency over the last five years, and relatively low-quality businesses like steel manufacturers and other capital-intensive industries that investors tend to not like actually performed a lot better than all the other great businesses that were more domestically focused, and it was purely because of the currency translation effect. So that's kind of one of those elements where you have to kind of understand or incorporate your view of where the currency might be going and whether the company has the pricing power to pass on the associated inflation. There are other elements to the analysis that can get a lot more complex, but it's typically centered around the balance sheet analysis where we try to look out for companies that have mismatches in terms of dollar earnings and dollar liabilities. You know, we don't like the companies that raise cheap dollar debts while not having any dollar revenues.

- Sure. They're going to have to pay that back in dollars, right?

- Exactly. They're going to have to. And it works really well when other currency is appreciating. So you tend to see companies do that kind of thing in the boom times because it seems like a no brainer. Like, you raised debt at cheap price in dollars and your local currency is appreciating, so over time, it's actually easier for you to pay it back and it looks great until the cycle turns and the currency starts depreciating and suddenly, even though your business is doing great in local currency terms, actually your debt burden is increasing because the currency is depreciating even faster. If we see that management is taking these financial risks that we think are not appropriate for the business, it gives us a signal of, maybe, how the rest of the business is managed. By combining all these different pieces of information, you could get a sense of … What's the culture of the company? And is it run really aggressively? Are they taking risks or not? Or is it more conservatively managed business?

- That brings me to a question that I’ve really been dying to ask you here, which is how do you deal with situations where you have a really good company, like the merits of the company, but it's in a country that you think is less desirable? And then contrast, you could have a country that looks very stable and looks in very good shape from a macro standpoint, but you struggle to find individual companies that you think are worthy of investment. So how do you deal with the good company, bad country or you know, bad country, good company?

- These are kind of interesting situations because these are, in some ways, fun situations because to have a really unique investment opportunity there has to be some sort of challenge. There has to be some sort of tension in the stock that makes the stock attractive. And sometimes bad macro can create an opportunity to buy a really good company at a cheap price because people are focused and worried about a big macro variable that they can't fit in. And we sometimes find situations where we like a company, and it's a strong one — buy one-rated security — but it's located in a country that is three-rated because we don't like the macro direction, at least in the medium term.

- And that just one-rated meaning that you’re most favorable, and three-rated meaning that you’re least favorable in the eyes of the investment team.

- Exactly. So if you make the right decision, you can really create a lot of alpha in that environment. We typically would invest in the security, even in the three-rated country, but we would size the position accordingly. We would make it a lot smaller position. Then it would be if the country was a lot better from a macro perspective. Being an emerging markets investor, you have to also be comfortable to be contrarian at times because in the country that is very well positioned, has no macro risks, no political risks and it has a great company in it, you're very likely going to see a valuation that is unlikely to be attractive. It's not really two factors. There's three factors that you think about. That is, is the company interesting fundamentally? Is the country structurally sound? And well what is the valuation for that security? So the investment decision, to buy or not to buy, is somewhere in the middle of that triangle. And that's where I think informed judgment comes in play to be able to make an informed decision, both about security, about the macro and the valuation, I think helps us make a better decision than average.

- Well, that was just an amazing way to tie up the conversation here. And really, I think helps bring home this idea of tying that macro environment to the bottom-up fundamental security selection process that we engage here every day at MFS. So with that Deividas, we've covered a lot of ground. It's been absolutely fascinating. I really appreciate you being here with me today and thank you so much for your thoughts and insights.

- No, thank you. It was great to be here and share my thoughts.

The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.

FOR INVESTMENT PROFESSIONAL AND INSTITUTIONAL USE ONLY.  Should not be shown quoted or distributed to the public.

 

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