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Allison Fisch, principal and portfolio manager at Pzena Investment Management.
A lot of people have been asking what’s driving the turnaround so far in 2019 in emerging market equities. And I think in order to put that into context, we need to take a step back and think about, what was the pain of 2018? When you look at underlying earnings of emerging market companies, they’re actually still improving, and in fact the terms on equities for the index overall is at about average or slightly above average levels coming off of the bottom where they bottomed out at the beginning of 2016.
What really caused the pain to stock prices over the year was the heightening of fear. So what we saw happening in 2018 was fears around the reverse of globalization, tariffs going up, trade war, political instability heightening across a number of geographies. Fears of recession across many different parts of the world, coupled with higher rates and reverse of global liquidities, which have been positive to a lot of emerging market geographies over the past few years. And so with these fears ratcheting up, we saw equity prices falling, and a widening of valuation spreads, really globally. When we look at what has happened so far this year, there have been some positive macro developments, perhaps rates not going up as fast in the US, trade talks taking on a slightly more positive tone. But really what it feels like is just people thinking that equities have gotten too cheap and a little bit of a relief in terms of people coming back into the market. This year you’re seeing those lows come back a bit into emerging market equities.
EM is the place where the cycles of fear and euphoria are even more attenuated. It’s not that unusual to see markets moving in these big ways over a relatively short period of time. When we think about will it last, I will tell you that at Pzena, the last thing that we are is market timers. From our perspective, fourth-term stock price moves are not something that we’re able to predict, but they can be opportunities. Because when you have moments where markets are selling off, and where valuation spreads are widening out, that gives us the chance to buy really great companies for very cheap prices. And those cheap prices are only available when we do have these cycles of fear really driving down equity prices on businesses that are good businesses.
When we think about the risks that we’re watching for, the set of risks that we’re afraid of really varies from one investment to another, from industry to industry, and from geography to geography. So part of the work of our team is to really lay out: what does a downside scenario look like for this business? And every day we’re watching the data come in as the situation develops, to monitor whether this company is on the path that we would like for it be on, i.e., normalization of earnings and improvement of stock price, or are things moving in the wrong direction in terms of the risks. As I mentioned, those risks really vary across companies. When I think about the types of businesses that we’ve been able to add to the portfolio over the last year, it really is quite a diverse set of business models and geographic exposures, and that’s just a reflection of the valuation spread environments that we’re in. But as a result of that, the risks are quite varied as well.
For example, within Brazil, we’ve recently added to our utility exposure. We have a thesis that the earnings of this business are going to improve because a regulatory regime has moved more positive. There are a number of self-help levers that the company can pull, and there are even hopes of privatization, which would improve the earnings further. If any of these situations doesn’t happen, or the regulatory environment moves in reverse, that is a risk to our thesis overall.
Another example would be in the Taiwanese tech space. We’ve added a number of mid-cap type companies that have exposure to Apple. These companies became cheap because of fear around Apple value, which of course does harm the earnings of a supplier business. But we believe that the earnings were unfairly penalized as a result of this short-term volume pain. Now with that said, if there is a big change beyond our expectations to volume, or these companies lose their competitive foothold in the market, know that could be a risk to earnings there. So from our perspective, understanding the risk in the portfolio is really about understanding the risk to each of the individual businesses that we own, and to their ability to create value over time.