Download Emerging markets in 2017

PERSPECTIVES
JANUARY 2017
FIDELITY EMERGING MARKETS FUND
This is for investment professionals only and should not be relied upon by private investors
Emerging markets in 2017
Emerging market equities rallied in 2016: Local politics, a recovery in
commodity prices, and the hunt for yield were amongst the key drivers
of a fast rising market. In large part, the rally was indiscriminate and, in
our view, longer term fundamentals were overlooked. This Perspective
looks at some of the factors set to influence emerging market assets in
2017 and sets out the rationale for current portfolio positioning.
HOW DOES 2016 FRAME YOUR THINKING FOR THE YEAR
AHEAD?
There were aspects of 2016 which were very challenging; there is no doubt
that Brazil was a tough market in terms of the very strong price moves.
Fuelled by a more positive political backdrop, Petrobras was up in the region
of 220% from the January lows to October high, despite being one of the
world’s most indebted companies. Looking back over my tenure, we have
experienced these periods before and maintain that you always have to think
medium to longer term in investing. We continue to focus on buying great
businesses that compound over time; an approach which underpins a strong
long-term track record. In 2016, we saw such businesses de-rate which
impacted performance. I would remind investors that changes such as
demonetisation in India or concerns about remittances of money provide an
opportunity in general, although sentiment can have a marked impact on
valuation in the short term. One such example is HDFC, one of the largest
holdings, which was hit by demonetisation but as the market begins to
refocus on results there should be re-rating as the Indian economy moves to
a more formal structure. Broadly speaking, earnings have not disappointed
and our target prices have not changed so that means, by definition, we see
more upside in the portfolio. I am hopeful that 2017 will be a better year.
IS THE REFLATIONARY TRADE SET TO CONTINUE?
There has been much comment on the reflationary trade, something we
would argue commenced before Trump’s victory. Whilst future US
infrastructure plans bolster sentiment towards commodities, they pale into
insignificance when set against Chinese demand and supply side response.
Our estimations are for the push on infrastructure spend in China to last
another 18 months. Our analysts base their earnings estimates on long-term
commodity price assumptions rather than spot prices to better gauge
through-the-cycle earnings potential. Whilst we see a healthier backdrop for
commodities, currently our work points to iron ore prices, in particular, being
too high.
NICK PRICE is the team leader of
Fidelity’s Global Emerging Markets equity
team. Nick has led the development of
Fidelity International’s EM equity
investment team since 2005, and draws
on Fidelity’s extensive emerging market
equity resources, which includes specialist
portfolio managers and 51 research
analysts. Nick has a Bachelor of
Commerce & Accounting from the
University of Natal and is a Member of the
South African Institute of Chartered
Accountants. He is also a CFA
charterholder.
Top Active Positions
Overweight
%
Under-weight
%
AIA Group
5.3
Samsung
-4.3
Sberbank
4.7
Tencent
-3.5
HDFC Bank
4.7
Alibaba
-2.5
Naspers
4.0
China Mobile
-1.7
Steinhoff
3.6
China Const.
Bank
-1.6
TSMC
2.8
Indl. & Coml.
Bank China
-1.1
NLMK
2.4
Hon Hai
-1.0
Tectronic
2.4
Bank China
-0.9
SK Hynix
2.3
Itau
-0.9
Cognizant
2.3
Petrobras
-0.8
Source: Fidelity International, as at 31 December 2016.
Within our universe, Brazil’s Vale continues to trace a strong iron ore price, regardless of capacity cuts in China’s steel
industry. This is an important observation given that iron ore is used to produce steel. Elsewhere, we have good
exposure to a broad range of businesses in the materials sector resulting in a modest overweight versus the benchmark.
Our investments remain focused on low-cost producers with strong balance sheets that have the ability to generate free
cash flow and pay dividends to shareholders through the market cycle.
IS THERE ANY CASE FOR INVESTING IN VALUE AREAS OF THE MARKET SUCH AS CHINESE
BANKS?
Value stocks had a strong run in 2016 and as such multiples have moved up towards the long-term average. Conversely,
quality and growth stocks have de-rated sharply. If we look at the investable universe there are examples of companies
that on the face of it, look cheap. Chinese Banks trade at around 0.8x book value. However, there are reasons to be
sceptical. We have concerns on the quality of the loan book; our research analysts estimate that 10-12% of Chinese loan
books in aggregate are bad, potentially wiping out any equity value. Whilst we don’t see any near-term catalyst, we think
there is a very real risk in the medium term that there is an enormous recapitalisation of these banks and we see them as
‘value traps’.
Whilst we remain cautious of these so-called ‘value traps’ an attractive valuation remains a critical component of what we
seek, given our unwavering focus on identifying companies that can offer attractive levels of Total Shareholder Return.
Sberbank was added to the fund last year because the business has been trading on about 1.1x price-to-book, with a
20% Return on equity. This compares with a Brazilian bank where Return on Equity is running in the late teens, and
you’re paying about 1.7x price-to-book, so you can see there is a huge difference in terms of the multiple that’s being
ascribed across different markets.
HAVING MENTIONED SBERBANK, HOW DO YOU BALANCE THE IMPROVEMENTS IN THE
RUSSIAN ECONOMY WITH THE RISKS AS AN INVESTOR?
I’ve been looking at the Russian market for 15 years and it’s important to acknowledge that it is an extremely corrupt
economy and that brings with it issues. I would also underline that none of my thought process is predicated on a
reduction in sanctions or a closer relationship between Putin and Trump. However, there are signs of improvement in the
economic backdrop in Russia which can drive benefits for companies available to us as investors. We continue to believe
that the oil price should trade up to a level of $60-65/barrel, and that’s more than discounted into the oil stocks. Therefore,
we are not chasing those names. For me, Sberbank’s appeal is that it dominates the landscape in Russia in a way in
which most banks across other developing countries do not. Market dominance provides access to a huge profit pool
share and share of deposits. The materials sector is an area where we also have a few positions: NLMK is the world’s
lowest-cost steel producer, benefiting from vertical integration (i.e. captive iron ore & coal) which provides a cost
advantage. Generally, the Russian steel companies came out of the global financial crisis incredibly indebted and in many
cases bankrupt. They engaged in enormous cost cutting and, as a result, have created a far higher sustainable profit
pool. Management teams of businesses like this have realised that it is pointless to direct more capital into expansion
and so we are getting very nice dividend returns out of these companies.
HOW DO YOU FACTOR FUTURE US POLICY UNDER DONALD TRUMP INTO YOUR
THINKING?
Whilst there is still uncertainty regarding how far Trump’s protectionism will go, we have been reducing some positions so
that we are not overly exposed. Indian IT outsourcers Cognizant and Infosys are companies that benefit from the growth
in digitisation and labour cost arbitrage, but they may be vulnerable in the event that Trump imposes significant visa
restrictions. We have also reduced the exposure to Mexican conglomerate FEMSA, contributing to the reduction in the
fund’s overweight to consumer staples. Although it has one of the most attractive food retail formats globally, the
risk/reward balance has shifted given Trump’s stance on Mexico and the knock-on effect of a weak peso. The fund
remains overweight Mexico due to the position in Grupo Mexico, which is an exporter of copper with costs in pesos and
revenue in dollars. This company is unlikely to get impacted by Trump walls, both physical or in tariff format.
PERSPECTIVES | Emerging markets in 2017
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Chart 1
Sector positioning
30%
Fund
Index
25%
20%
15%
10%
5%
0%
Cons.
Disc.
Cons.
Stap.
Financials
Materials
Health
Care
IT
Real
Estate
Industrials
Utilities
Telecoms
Energy
31.12.2016
14.5
3.1
1.2
0.3
-0.5
-0.7
-2.6
-2.6
-2.9
-5.9
-7.9
30.11.2016
14.3
4.2
0.4
-0.4
-0.6
-1.9
-2.5
-2.4
-2.8
-5.9
-7.5
31.10.2016
14.8
7.3
1.0
-3.2
-0.9
-0.9
-2.6
-2.1
-2.9
-6.0
-7.3
Relative
Source: Fidelity International, as at 31 December 2016. Index: MSCI Emerging Markets Index. Cash = 4.0%.
WHAT COMMENTS WOULD YOU MAKE ABOUT CURRENT POSITIONING?
Broadly speaking, a number of areas of the portfolio remain unchanged. We remain underweight the energy sector as
we see limited value in the oil sector at current share prices. We also have no exposure to the telecoms sector, which
we view as a declining returns sector, and no exposure to the utilities which will be impacted by higher discount rates
and the higher cost of fuel that goes into producing energy. The real estate sector is dominated by Chinese names and
we do not own anything given our negative views on the property market resulting from the restrictions on sales of
properties in certain Tier 1 cities.
There remains a risk that bond yields move higher and we have reduced exposure to some of the more defensive
names in the portfolio. Where we do maintain exposure, the businesses we own are all capable of generating low to
mid-teens earnings growth and generally pay good dividends. We have recently moved to a modest overweight position
in the materials sector. I have already alluded to the fact that we are very directed in our approach towards the lowest
cost producers. The investments include a position in Phosagro (the lowest-cost phosphate producer), NLMK (the
lowest cost steel producer) and Grupo Mexico (owner of the best quality copper assets).
OUTLOOK
In general, valuations in EM remain very attractive which supports the case for the asset class. Our approach to
investing remains very much about identifying good quality businesses positioned to deliver high returns on a
sustainable basis over the medium to long term at a reasonable valuation. We remain cautious on companies with large
state ownership, where capex is potentially misdirected by the government and results in a permanent destruction of
capital. We are also wary of businesses like Petrobras where the debt burden subsumes all equity value. In 2016 many
stocks like this were bid up purely as a function of being large constituents in the index or cheap on the face of it. As the
market begins to refocus on results, a number of the portfolio’s holdings are showing strong upside for the year ahead.
PERSPECTIVES | Emerging markets in 2017
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PERSPECTIVES | Emerging markets in 2017
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