Download Competitive aspects of foreign markets appear attractive

GLOBAL INVESTING
Competitive aspects of foreign markets appear attractive to money managers
T
he final session of the day focused
on strategies for investing internationally. Nick Sargen moderated
the panel which included Zulfi Ali
– Emerging Markets, Rob Maeder – Private
Equity, and Jamie Wilhelm – Public Equity
Nick Sargen: One of the reasons we asked
Professor Morris to be with us today was to
give us a truly global perspective. We are believers that when you’re talking megatrends,
globalization will certainly continue. Our three
panelists for this section are Zulfi Ali covering
emerging markets, Jamie Wilhelm discussing
public equities, and Rob Maeder representing private equity. I’d like to have them talk
to us about how, in their investment processes,
they incorporate decisions about when and
where to go with respect to investing outside
the United States.
I’ll start with Jamie Wilhelm because he has
a domestic benchmark; therefore, if he goes
outside the U.S., he is actually taking benchmark risk. So Jamie, how do you think about
investing internationally?
Jamie Wilhelm: There are really three
ways we think about it. One, we will buy foreign
to think about the competitive aspect coming
out of these countries.
MODERATOR
NICHOLAS P.
SARGEN, PHD
Nick Sargen: Zulfi, your benchmark is the
emerging market bond index, so let’s focus on
that rather than going opportunistically into
other assets. We brought you on a year and a
half ago. When you constructed your process,
you had to consider a huge universe. How did
you take advantage of that?
Senior Vice
President & Chief
Investment Officer
companies that are traded on U.S. exchanges.
The second way we get exposure is by owning domestic companies that have significant
international exposure. For example, we own
a food company that conducts 40% of its business in emerging markets. The third way we
think about it is by looking at the increasing
competition from foreign emerging market
companies and what impact they’ll have on
the domestic companies that we own.
There are a lot of companies that are gaining
share in emerging markets. Think about the
Japanese and Korean automakers, for example,
and how they’ve impacted the auto industry
over the past half century. I think over the next
10 years there’s going to be a dramatic change
in the number of companies that managers
like me will invest in domestically. You have
Zulfi Ali: Just to explain to the audience,
when you hear about emerging markets, it can
often be a vague term. If you read the headlines, you’re not sure exactly what emerging
markets means. We are running a portfolio
against a benchmark of dollar-denominated
bonds from emerging market countries. And
it’s a unique benchmark because when you
think about emerging markets, you think about
smaller economies, but China is in the benchmark, which is the second largest economy
in the world.
Historically emerging markets have had scary
connotations. When the benchmark index
started in 1994 it had about 10 countries and
these countries were definitely emerging. Now
you have more than 60 countries in the bench-
mark and two-thirds of them are investment
grade rated. So we’ve come a long way, even
though the name is still the same.
The way we look at emerging markets is
from a global-macro perspective. We look at
it from the top down, what our expectations
are for what is happening in the U.S., what is
happening in Europe, and what is happening in China. We look at those, divided up
into regions, and then we look down through
the countries and decide where to over and
under-weight based on our algorithm on each
individual country.
Nick Sargen: Rob, you are overseeing our
portfolio construction of our funds of funds in
private equity. My question is when you have
to make a decision about investing in international private equity outside the United States,
how do you go about it and what would be a
typical allocation in our funds?
Rob Maeder: We manage diversified funds
of funds. The core of the funds are actually
the United States, but we target about 20% to
CONTINUED ON NEXT PAGE
PANELISTS
M. ROBERT
MAEDER, CFA
Assistant Vice President and
Senior Investment Manager
Rob joined FW Capital in
2007 and focuses on private equity primary investments. Rob has more than
17 years of relevant M&A,
strategy consulting, and private equity investment
experience. Prior to FW Capital, Rob worked as an
Engagement Manager at L.E.K. Consulting where
he developed growth strategies for corporate clients and led strategic due diligence assignments for
M&A and private equity transactions. Prior to L.E.K.
Consulting, Rob was an Associate with CIVC Partners,
a middle-market buyout firm, and an Analyst in the
M&A group with Merrill Lynch & Co. Rob earned a
BA in Economics from Northwestern University and
an MBA from the Kellogg School of Management at
Northwestern University. Rob also holds the CFA professional designation.
JAMES E. WILHELM, JR.
S. ZULFI ALI
Vice President and Senior
Portfolio Manager
Vice President and
Senior Portfolio
Manager
James Wilhelm, Jr. is
Vice President and Senior
Portfolio Manager, overseeing the Focused Equity
investment strategy. In this
role, he is responsible for
the investment process and portfolio construction.
He also has primary research responsibility for a
number of sectors, including consumer discretionary and staples, industrials, and telecom services.
James joined the firm in 2002. Prior to joining
Fort Washington, he served as a research analyst
for Riggs Investment Management, First Union
Securities, Evergreen Funds, and a financial consultant for Salomon Smith Barney. James earned a BS
in Business Administration from Wingate University
and an MBA in Finance from Johns Hopkins
University.
Zulfi Ali is Vice President
and Senior Portfolio
Manager responsible for
the Emerging Markets
and International strategies. Zulfi joined the firm in 2012. He previously
served as Managing Director for SGH Macro
Advisors in New York focusing on emerging
markets and the European credit markets. Prior
to SGH Macro, Zulfi worked for IGI Funds Ltd in
Karachi, Pakistan where he was Chief Investment
Officer. He has also served as Vice President
for Prudential Financial, where he was Portfolio
Manager for the emerging markets debt strategy. Zulfi received a BA in Economics and
International Relations from Brown University and
an MBA from Oxford University.
‘There are a lot of
companies that are
gaining share in
emerging markets.
Think about the
Japanese and Korean
automakers, for
example, and how
they’ve impacted the
auto industry over the
past half century. ’
– JAMIE WILHELM
CONTINUED FROM PREVIOUS PAGE
30% of the portfolio to be invested internationally. About 40% of that exposure will come
from U.S.-based managers who are seeking
out opportunities abroad.
Typically we find that to be more ventureoriented, more growth equity-oriented tech investors or health care investors, who are seeking
to leverage a technology globally. We do have
an emphasis on developed economies when
we invest abroad, but we will selectively and
carefully think about emerging markets. We’re
careful about adding that risk to the portfolio.
The other area that we indirectly participate
in through the emerging markets is the energy
space. We typically have about 15% of our
portfolio targeting energy investments. So why
do we incorporate international at all, when,
in fact, our emphasis is on the U.S. market?
There are really two principal reasons. The first
is more of a portfolio reason. The second really
is more of a bottom-up fund selection reason.
On the portfolio side, we’re looking for diversification. When we look at a standalone,
international private equity investment, we do
think it’s riskier than we typically see here in
the United States. And as such, we underwrite
it to a higher return.
‘I think there are
some very interesting
opportunities in the
emerging markets. As
I said earlier, a lot of
this is about finding
the right manager.’
– ROB MAEDER
So whenever we commit to a manager outside of our borders, we do expect to earn a
higher return on average. Having said that,
by incorporating the different types of risks to
our portfolio, we actually think we reduce the
risk of the overall pool. That could be different
macro risks, different currencies, but it could
also be at the fund level where we have managers who do very different types of transactions
or are bringing some type of value-add that
is very different from what we’re seeing from
our U.S. managers.
The second reason is that looking abroad really expands our opportunities. It creates more
ability for us to find very high-quality managers. The reason that is critical in private equity,
I can illustrate with a statistic. If you look at
a top-performing private equity manager, so
a top-quartile – top 25% of all managers in
a group compared to a median-performing
manager – the difference is substantial. On
average over the last decade, it’s been about
500 to 1,000 basis points a year of outperformance between a top-quartile manager and
a median manager. In private equity, it’s really
more about picking top-performing managers
than it is about any kind of market calling.
Nick Sargen: Jamie, let’s go back to you
on your equity portfolio. You’ve become quite
a student of financial markets. When you look
at developed markets’ histories and you compare them to emerging markets today, where
are they in the life cycle? That is the big picture question. But then the other question is,
if emerging markets trail for two consecutive
years, does that perk up your interest as a value
manager?
Jamie Wilhelm: Let’s state the obvious,
there are numerous stages and I’m not going to
do it justice like our speaker did, but when you
think about the Industrial Revolution, when
you think about Britain, it took them 150 years
to double economic output per person. The
U.S. did it in something like 50+ years. China
did it in 15, and they did it with bigger populations and much larger economic forces.
The way I frame it is pretty simple. There is
a huge opportunity from a productivity standpoint within emerging markets. For example,
65% of the people in emerging markets don’t
have a mobile phone at this point. Think about
putting a smartphone in the hands of a person
in these countries and the impact that could
happen pretty quickly.
Also, think about the impact in terms of the
factories in emerging markets. Think about
what robotics will do for their productivity. I
think potential for productivity improvement
is tremendous because the number of robots
in China is miniscule compared to our factories in the U.S. There is a lot of room for
improvement ahead.
With respect to valuation, in my opinion,
the emerging markets as a whole earns about
its cost of capital. If you look at the price of
those markets now, at this point the market is
pricing in declining returns on capital in the
future, which is very interesting to me.
The caveat is, be selective. Valuation looks
interesting, but you have to make sure to not
be stepping into something. You may want
to stay away from those countries that have
a combination of current account deficits,
a fiscal deficit, and a high amount of foreign denominated debt. I would defer to
Zulfi to ask him a question, is there going
to be a crisis?
Nick Sargen: Zulfi that is perfect because
I was going to ask the same question based
on the fact that we did see a hiccup when the
markets got worried about a rise in U.S. interest rates. And if we see an additional rise this
year, could you see capital flight and could it
compound?
Zulfi Ali: That’s a good question to have
because you have seen a lot of that happen
already in 2014. It’s interesting to look even
a little bit deeper. China is the biggest emerging market. They have two stock exchanges in
China. One is the Shenzhen Stock Market and
the other is the Shanghai Stock Market. The
Shanghai Stock Market was one of the worst
performers and the Shenzhen Stock Market
was one of the best performers in Asia last
year, so it can happen in the same country.
Nick Sargen: What is the explanation?
Zulfi Ali: The explanation is the Shenzhen
Stock Market has more private companies
and Shanghai has more stated-owned companies, which are not run efficiently. Therefore,
you have a tale of two economies within
China. So you have very interesting things
going on. And what happens in China, in
my view, is going to determine how the Asian
market does above and beyond the interest
rates in the U.S.
Their policies are a question mark in my
mind right now because you saw a crisis in
the U.S., a global financial crisis here, and
now we’re in the recovery phase. In Europe,
you saw that happen later, around 2010-2011.
They also deleveraged and are now recovering
slowly. China hasn’t really had a crisis. There
has been a huge amount of credit growth in
China, but my view is I don’t try to make a
long-term call on whether China is going
to rise or fall. My view is that I think every
country has a credit cycle. That’s part of capitalism. That’s part of capitalist economies. I
think China is bound to have the same thing,
and go into recession. So, I think that the
market is worried about that. I’m worried
about that. Do I think it’s going to happen
this year? Probably not. Could it happen next
year or the year after that? I think the chances
increase as time goes on.
Nick Sargen: So Rob coming back to
you. Your asset class is very illiquid and you
make very long-term investments. You heard
the scenario. So, what do you say for the near
term? And how do you make a private equity decision?
Rob Maeder: Invariably when you start
talking about international private equity opportunities, the conversation gravitates toward
the discussion around the macro environment
and how that’s going to affect the investment
potential. But it’s important to understand that
in private equity, particularly as a private equity LP – limited partner – it is very difficult
to make market calls. If we commit to a manager today, he’s going to take the capital over
a period of three to five years, investing as he
goes. And for each of those investments, the
typical hold period is another three to seven
years on top of that. So when you look at a
typical life cycle of any fund, it could easily
be 12 years long.
Now think back 10 years to 2004. What
macro issues were private equity partners
thinking about back then? Were they thinking
about the impending financial crisis and how
that was going to impact their investments in
2008 and 2009? I don’t think that they were.
To further illustrate that with an example,
look at all the funds raised in 2007. In hindsight, maybe not the best time to be committing to private equity. You had record fundraising going on in the United States, $300 billion
raised, a very competitive market. Valuations
were at all-time highs, and the financial crisis
is right around the corner.
Let’s fast forward now. The 2007 vintage
has actually outperformed. So, having said
that, even though it is very difficult to make
these market calls, the truth is that macro is a
huge driver of how LPs are behaving and how
they’re committing to the asset class.
Emerging markets are a great example,
and I think certainly we’ve had a frontrow
seat as we’ve looked at markets like China
and Brazil since 2009. But try to think about
what all the LPs were considering in 2009.
We were certainly worried about the growth
picture in the United States. In private equity, specifically, deal activity was quite depressed. There was limited leverage available
for buyout funds, so you weren’t expecting
much return from leverage. There was also
a lot of dry powder in the markets, so the
markets were still very competitive even
though the S&P was depressed.
Then you looked at the emerging markets
and that was interesting. There was growth
Nicholas P. Sargen, PhD
Chief Investment Officer
www.nicksargen.com
there. These markets were not that penetrated
by private equity and capital chasing deals.
There was actually a lot of deal activity taking
place, so I think a lot of people recognized
this. Wall Street cranked up the marketing
machine for emerging markets funds and they
went from about $20 billion in 2009 to about
$40 billion two years later.
So for the emerging markets investments
within private equity, I’d say it’s still too early
to tell. You never know what’s going to happen with the markets over there, but if we look
at all the funds raised in the 2009 vintage, a
top-quartile emerging market private equity
fund has earned 7.1%. The U.S., same vintage, has earned 15.9%.
So have emerging market private equity
managers compensated their LPs for the
risk their taking? Certainly not. Don’t get me
wrong; I think there are some very interesting
opportunities in the emerging markets. As I
said earlier, a lot of this is about finding the
right manager.