Talk Your Book: Emerging Market Fundamentals

0:00Today's Animal Spirits Talk Your Book is brought to you by Schaefer Cullen Capital Management. Go to CullenFunds.com to learn more about their Emerging Markets High Dividend Fund. That's CullenFunds.com. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:34Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:42Welcome to Animal Spirits with Michael and Ben. On today's show, we are covering emerging markets. A lot of people are looking at like investing now, and they're saying, I can't invest now with the market at all time highs. And I guess I say a lot of people, who's the source? You know the meme, I made it up? Me. Many people are saying this. The stock market is overvalued and where am I supposed to put my money? Yeah, yeah. Well, there are other areas of the world that have not had nearly the same success over the last five to 10 years as the mega cap stocks in the S &P 500. Emerging markets is certainly near the top of the list.

1:25So we've been talking about emerging markets being relatively cheap for a while. And they always kind of trade at a discount to the US. but they've just sucked wind in terms of performance for well over a decade now. And I think I've come around to the idea. We've been talking about what's the catalyst for this, right? What would cause foreign stocks or emerging markets outperform? And I think it's just the dollar, which we get into this. I think if the dollar were weak for a prolonged period of time, you would see emerging market stocks do really well. Is that fair? Well, have you seen the deficit?

1:51It's coming. That's true. If you're an anti-deficit government spending, government debt kind of thing, emerging markets are, that's where you put your money, right? What if gold and emerging markets are the big one for the next decade? That would throw people for a loop. That was the last decade of the first decade of the century. But anyway, we got into a lot of really good stuff on India and China and the opportunity set in emerging markets and the crazy high dividend yields that you can get there too, which are way higher than the United States. So we talked to Raul Sharma, who is a portfolio manager, and he's been doing this apparently for about as long as anyone in emerging markets.

2:25He's been doing it for over 20 years. He's a really, really sharp guy. So we learned a lot from him. Yeah, this was a good one. Excellent conversation. Here is our talk with Rahul.

2:36We're joined today by Rahul Sharma. Rahul is a portfolio manager and an executive director at Schaefer Cullen Capital Management. Welcome to the show. Thanks for having me, Michael. All right. Today, we're going to be talking about emerging market equities. And maybe let's start here. So from the perspective of a US-based investor, things have not been great over the last decade. Emerging market stocks have done 3.6 % a year. That's a 43 % total return versus the S &P 500, which has obviously crushed it, doing 13 % a year for a total return of 235%. The reasons for how we got to where we are now are very well documented, the tech trade.

3:17We get it. So if you had to put your crystal ball on, that doesn't make sense. If you had a crystal ball, what would you guess would be the reason why emerging markets could outperform US stocks over the next decade? Well, I think emerging markets are so diverse. So there have been several emerging markets that have been doing very, very well. But everyone is just so focused on China. And China is such a large weight in the emerging market index. And China has been really underperforming. And that more than anything has caused the emerging markets to underperform. But if you look at other markets like say Mexico or India or Indonesia or Taiwan, those markets have actually done very, very well.

4:00And in some cases, they've actually outperformed the S &P 500. And a lot of the same drivers that are driving the US market, namely tech, there's a lot of that in emerging markets. in places like Taiwan and South Korea, you can get very good exposure on things like AI and semiconductors and that sort of thing that are also doing very, very well. One of the other problems has probably been the dollar. I mean, typically there's a very strong correlation for when the dollar weakens. That's usually a very good thing for emerging market stocks. And seeing that the dollar has outperformed for the last decade or so, we definitely think we're getting into a period where you might start to see a reversal of that trend.

4:38And I would expect that to be a big catalyst for all emerging markets. In the meantime, I expect those certain emerging markets to continue to do very well. And you got to watch China. You never know if China is going to improve. It's a very sizable economy. They're pretty much the biggest consumer of most products globally. So while we're quite underway, China, I wouldn't say that China is, say, uninvestable. I was going to ask you actually about the currency side of things here. Maybe you could explain for the audience just why it matters when the dollar is strong that emerging market stocks tend to do poorly.

5:11Well, a lot of the, some of certain emerging market countries and companies might have a lot of US dollar denominated debt. So, you know, as the dollar strengthens, that debt gets more expensive, the interest expense, you know, starts to rise. So that's, you know, a big reason for it, I would say. You know, usually when the dollar is strengthening, you're generally talking about kind of a risk, or oftentimes you're talking about a risk-off environment, which is usually not a good thing for emerging market stocks as well. So with China as such a large percentage of just passive indices these days, there's a lot of – well, first of all, there's a lot of money coming out of China, right?

5:51Foreign investment is just going the wrong direction. But when I see calls for EMX China or China is uninvestable and their stock market already in a 70 plus percent drawdown. I don't know. I tend to think that like, it's not to say that things have to get a lot better, but what if they're not catastrophic? What if they're just really bad? Like that in and of itself could potentially spark a nice rally. What I guess what I'm saying is, uh, maybe this is wishful thinking is not all, is there, is anybody pessimistic? I'm sorry, optimistic on China. Like, Isn't all of the bad news baked into the pie already or a lot of it?

6:29I think sentiment is pretty terrible on China. I mean, I've been doing this for almost 25 years and I've never seen it as bad as it is in terms of either the sentiment or the overall economic activity. But I do think it's kind of bottomed out and I think it's just going to generally improve. And then there's areas of the Chinese economy that are doing a lot better than other areas. So if you look at things like say travel and tourism, that's an area that's doing quite well. I mean, domestic travel is well beyond pre-COVID levels and now outbound travel is really, really picking up. So we own a few kind of travel and tourism related stocks that are doing pretty well.

7:05You know, there's also been this, you know, general change in the way people think about travel. A lot of younger people, you know, are really more after experience rather than materialistic things. So that's helping travel a lot. And then also having these kind of hybrid work environments now makes it a lot easier to maybe get a three day weekend or a four day weekend in another place. and you could still maybe work a day. And so that's one example. There's other areas where certain Chinese companies are just extremely dominant. I would say electric vehicles would be one example of that. If you look at companies like DYD, they're now selling more electric vehicles than even Tesla and their cars are quite competitive.

7:44If you look at battery technology, if you look at companies like CATL, they are by far the leaders in battery technology, be way, way ahead of everyone else and really dominant in that area where they have something like 40 % global market share. And like I said, that big lead. So those, to the extent we have exposure to China, those are kind of the areas that we like to be involved in. But I still think there's better ideas outside of China. Because again, just like you said, there's money coming out of China. Either people aren't investing in emerging markets or they're reinvesting from China into other emerging markets.

8:18So markets like India, Mexico, Indonesia, and other markets are seeing very, very strong fund flows. And if it was just that, I'd say that's a problem, but it's also coinciding with a lot of huge long-term opportunities, things like nearshoring and reshoring where people are trying to relocate their supply chains to places like Mexico or India, first because of the problems that supply chains had during COVID, but now because of the geopolitical tensions between China and the US. We have AI, everyone's talking about AI. So there's a lot of stocks in Taiwan and like I mentioned, South Korea that are really benefiting from that.

8:51Climate change is another big thing. I mentioned the EVs, finding the companies that are providing the products and solutions to address climate change concerns. And so those same markets where the fund flows are going into are also benefiting from these trends, and that's creating excellent opportunities in those markets. So Michael mentioned the fact that the pessimistic side of things for EM is pretty well documented. It's funny because it was the opposite heading into the 2010s where everyone said, well, the only place you can find growth is in emerging markets. and they have billions of consumers.

9:20So that's the place that you want to be. And it turned out to be the opposite. And I think one of the things a lot of US-based investors have figured out is that, well, you don't get to hold a lot of your returns from the corporations in some of those countries. So how do you ensure that you actually do get those returns? And it's not something that the government regulation is taking away and making sure that they're not getting those same returns from their companies. Yeah, I mean, we're just really focused on kind of, we're really kind of simple stories that are, you know, we're very, very focused on earnings growth.

9:53So, you know, even though we're value investors, you know, we're very focused on the earnings growth. We tend to be quite thematic in nature. I mentioned some of those themes that we're exposed to, whether it be something like AI or we have a lot of exposure to this nearshoring, reshoring. And also to the consumer, like you mentioned, that still is a very good long-term story, particularly in Asia. And so if you just focused on companies that are kind of selling into those areas, you can get very good growth. And we also pay a lot of attention to things like corporate governance. That's much more of a problem in emerging markets.

10:24So it's just a lot more kind of value traps potentially in emerging markets. And so you need a lot of tools to be able to avoid those. And we're quite experienced and quite focused on doing that. Are there certain countries that you avoid altogether? How do you think about that side of things? Well, these days, obviously, Russia, we can't invest in there. We typically, we do a lot of country research. So that's one of the things when we first started these strategies really back, or really started investing in EM really back in 2001. We noticed it was a little bit different than what we were doing in the US.

10:53And usually it was because of country factors. And if you look at empirical research, you'll see that country selection matters just a lot more when you invest in emerging markets. So we had to kind of come up with a framework to analyze countries. And we started publishing a country report that we do every year where we basically rank and assess countries on a broad array of metrics. We go beyond the stocks. We're looking at bond markets. We're looking at economic statistics. We look at a lot of surveys on the ease of doing business. We look at their past experience in certain crises. Doing all this helps us identify the strengths of certain countries.

11:30That helps us identify certain types of companies within countries because we always love to leverage the strength of a country through a company. But then it also points out some of the vulnerabilities that countries have. And probably the biggest problem, this gets back to that dollar issue we were talking about, is when an emerging market country has a weak external position. When they have a lot of debt, when they don't have a lot of reserves, when they have twin deficits, that tends to lead to big currency depreciations, which then could lead to blowups in certain emerging markets. So we tend to be a lot more selective or really not even invest in those sorts of countries.

12:07The good news is that they're not a big part of EM. They're just much smaller countries like, say, Turkey or Argentina that don't have large weights. But that's one of the tools we use to kind of avoid those pitfalls. And sometimes you also get very, very good opportunities. Greece was a very good example of a country that you really wanted to avoid after it had a huge crisis many years ago. But when you looked kind of five or 10 years later, all of a and things had really turned around a lot, the government really changed. It went to a more business-friendly government. They put in a lot of sound economic development policies.

12:42They refinanced their debt at low rates, and they benefited from a lot of the kind of changes that have happened during COVID and because of the wars too. And so all of a sudden, Greece went from being a pretty weak market to one of the best performing markets in the world. And that's the market that we're actually overweight. Greece was up 43 % last year. I would not have guessed that. Yeah, it's still cheap. If you look at the valuation, it's still one standard deviation below its long-term average on either a PE basis or a price-to-book basis. So we still like that market a lot. You said you're a value investor and you mentioned that Greece is still attractively priced.

13:15How do these companies or countries get re-rated? Does there need to be a catalyst or can it generally just be, I don't know, value finds a way? I think it's both. I think certain companies within a country that might not be performing well will still perform well because they have very good company factors and they're kind of firing on all cylinders. And so there's examples of Chinese companies that are doing quite well over the last couple of years, even though that market hasn't. And then, yeah, you get these huge re-ratings of a country, like we mentioned, Greece, or probably the best example of a re-rating would be India over the last 10 years.

13:45And usually it's when governments change. And like I said, you get a combination of a less corrupt government that's more business friendly, that puts in sound economic development policies, and then in a country that just has a lot of potential. So if you look at India with 1.5 billion people, yet per capita income, it's still only 2 ,000 US dollars. There's just huge opportunities for growth. There's a lot of management talent in India. There's just a labor advantage with 450 million young people that often speak English. So that allows a country to kind of start firing on all cylinders and that could create great long-term opportunities.

14:19And that's basically what's happening in India and to a lesser extent Greece. And there's other markets too, like Mexico, like Indonesia, like Vietnam, that I think you could say a similar thing. India is one of the hottest markets right now. I'm curious, what are the leading companies, maybe not companies specifically, but what are some of the sectors that are driving those returns higher? Yeah, the whole market has been doing well. Certainly the big conglomerates, which are probably the companies people know best, the Adonis and Reliance Industries of the world, they've been performing reasonably well.

14:49But it's actually been the SOEs more recently and some of the kind of SMID caps have been doing well. And by SOEs, I mean state-owned enterprises because usually we don't like state-owned enterprises in emerging markets. That's usually where you do see a lot of governance problems and you see a lot of value traps in markets like China or Russia. And that's usually because these companies are not really acting in the interest of shareholders, but rather they're acting in the interest of the state and that becomes a problem. But when you get a really technically sound government that is making just frankly brilliant economic development plans really over the last decade, all of a sudden those SOEs become a big beneficiary about it.

15:23And they're often the means to which these development plans are kind of implemented. And so you've seen a lot of the utility stocks do really well in India. That's an area that we own because that was still an area where you could find cheap stocks to pay dividends. They're doing well because India is growing and so there's a lot of demand for electricity, but probably even more so. They all have some exposure to renewables. And if India has one problem, well, one of the problems India has is pollution, certainly. So they're making a huge push into renewables, and there's just a ton of money coming into the sector.

15:54And so a lot of these utilities have really benefited from that. So that's an area where we've really been able to do well in our fund and still more or less like the exposures. Some of the banks, I mean, anytime you have an economy doing well, like whether it be Indonesia or Mexico or India, and you're seeing strong macro trends, banks tend to do well. So that's another area where we've had some exposure that's also done very well in India. How do you think about some sort of valuation discount there? Because a lot of people have been saying for years that the US deserves to have a valuation premium to the rest of the world, and then places like some emerging markets and maybe even Europe actually deserve to have a discounted valuation multiple.

16:31How do you think about that when building a framework for thinking about what the right valuations should be? Yeah, I mean, I think that's true. I think it's hard to argue that the US shouldn't have a premium. I mean, there's just things about the US, the ease of doing business, the rule of law, the dominance of the technology companies that probably weren't that premium. But the question is how much of a premium? So if you look at valuations now, emerging market stocks, if you look at the MSCI EM index, it's trading about 12 and a half times earnings versus the S &P 500 trading at 21 and a half times earnings.

17:01So EM is over 40 % cheaper on a PE basis and it has double the dividend yield just on an index level. And then value managers like ourselves are even cheaper than the EM index. So to me, that's way too much. Maybe you should get on average a 10 % or 15 % discount, but I don't think it should be that much. And so that allows it for the opportunity for a re-rating. And then within certain markets, you probably shouldn't have much of a discount at all. India probably does deserve to trade at a similar multiple as the US because like I said, things are going just so well in that economy. And then you have other markets like Mexico and Greece, which are also doing very, very well, but they're still really quite cheap when you really look at them.

17:41So there's a lot of opportunities there too. And it's just not on a P base. It's even probably more dramatic on a price to book basis. So that's how we think about it. How much should the discount be both overall and then on a company-specific basis as well. How important are demographic trends in your process? They're important. We definitely like favorable demographics. That's another thing we love about places like India or even that's one of the advantages that Mexico has always had. And it's a reason why people are outsourcing so often to Mexico because they have a pretty good skilled labor force.

18:15It's definitely a problem for places like China in terms of a shrinking labor pool and also in places like Eastern Europe where you have quite an older kind of demographics. We also think about it just in terms of, you know, opportunities. I mean, things like kind of like healthcare are kind of interesting when you see demographic trends, you know, because unfortunately, as you get older, you do then to use more, you know, kind of healthcare services. And then we mentioned like the consumer in emerging markets in places like India, that that's, you know, something we want to be exposed to. or you look at how changes in behaviors among certain demographic groups, like we were mentioning, travel and tourism, that also can create opportunities.

18:55So it's definitely something we look into and we do think it's important. Your strategy is called the emerging markets high dividend strategy, which is kind of funny because in the US, it seems like most investors have kind of just let go of the dividend thing from the overall market perspective. The NASDAQ 100, I don't know, it's a 1 % dividend. S &P is probably what, 1.7 % or something, 1.6%. So what are the differences there in terms of the kind of dividend yields you can find in companies in the emerging markets? Yeah, I mean, you wouldn't believe. And I always say that emerging market dividend paying stocks are the best kept secret for income seeking investors.

19:28We do have a bit of flexibility with the mandate too. The mandate is that 90 % of the companies will have a dividend yield of 2 % or more at cost when we invest in them. But the other 10 % might have lower yields and there might be other things we like about them, like just their peer valuations or whatever it might be. But like I said, there's such a diverse set of companies. Who would have ever thought that the biggest driver of our relative performance last year would have been AI? I mean, no one would have thought a value dividend manager would be able to get that exposure. But you can just load up on companies that are basically supplying the Magnificent Seven that pay dividends and that are cheap, like I said, in places like Taiwan.

20:06So it's quite a diverse opportunity set. And I think it's just almost kind of more important in emerging markets because it gets to that governance factor that usually companies that pay dividends do have better corporate governance and corporate governance is so important in emerging markets. So it's kind of a good way to start, you know, to kind of get to where you want to be in terms of getting into higher quality companies, you know, in EM. And I think that's more important in emerging markets than say in the US. So that's kind of how the dividend opportunities look outside. You know, we're usually, our dividend yield is usually about 60 to 100 % higher than the index.

20:40So we're currently and over a 5 % dividend yield. Wow. Yeah. So there's a lot of opportunities out there. I'm curious how you think about portfolio construction. Do you view it through the lens of, okay, these are like our sector constraints or we're bullish on this country, we want to be underweight that country? How does the portfolio management process work? Yeah. I mean, we are officially benchmark agnostic, but we do have certain concentration limits on position size, country size, and exposure to any industry. But that doesn't mean that we can't have big conviction in certain markets and have huge overweight.

21:14So we've been 10 times the index in places like Greece, four times it in places like Mexico. So obviously, those are markets that we like. But we're really looking – we're very rarely are we saying, all right, we want to get overweight this market. It's more of a bottoms-up process. We're looking for companies in markets. And then maybe we can get to an overweighted position if we like the companies enough. But like I said, oftentimes that works out pretty well because a lot of the things that make you like the country are the things that the company is capitalizing on. And so it leads to good growth opportunities.

21:51So that's how we think about portfolio construction. We also like price momentum a lot, believe it or not, as a value investor. So a lot of times you'll see the bigger positions in our portfolio, they've become that way because they are benefiting from positive price momentum trends. And we love to let our winners run. We do not just keep doubling down on our losers. As long as the thesis is intact and the stock has positive price momentum and the valuations are reasonable, we're going to keep holding on to it. So you use Momentum as more of a way to like entry and exit signals? Yeah. I mean, what we do is when we're doing fundamental research on companies, we have bull bear base case scenarios for each company we invest in, where we kind of stress certain macro factors and obviously company factors to come up with a bull price target.