Notes from the Investment Floor: Quality can thrive through volatility
Nick Payne examines how recent macroeconomic events have produced headwinds for emerging market investors.
Quality businesses can thrive through volatility
Nick Payne, Head of Strategy, Global Emerging Markets Focus, examines how recent macroeconomic events have produced headwinds for emerging market investors.
The universe of stocks in global emerging markets is vast, with over 30,000 different companies available to invest in. For concentrated active investors like us, this universe needs to be reduced significantly if one wishes to invest in only a handful of the best businesses available. In seeking these outliers, one of the key metrics we look at is return on equity (ROE), which measures the raw power of a business to generate return on owner’s capital. Companies that consistently generate excess returns on capital are generally quality companies that have the ability to ‘supercompound’ for periods of 10 years and greater. We also favour companies that are highly specialised in one field, exceptional at what they do, and have the opportunity to dominate their specific market.
Recently, there have been significant headwinds for emerging market investors as geopolitical events including the Russian invasion of Ukraine caused significant market volatility. Although this doesn’t hinder our ability to find quality companies to invest in, it impacts investors’ ability to hold or allocate further capital to well-run businesses through periods of volatility. However, what we have found is that quality businesses typically thrive through volatility as they are more resilient, well-run, and therefore better-placed to navigate periods of uncertainty.
The current inflationary environment means that it is more important than ever for us to find companies that have pricing power, so they can pass on higher costs to their customers without adversely impacting demand. This is increasingly important given the inflationary pressures many companies are facing, and the companies that can pass on these pressures to consumers without it affecting their margins are better positioned to retain profitability and continue generating superior return on invested capital over the long term. This demonstrates one of my core beliefs – that over the long term it is more important to find quality businesses to invest in at the right price, than worrying about where a business is located.
Yen weakness a headwind for international Japan investors
Mitesh Patel, fund manager specialising in Japanese equities, looks at the dynamics driving the Japanese market this year, as the weakness of the yen, low interest rates, and still relatively low inflation makes Japan look quite different to its developed market peers.
It has been a tricky start to the year for investors in Japanese equities, especially international for whom yen weakness has been a pronounced headwind (in local currency terms, the Japanese market has seen performance closer to, and in some cases, better than developed market peers). That currency weakness has been caused in part by the monetary policy of the Bank of Japan (BoJ), which has kept interest rates low at a time when other major central banks have already raised rates and signalled further hikes to come.
The widening differential in interest rates has undermined the yen in FX markets, but to some extent the actions of the BoJ are understandable – after all, in contrast to much of the rest of the world, inflation in Japan remains muted at 1.2% (compared to 8.5% in the US, 7.4% in the euro area, and 7% in the UK)1.
Inflation nevertheless is on a steady upward trend in Japan, exacerbated by higher energy costs, as Japan relies on imports for the majority of its energy needs, but in Japan there are longstanding deflationary factors at play as well. Yen weakness increases the costs for business importing dollar-denominated materials from overseas, but corporate Japan is in a good place to absorb those costs, as corporate profitability is as strong as it has ever been.
In many respects, higher inflation would be a boon for the Japanese economy (they’ve been trying to stimulate inflation for decades now with little success) – although preferably this wouldn’t be ‘cost-push’ inflation driven by rising material prices nor a function of a weakening yen, but instead demand-led inflation triggered by higher wages. Wages in the Japanese labour market have been moribund, despite the country’s demographic picture meaning that the employment market is extremely tight.
In our Japanese equity strategy, we try to be macro-aware but not macro-led. At heart we are stock pickers, looking to build a portfolio that can offer both income and growth potential. This year the Japanese market performance has been led by anything that is positioned to benefit from higher commodity or energy prices (e.g. mining, oil, energy) – but we fundamentally see those sectors as unappealing since we do not see them generating value for shareholders across the cycle. Our preference remains for dividend-paying stocks in less cyclical sectors, as well as quality growth companies where their longer-term opportunities remain undiminished even as they deal with short-term headwinds and a reduction in their share price valuations.
The value of active minds: independent thinking
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