Q2 performance summary

Emerging markets were reasonably flat during the second quarter in US dollar terms. The strategy outperformed the benchmark MSCI Emerging Markets Total Return Index. The position in Australian-listed gold miner Newcrest was a notable contributor, as was stock selection in Brazil.

Portfolio positioning:

Latin America

The strategy has benefitted from this year’s rebound in Brazilian equities from what were quite distressed valuations. While on a short-term view valuations are no longer so attractive, on our five-year outlook we believe businesses such as Duratex, MAHLE Metal Leve and Banco Bradesco are well positioned to enjoy a cyclical recovery when it comes.

In Chile we note that Heineken may be interested in acquiring all of the outstanding shares in Latin American brewer CCU, one of the strategy’s top-ten holdings. While not in itself a reason to own the shares, this may make sense against the backdrop of a consolidating global beer industry. CCU’s controlling shareholder, the Luksic family, has a good record of trading its local assets for stakes in multinational businesses. In our opinion CCU is reasonably valued and we also have a position in Quinenco, the family holding company within which CCU is held. Quinenco is currently trading at a substantial discount to its net asset value.

Central Europe

Like many Western European banks, Italy’s Unicredit is short of capital. As a result it may have to sell its stake in Bank Pekao of Poland, a portfolio holding. Despite this potential overhang, Pekao’s conservative culture, healthy capital ratios and attractive dividend yield are appealing for longer-term investors such as ourselves.

Africa

After a prolonged period of poor stock and currency market performance we find valuations of many good-quality African businesses attractive. During the quarter we added to the strategy’s holdings in Guaranty Trust Bank (GT) of Nigeria. GT has the most conservative record of the local Nigerian banks and trades close to its book value despite generating a high return on assets and offering a generous dividend yield. The long-term potential for asset growth in West Africa is substantial.

During the quarter team members visited South Africa. We were excited by how many high-quality companies there currently trade at reasonable valuations. Many of these also have growing operations across sub-Saharan Africa meaning they should be able to deliver long-term growth. We have increased exposure to existing holdings and are likely to add new names to the portfolio in due course.

Asia

The strategy’s exposure to Asia increased over the quarter.

A recent research visit to Hong Kong and mainland China did little to dispel our concerns about the sustainability of China’s investment led growth model. We remain cautious on Chinese state-controlled businesses as we fear these may be forced into ‘national service’ in an attempt to shore up the economy and protect jobs in uncompetitive industries. What was clear from our trip, however, was how China’s large urban middle class are becoming more discerning consumers. As a result we have become more interested in businesses building genuine brands in China and the wider Asia Pacific region.

Asian brand builders added during the quarter:

Taiwan-based Merida is a leading manufacturer of bicycles and also owns a stake in US bike business Specialized. Concerns over an inventory glut and soft demand in China resulted in its share price falling more than 50% from a peak in early 2015. As long-term investors we viewed this as an opportunity to invest in a brand owner with an excellent financial track record, a net cash balance sheet and healthy dividend yield.

We initiated a new holding in Hong Kong listed Uni-President China (UPC). UPC is a subsidiary of Taiwanese Uni-President Enterprises in which the strategy also has a large position. Uni-President has spent many years building food and beverage brands in China and we believe this hard work will be rewarded in the form of higher margins. UPC’s margins remain well below global peers and we hope this will change over time.

Another new holding was Stella International. Stella’s main business involves manufacturing high end leather shoes for global brands. The company has, however, expended considerable energy developing its own Luna brand, which is beginning to be accepted by Chinese consumers at not dissimilar price points to the high end Western brands. Stella’s founders and employees own a significant percentage of the company meaning minority shareholders enjoy a high degree of alignment.

Asian holdings sold during the quarter:

Following SABMiller’s exit from its long running joint venture with China Resources we have exited our position in China Resources Beer. We are sceptical that a state-owned enterprise will deliver the required ‘premiumisation’ of its beer brands without any SABMiller input. In the absence of a significant increase in profit margins we believe the shares are very expensively valued.

We also sold our holding in Airtac of Taiwan based on both valuation and balance sheet concerns.

Strategy going forward

Weak rule of law combined with many undesirable political and business leaders mean there are parts of the emerging markets universe that are cheap for a reason. We are not deep value investors and aim to avoid being seduced by low-quality companies trading cheaply. Neither are we outright growth investors and we continue to avoid what we believe are overvalued businesses. Instead, as bottom-up stock pickers our focus is on combing unpopular markets for good-quality companies trading at reasonable valuations.