How to use themes to understand emerging markets

Investment themes such as consumption, education and technology are central to many emerging economies, but how they translate to opportunities varies as much as the countries’ local cuisines.

Economic patterns are the first things Christine Tan, senior portfolio manager and CIO at Excel Investment Counsel in Mississauga, Ont., and her team investigate when considering investing in a country.

“Consumption is the strongest theme for us in emerging-market countries, because income levels are so low,” explains Tan.

For instance, with an average GDP per person of about $10,000, Chinese consumers have more income than those in other Asian countries. In Indonesia, for instance, the average is about $4,500.

“What that means is that while a lot of other EM countries are still spending mostly on primary goods, like their first car or refrigerator, China was already moving farther up the curve of consumption into services,” she explains. There, the middle class can spend on travel, healthcare and education.

Once she identifies how a theme is playing out in a country, Tan uses the principle of growth at a reasonable price to pick firms.

“We’re trying to find businesses where the penetration rate of whatever they’re doing is still low, and they have a strong position in that particular segment, whether it’s because of a brand name or something they do differently,” she explains.

She looks at a company’s operating track record, to make sure management has a history of explaining its decisions to shareholders and following through on plans. She also checks that management’s pay is aligned with the company’s success. She invests through publicly traded depositary receipts, an instrument for investing in a foreign company’s securities through an exchange like the NYSE. The instruments are held to the standards of the exchange they’re traded on.

Still, if management wants to mislead shareholders, they’ll do it no matter what standards they’re held to, says Tan. She keeps portfolio positions small: “Our top-10 holdings usually average around a 2% to 2.5% weight, and we typically have 60 to 70 holdings in a portfolio.”

Hit

TAL Education Group (NYSE: TAL)

TAL Education Group is a Chinese company that provides standardized tutoring for children from kindergarten to Grade 12. The company, founded in 2003, started with tutoring centres in major cities like Beijing and Shanghai, and is now in secondary markets like Nanjing and Suzhou. Tan says TAL has a reputation for good wages that attract quality tutors, which translates to high marks for students.

Putting it through her process

Once Tan identified education as one of her core themes for China in 2013, she investigated all the publicly listed education businesses in the country. “At that time, there were only a handful,” she says.

She looked at TAL and two competitors. One, New Oriental, offered adult English education and skills training. Another company offered training for new graduates. TAL was the only one tutoring children. The rise of the middle class and the legacy of the one-child policy meant Chinese parents could now focus resources on their children.

“The product is viewed as almost non-discretionary when you talk to parents,” Tan says. “They’ll cut almost any other spend to ensure tutoring for their kids.”

There were initial concerns about TAL. For one, the company was worth about US$1 billion at the time, and few analysts were covering it, Tan says. She typically invests in companies with a market cap of US$2 billion or more, because increased scrutiny and better accounting are typical of larger firms.

Further, she was concerned about the low barriers to entry in the tutoring business. Competition is scattered across informal networks of parents and tutors. Anyone can set up shop, Tan notes. But industries with artificial barriers, such as licenses, aren’t much better off, she adds. “It’s great for now,” she says, “but, at some point, someone else could be issued a licence.”

Instead, TAL’s management warded off competitors by hiring top tutors and conducting one-on-one or small-class tutoring. It was building a reputation for consistently high-quality work throughout its tutoring centres, and satisfied parents were its best advertising.

Company stats

HIT: TAL Education

Ticker: NYSE: TAL

HQ: HQ: Beijing

What: Tutoring

Average purchase price: US$13.20

Current price: US$83.33 (Feb. 6, 2017)

MISS: Magnit

Ticker: LSE/MCX: MGNT

HQ: Russia

What: Grocer and retailer

Average purchase price: US$49.50

Sale price: US$40.97 (Dec. 14, 2016)

Current price: US$36.90 (Feb. 6, 2017)

REPLACEMENT: Lukoil

Ticker: LSE: LKOD

HQ: Russia

What: Oil and gas

Average purchase price: US$34.89

Current price: US$56.31 (Feb. 6, 2017)

Tan bought an initial position in late 2013 and continued adding to it in early 2014. As TAL was smaller than her usual companies, she built her position over several quarters as she got to know management and saw the company delivering on promises. The average purchase price of her entire holding is US$13.20. “It was inexpensive when we bought it,” she notes.

Turning point

New Oriental has started tutoring children, but Tan believes the market is large enough for two companies. New Oriental “has been able to grow in kindergarten to Grade 12, but TAL is still by far the go-to,” she adds.

TAL’s biggest issue is that tutoring demand outstrips the supply of qualified tutors, Tan says. As the company expands into smaller cities, it’s turning to technology to provide the same tutoring experience as in the big cities. “They have e-classrooms, which means that they’re able to leverage the tutors in the major city centres to reach out into the smaller towns as well,” says Tan.

She appreciates that management is growing the company cautiously. If TAL’s quality slips, customers will begin comparing it to cut-rate providers, and its value advantage would be lost. So far, the expansion hasn’t sacrificed TAL’s reputation, says Tan. It’s also boosting the company’s return on invested capital (ROIC), she adds, because it doesn’t cost much to connect tutors with students online.

ROIC is one of the key ways she measures a business’s success, though the benchmarks vary by country. For example, in China, a company with a US$4-billion market cap can borrow money at an interest rate of 3%, says Tan, but that same company would have to pay 15% in Brazil. So while a 10% to 12% ROIC is fantastic in China, a Brazilian company with the same ROIC wouldn’t break even.

Results

“For the last five years running now, the company has actually beat expectations, even though growth expectations were already pretty high,” she says.

The stock, which is still a top-10 holding, was trading at US$83.41 as of February 6. As its price has gone up, Tan’s trimmed her position to keep its portfolio weight steady. “Whenever it gets closer to 2.5% or slightly above, we’ll take a bit of money off the table just to keep the diversification,” she explains. TAL currently has a 2.54% weight.

Today, the company trades at about 30 times earnings, says Tan, who says that’s expensive but fair. Since she purchased it three years ago, return on equity has ranged from 23% to 27.4%. As the company has invested in expansion, ROIC has ranged from 10% to 22%, while the operating margin has ranged from 13.7% to 18.3%.

Going forward, Tan says return on equity will be more in line with earnings growth, which she predicts will be a rate of 35% as TAL expands its tutoring over the Internet. “There’s still a lot of room to grow,” says Tan, who explains there remain Chinese cities of 10 million to 12 million people that don’t have a standardized tutoring business like TAL.

TAL is “almost being pulled along by growth, as opposed to seeking growth,” she says, “which is a great place to be.”

Miss

Magnit (LON: MGNT)

With more than 14,000 convenience, grocery and drug stores, Magnit is “the Loblaws of Russia,” says Tan. Founded in 1994, Magnit was initially a household chemical wholesaler. Four years later, it opened its first convenience store and began expanding. In 2010, it began growing its own vegetables to sell in-store, and in 2011 it became publicly listed.

Putting it through her process

Western sanctions and state participation in business make Russia a tricky emerging market to invest in, says Tan.

State-owned companies can make for poor investments because the government’s interests aren’t always aligned with shareholders’. For example, the state could be more interested in employing people or paying dividends to fund social programs than running the business well.

Publicly traded Magnit was attractive because states don’t have much involvement in the consumer goods sector, says Tan.

The Russian consumer goods market is competitive, but what sets Magnit apart is its focus outside Moscow and St. Petersburg. Two-thirds of its stores are in cities with fewer than 500,000 people. Tan says the company is particularly effective in towns with 50,000 people or fewer. There’s less competition, and operating costs, such as wages and rent, are lower.

To comply with economic sanctions, Tan bought an initial position in Magnit in October 2014 through its global deposit receipt, listed on the London Stock Exchange, for an average price of US$49.50.

“Nothing has changed too much from the operational side, but it hasn’t worked out yet,” she says.

Turning point

In 2014 and 2015, plunging oil prices contributed to a weakening ruble, which fell 34% against the U.S. dollar between January and December 2014. (It’s down further since then.)

Economists had already predicted that Russia’s economy would stagnate. The environment worsened that December when Russia’s central bank raised its benchmark interest rate from 10.5% to 17% overnight, after raising it one percentage point just days before.

Against this backdrop, Tan bought Magnit. She thought a consumer goods company would be safer than some of her other Russian holdings. That year, Russia invaded Crimea, nationalism was rising and President Vladimir Putin was cracking down on internal unrest.

At the time, Tan had a position in Yandex, Russia’s largest search engine. The government was increasingly using legislation—introduced under the guise of blocking child pornography and extremist websites—to censor anti-government and pro-minority rights views. Earlier that year, politicians had passed a law mandating that online companies with data on Russians must house the information on servers inside the country. There were few details about how the law would be implemented.

The new rules were creating an unpredictable environment for Yandex, so Tan sold and replaced it with Magnit.

“We thought it was much more defensible in terms of a business model, but we did not anticipate the deterioration in the ruble, and inflation,” she says. In 2014, the inflation rate was 11.4%, making it difficult for Russians to afford necessities.

A little bit of inflation is good for grocers, as they can nudge up food prices to keep pace while adding extra margin, Tan explains, but double-digit inflation hurts retailers.

“You can’t pass it on [to customers], or if you do pass it on, it impacts volume and sales,” she says. Russian consumers buckled down. They bought less protein, switched from beef to pork, and began eating more carbs to save money.

“I underestimated how quickly and sharply the ruble would correct, and it had a pretty sharp impact on Magnit’s business,” she says.

Results

In mid-November, the stock was trading at around US$37.09, down about 25% from Tan’s average cost.

In the end, Tan sold Magnit for US$40.97 on Dec. 14, 2016.

“We didn’t see an near-time significant improvement in Magnit’s outlook,” she says. “We try not to get anchored by something. If I choose not to sell Magnit today, it’s as if I’m buying Magnit today. Just because we own it, doesn’t mean we should be anchored and stick with it.”

She used the proceeds to buy Lukoil, a Russian oil and gas company, thereby increasing her Russian position.

“Lukoil has a better outlook, given what oil prices were coming off of, and we thought the potential cashflow outlook was much stronger,” she says. “The portfolio was also very underweight energy, and this was another way for us to increase our energy weight.”