When investing in emerging markets, you can’t ignore the top-down, Janus Henderson’s Daniel Graña says. If you do, you might end up with some nasty surprises.
Investors in developed market countries often focus solely on the analysis of the companies they want to invest in. This bottom-up approach makes sense for them, because external factors such as government policies and regulatory change have a relatively minor impact on the day-to-day operations of these companies.
But the same cannot be said for emerging markets. Government policy, or even interference, change in leadership and the rule of law are more fluid in these markets and have a real potential to influence outcomes at a company level.
In other words, the top-down matters – a lot.
“In emerging markets, every two or three years we are reminded why the top-down matters,” Daniel Graña, Portfolio Manager for Emerging Market Equity at Janus Henderson Investors, says in an interview with [i3] Insights.
Countries and companies are at different stages of development in this asset class and, therefore, acceptable business practices and acceptable government behaviour are all much different in emerging markets [than in developed markets], so that leads to a much wider standard deviation of outcomes
“Countries and companies are at different stages of development in this asset class and, therefore, acceptable business practices and acceptable government behaviour are all much different in emerging markets [than in developed markets], so that leads to a much wider standard deviation of outcomes.
“If you don’t incorporate top-down factors, then you’ll be surprised.”
In addition to corporate governance, investors in emerging markets need to ask themselves questions about what he calls the ‘political governance’ in each country, Graña says.
“Before we invest in companies, we ask ourselves: Is this a rule-of-law country? How predictable is the regulatory regime? If it’s not a rule-of-law country, then what do those in power want? Are these companies swimming in the right direction of government policy?” he says.
“If they’re not, then the companies become vulnerable. You have to understand that in some countries the judiciary isn’t independent; the judiciary does not act as a check on the government. You don’t always have recourse.
“If the government decides to do something, then you may not be able to seek a refuge through the courts and so you have to respect that there are rules to the road.”
The Case of Copper
To illustrate his point on the importance of a top-down approach, Graña gives an example of companies that look good from a bottom-up perspective, but where ultimately the external environment is against them.
“A few years ago we came to the conclusion that China’s decarbonisation pledge was credible and that had enormous implications, most notably for copper. Copper was going to be one of the areas we want to be invested in,” he says.
“Of course, copper is important for electric vehicles; they have a lot more copper per vehicle than internal combustion engines. And if everyone’s going to charge their cars at home, then you’re going to need more electrification, more transmission towers and so forth.”
Graña and his team looked across the various emerging markets for companies that mined copper and discovered 40 per cent of the world’s copper production comes from Chile and Peru.
It would make sense to look for businesses in these countries, but when they did and started to ask questions about the political governance of Chile and Peru, the answers they received were not always the ones they wanted to hear.
“Many of the multinational mining companies [in Chile and Peru] have complicated relationships with the local communities in those countries and so while we certainly were excited about the implications of decarbonisation in China for the copper demand and the electric vehicle penetration around the world, we were very concerned about the regulatory framework
“We couldn’t get comfortable for political governance reasons,” Graña says.
“Many of the multinational mining companies have complicated relationships with the local communities in those countries and so while we certainly were excited about the implications of decarbonisation in China for the copper demand and the electric vehicle penetration around the world, we were very concerned about the regulatory framework.”
As it turns out, both countries went through some significant changes shortly after. In Peru, the far-left Pedro Castillo was sworn in as the country’s new president in July last year, while Chile also faced some significant political upheaval.
“Of course, we could not have predicted that Peru elected a Marxist president on a platform of attacking mining companies, or that Chile, would have a full-on protest and now in the process of rewriting the constitution, which includes depriving the mining companies of their water rights, while they potentially facing much higher taxes,” Graña says.
“And so all greenfield and brownfield expansions of projects have ground to a halt and those stocks have struggled even though the copper prices are soaring. So political governance matters.”
Russia
The top-down approach helps the team understand the political process in a country and in extension the drivers behind economic policies, which ultimately affects the risk and the growth potential of the companies they invest in.
The recent invasion of Ukraine by Russia’s President Vladimir Putin was a dramatic event from any perspective, whether humanitarian, historical or political, but from a financial perspective it also presents a challenge in that it has changed the economic status quo so quickly.
“From a top-down perspective, I understand the political process. But something geopolitical like this skips that economic policy-making step and immediately goes to the potential impact on the economy,” Graña says.
Yet, the top-down approach did help the team recognise early on that there might be a problem.
It was in November that we came to the conclusion that there was a rising risk of military action, and so our concerns were that if this were to happen, then there would be negative implications for not only the short term, but also the medium term. So as a result we saw that the picture for emerging markets’ riskiest asset classes also became more complicated
“It was in November that we came to the conclusion that there was a rising risk of military action, and so our concerns were that if this were to happen, then there would be negative implications for not only the short term, but also the medium term,” Graña says.
“So as a result we saw that the picture for emerging markets’ riskiest asset classes also became more complicated. Russia, of course, was one of the most important markets in our asset class and as of Wednesday last week [9 March] MSCI has kicked it out of the index.”
Up until the invasion, Russia had become an interesting market for investors, where the internet gave birth to some rapidly growing businesses.
Graña gives the example of Yandex, a provider of internet-related products and services, including search and information services, e-commerce, ride-hailing, navigation, mobile applications, and online advertising to a largely Russian-speaking customer base.
Yandex’s business model is more akin to the large Asian e-commerce behemoths that provide a range of services through a single app.
“The American way of looking at things is that you have silos and so you go to Amazon to buy things, you go to Facebook and Instagram for social media and to PayPal to pay for your goods,” Graña says.
“But in Asia, you already play games on Tencent, so why not interact with your mates in a social media context through the app too? The model here is more that of a super app, where consumers see the convenience of having one app that can do everything digitally.
“Yandex is the super app of Russia. It’s core business is search, but they have a dominant share now and ride-hailing services and they continue to add more and more capabilities.
“So there were some pretty interesting stories in Russia that caught our attention.”
But even though Yandex is listed on the Nasdaq, the stock has been suspended along with the rest of the Russian stock market. Luckily for Graña, the early warning signs from his top-down analysis resulted in exiting the position beforehand.
“What this all reminds us of is that the top-down matters, that geopolitics matters and this is why emerging market investing is different than investing in developed markets,” he says.
Innovation
Looking towards the future, Graña sees further growth in emerging markets coming from innovation. Whereas emerging markets in the past had little value-added activity, this picture is starting to change quite rapidly, he says.
“Emerging markets have largely been makers of widgets. We were part of the supply chain, but we weren’t necessarily at the leading edge of innovation,” he says.
“But in this most current wave [of innovation] that we’re experiencing now – which is 5G, blockchain, artificial intelligence, the internet of things and big data – emerging markets are increasingly playing a leading role.
“It is a function of the ecosystems that we’ve built. So think of the number of STEM (science, technology, engineering and mathematics) graduates in China and India. Think of the number of entrepreneurs that have worked in multinational companies that now want to come home and start their own businesses. And think about the R&D budgets.”
He argues the smartphone has done much to lower the barrier for lower-income families to access a wide range of services previously inaccessible to them. Suddenly, these people can access banking services through fintech and health services through telehealth. This has driven much of the innovation in these markets.
“If almost two-thirds of Mexicans don’t have a bank account, then how do you solve that problem? Well, it’s not by building a branch in the rural parts and semi-rural parts of Mexico; that’s going to be expensive. Instead, it is fintech for a smartphone,” Graña says.
“The exciting thing about this kind of innovation is that it’s looking to address the problems that the incumbents have not been able to, or unwilling to, solve, largely because of their legacy business models and legacy systems.
“They can’t make it economically viable, whereas the disruptors are going to be in a different position; they have a different mentality, a different mindset of how to target this market.”
For example, Graña has invested in Chinese fintech company LinkLogis. This company is revolutionising the financial supply chain through blockchain, artificial intelligence and a digital currency.
In practical terms, this technology helps small and medium-sized enterprises (SMEs) get better access to financing. Whereas in the past, Chinese banks were predominantly lending to state-owned enterprises, LinkLogis’s blockchain gives lenders the confidence to lend to SMEs at competitive rates.
Historically, there were two reasons for growth in emerging markets: outsourcing and convergence [the idea emerging markets grow faster than developed markets because they have some ‘catching up’ to do]. We're seeing this rise of the third reason – innovation – and that gets us very excited
“Instead of lending to an SME at 12 or 15 per cent, or even not lending to them at all, now suddenly you can lend to them at five, six or seven per cent [interest rates] and with much less credit risk because the contracts are proven, the relationships are digitised,” Graña says.
“And what is interesting as well is that this technology was designed in China. This is not off-the-shelf Oracle or SAP technology. This was designed in China and it solves a social need, which is better access to financing.”
He says a top-down approach is important here too as not all countries have the right set of circumstances to facilitate innovation.
“Historically, there were two reasons for growth in emerging markets: outsourcing and convergence [the idea emerging markets grow faster than developed markets because they have some ‘catching up’ to do]. We’re seeing this rise of the third reason – innovation – and that gets us very excited,” he says.
“But the problem is the rise of innovation is unequal across emerging markets. We often speak of emerging markets as if they were a monolithic asset class, but they are not. There are significant differences between Korea, Taiwan and Brazil in terms of the history of these countries and the choices that they’ve made. And there are significant differences.
“You need to have the right ecosystem to encourage innovation, the right universities and the right kind of capital markets that rewards the entrepreneurs, and so not all emerging markets have all these dimensions in their favour.
“Countries like Mexico, Brazil, Turkey and South Africa find themselves in that middle-income trap and in order to break out you need to spend more on R&D, you need to improve the quality of education and you need to make sure that entrepreneurs are rewarded for taking risks.
“For all of those reasons, many of the Asian countries are well positioned for innovation, including India, China, Korea and Taiwan.”
For an in-depth podcast interview with Daniel Graña, please see here.
This article is sponsored by Janus Henderson Investors. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.