Where I’m seeing value in emerging markets
I’ve been revisiting Philip Fisher’s Common Stocks and Uncommon Profits recently. Originally published over 60 years ago, its principles have proven enduring, so much so that it is required reading for new hires at Mawer as part of our analyst training program.
This isn’t to say that I see myself as a growth investor. In fact, our investment philosophy at Mawer makes no reference to growth. Instead, our investment criteria are focused on well-run companies that, by virtue of strong competitive advantages, can generate high returns on invested capital in excess of their cost of capital for long periods of time. Sometimes these competitive advantages allow companies to expand their market share and/or markets thereby growing their revenues and earnings at above-average rates. But we’re equally interested in businesses with terrific market positions that may have more modest rates of growth, so long as they generate durable excess cash flows. In all cases, we care about price too: i.e., we strive to buy them at a discount to their intrinsic value.
Scanning the opportunity set in emerging markets, I’ve been trying to imagine what Fisher would have made of the current investment landscape. Surely he couldn’t have envisioned the economics of today’s growth companies, even if his “15 points to look for in common stocks” remain a useful lens for analyzing their businesses. The companies that Fisher celebrated—Du Pont, Alcoa, and Motorola—grew at high rates but exhibited diminishing returns on invested capital and incrementally slowing growth as they got bigger. By contrast, virtual business models like Tencent and Alibaba demonstrate the reverse: increasing returns to scale given virtuous network effects and customer acquisition costs approaching zero. Tencent’s annual revenue growth has been in excess of 20% in each of the last twenty years and has a market cap approaching USD $800 billion. Investors who have long anticipated a more traditional path to mean reversion have been left behind.
Virtual business models that demonstrate high growth and optionality are difficult to value for a number of reasons.
First, they often invest heavily through their income statements. A more traditional manufacturing business investing in a new plant would treat this cost as a capital expenditure, in recognition that the plant will operate for many years and its cost should therefore be amortized over time. But many of these virtual businesses are treating software development costs as expenses on their income statements, despite the fact that the code itself will serve well beyond the year in which it was written. This masks the economic reality of how much cash flow these companies are expected to generate, and when the cash flows actually occur.
Second, and somewhat relatedly, their cash flow profiles tend to be longer-duration in nature. In a discounted cash flow (DCF) context, this means that estimates of intrinsic value are highly dependent on cash flows many years into the future. This introduces uncertainty, both through the sheer reliability of out-year assumptions as well as the sensitivity to changes in discount rates.
And finally, they operate in a rapidly evolving landscape. Strong network effects are indeed a wonderful competitive advantage, but their markets are often winner-take-all (producing a handful of tremendous winners and larger set of also-rans). As we’ve seen with increased scrutiny on technology companies in the U.S. and China, their strength invites attention, with regulatory risks introducing uncertainty. On the flip side, excellent management teams have the ability to capitalize on future optionality that these network effects afford them and prolong their growth trajectories at high returns on capital.
As a result—and borrowing from the probabilistic way we approach valuation assessments—80% confidence intervals for the intrinsic values of these virtual businesses are admittedly wide and require an even more probabilistic view to future ROICs, cash flows, and skew.
At the same time, many more traditional, high-quality companies have been richly rewarded of late. As an example, in our international equity portfolio we recently exited Kone, a leader in the escalator and elevator industry. We continue to think it’s a great business, but we concluded the assumptions required to justify its valuation were too aggressive on the back of its strong stock price returns. Quality has largely been in favour in an environment of falling discount rates, and we acknowledge that this emphasis has played a role in the results we’ve generated for clients over the last decade.
With so much value-creation taking place in these higher-growth, longer-duration companies, what to do? How to “win by not losing” while at the same time ensuring we don’t “lose by not winning”? Within our emerging markets portfolio, we’ve noticed that the opportunities that best meet our investment criteria have increasingly come from both sides of the spectrum, and we’ve leaned into the barbells of our investment philosophy. This approach has the benefit of producing what we believe is a core, resilient, and diversified portfolio, and one that is also more efficient, i.e., that may generate higher returns with lower levels of risk.
To illustrate, consider two recent additions to the portfolio: Kazatomprom and Kaspi.kz, both coincidentally based in Kazakhstan. (Put your Borat preconceptions aside: Kazakhstan may be the most successful of the former soviet socialist republics in transforming into a peaceful, stable country focused on economic development. For more, see Nazarbayev and the Making of Kazakhstan: From Communism to Capitalism by Jonathan Aitken.)
Kazatomprom is the world’s largest and lowest-cost uranium mining company. This is an “old economy” company, shorter-duration, and a relatively straightforward business model. Its intrinsic value is clearly influenced by the price of the commodity it sells, but we believe that the bear market for uranium that has persisted post-Fukushima has depressed capital expenditures across the industry, meaning that supply side responses from competitors to spot price increases are likely to be muted in the near- to medium-term. As the market leader, Kazatomprom thereby has favourable odds of wealth-creation with an upswing in demand; and given society’s focus on reducing emissions, nuclear is a clean baseload power source for electrical grids. But if that upswing fails to materialize, the company retains its competitive advantage as the lowest-cost producer thanks to Kazakhstan’s favourable geology, which has allowed them to generate ~12% return on assets during the uranium bear market. In other words, while shorter-duration, Kazatomprom certainly meets our quality criteria.
By contrast, Kaspi is the dominant super app in Kazakhstan. It has leading market shares in e-commerce, payments, and fintech, and its broader ecosystem has resulted in close to 50% of the population of Kazakhstan as active monthly users. The company has ample growth runway, given that the country is underbanked, and that despite Kaspi having a ~70% share of Kazakhstan’s e-commerce market, e-commerce penetration overall is only at 5%. Kaspi’s ecosystem has become increasingly difficult to replicate, and results in advantages such as lower customer acquisition costs, habit formation among its users, access to critical proprietary data to assist in pricing risk across its product offerings, and future optionality for new verticals that can leverage the existing platform. And even in simple valuation metrics at 18x P/E we do not appear to be paying up for Kaspi’s potential growth; in stochastic DCF terms, the current stock price is squarely in what we deem to be the fair value range for a reasonable price.
In a portfolio context, these two Kazakhstan-based stocks complement each other nicely, offering different end-market exposures, economic sensitivities, interest rate sensitivities, and act as a currency hedge to one another: in an environment of a weak Kazakhstani tenge, Kaspi’s value may be reduced but Kazatomprom’s value may flourish given that uranium is priced in U.S. dollars while the company’s labour costs are in tenge.
You’ll find many other examples of this barbell approach across the portfolio: e.g., Tencent vs. cement and hazardous waste treatment company China Conch Ventures; Taiwan’s e-commerce leader momo.com vs. China Merchants Bank. We believe that it pays to be discriminate: many shorter-duration companies fail to earn their cost of capital, and the valuations of many higher-duration companies seem unreasonable.
Fisher concludes Common Stocks and Uncommon Profits by stating that “the risks and rewards of the past hundred years may be small beside those of the next fifty.” Perhaps he did envision the spectacular rise of companies like Tencent after all.