FEM Q3 2022 Manager Letter
November 2, 2022
The strategy generated a net return of -2.0% in Q3 2022 bringing returns to -25.7% for the year-to-date period ending September 2022.
Relatively speaking, the strategy’s returns for the quarter are respectable. While a single quarter of outperformance versus global and emerging market equities is by no means significant, there are observations that we deem significant in shaping the medium-term outlook for the strategy. Those are summarised below:
- Investor positioning in frontier and emerging markets is light relative to mainstream emerging markets and developed equity markets. Given the non-core/off-benchmark nature of where we invest, outflows should generally have a less pronounced impact on performance.
- The political risk premium in key portfolio countries has arguably declined in the last few months. Peaceful and orderly elections in the Philippines and Kenya resulted in business-friendly governments in both countries. Even in Kazakhstan, a country that experienced seismic political shifts earlier this year, there are reasons to be optimistic. President Tokayev continues to consolidate power domestically while masterfully navigating the country’s precarious foreign policy position by pivoting toward China and the West whilst maintaining deep-rooted historical ties with Russia. Tokayev’s call for a snap election reflects increased confidence in his ability to win and push through with policies that are on net positive for the economy
- By process design, we invest in highly profitable businesses underpinned by sustainable competitive advantages and run by highly skilled and aligned managers. These characteristics are particularly valuable in the current market environment and are translating to market share gains for our companies at the expense of weakening competitors. Aligned ownership has and will continue to prove valuable in this environment. During the quarter, the CEO of a top ten portfolio company added to her already large stake through open market purchases. In October, another top ten portfolio company received a tender offer from its majority owners for part of the free float at over a 30% premium to the 30 day trading volume-weighted average price (VWAP).
- In a rising rate environment, our portfolio companies experience a net positive carry as most hold more cash than debt. Where there is debt, it is mostly in local currency or otherwise matched with foreign currency income. Of the top ten companies in the portfolio (accounting for ~55% of assets), seven enjoy a net cash position
- Our portfolio companies operate in sectors that are likely to outperform the general economy due to structural demand drivers underpinned by changing consumption habits and technological advancements. Nearly half the strategy’s assets are invested in consumer staples and information technology companies that we expect will prove more defensive in the next few quarters
The difficulty of investing in this environment is that visibility is particularly poor, and risks are apparent in every direction. Investors in such a market often exhibit paralysis or excessive risk aversion at a time when taking calculated risks can be very rewarding. We emphasise calculated because we believe there is a higher likelihood that markets will trade down rather than up in the next few months. Having experienced the global financial crisis, we understand how historical asset correlations can break down, markets can dislocate, and extreme volatility in one asset class or country can be a harbinger for significant volatility in other asset classes or countries. This is why we do not see the turmoil in British politics and the resulting gilt market volatility as isolated events but very much a result of a shift in global monetary and fiscal conditions that has a way to go. Of course, as Liz Truss has hopefully learned, reckless policy making will only exacerbate the negative impact of these shifts. That being said, we’ve made calculated additions to the portfolio and are well placed to take advantage of further volatility given the long term nature of the assets we manage and the dry powder we built up over the last 6 months.
An additional word on strategy is warranted in this environment: from a buy decision perspective, we are aware that valuations on certain high quality businesses on our watchlist have come down from “excessive” to “high” and that more than a few of those companies are still well-owned. We are making a conscious effort not to get tempted into those opportunities until we think the market has caught up with the economic realities and has adequately captured the meaningful earnings downgrades that are likely to come through in the next quarter.
It is also tempting to think that we are sitting on a portfolio of companies that is immune from further downside. However, our team is constantly looking for signals that we may have overstated our companies’ ability to generate cash flows (relative to the market’s expectations) or that there might be cracks appearing in the long-term thesis we’ve built when we invested in those businesses. This constant monitoring has and will continue to lead to downward position size adjustment and/or exits.
We believe this environment is ripe for value creation through active engagement with management teams of portfolio companies and other like-minded shareholders in those companies. Our evolving sustainability framework and the research work we conduct in that area is proving to be extremely valuable in guiding our discussions with key stakeholders. We view our work on sustainability as an enabler for better investment decision making and have committed resources in that area to ensure we reinforce our investing edge. Finally, our values as an investment business should serve the strategy well in this environment. Focus, curiosity, humility, excellence, and alignment form the bedrock of our culture and drive our daily pursuit of differentiated value-added returns for our clients.
Vergent Asset Management LLP