The Dividend Cafe - The Worldview of Emerging Markets

Episode Date: November 19, 2019

Topics discussed: We have spent way too much time talking about the trade war, tariffs, the Fed, and Trump this year, and not nearly enough time talking about sustainable growth in the emerging markets. Our Investment Committee thoroughly unpacks what we believe to be one of the more intriguing parts of our investing worldview at The Bahnsen Group in this extensive and thought-provoking discussion. Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. we're debating what we want to call it, a podcast or video or whatnot. I think we go a podcast because that's how most people listen to it. And then to the extent someone's watching the video right now, they kind of know it's a video because they're watching it. Yeah, that's a good point. All right.

Yeah, I think that's good. I'm still not comfortable saying vidcast. Is vidcast a real word? You can add it to the lexicon. I think that works, yeah. Is that what the young people are saying now? I wouldn't know. Tell us, Robert.

So listen, a lot of stuff going on in the markets. We can kind of do a quick summary of where things are at a macro level. Obviously, we've spent the last couple weeks talking about our view on equities. It's a more sanguine environment with a little relief in trade war fears and monetary policy. And then the earnings results for the quarter not becoming worse than people expected, a mostly pretty benign result. And then we sort of prepare for the end of the year and go into 2020 with a reasonably open appetite for risk, I think, for most risk-oriented investors. One of the things, though, that gets ignored is what we're going to focus our topic on today, is how a lot of these things that have made for a more sanguine environment for equities in the U.S.

actually benefit emerging markets. And you look back to 2018. It was a very difficult year for EM equity investor, unlike 2017 and 2016, which had both been gangbusters in emerging markets equities. But in 18, it was the same things I just said that were fearful in the risk environment for US were particularly weighing on emerging trade wars, impacting global trade flows, and therefore economic opportunity out of a lot of the emerging economies. And then in monetary policy, to the extent you get a stronger U.S. dollar, tighter flows,

you have so much dollar-denominated debt in emerging markets that it becomes a real hurdle for those economies to have to overcome if you get global weakness that held down EM. Their PEs got to a point of about on an index level at one point they're trading forward 10 to 11 times. So you had far higher growth rates trading at a much lower valuation. And so we maintained our view coming into this year. And frankly, EM's performed very well as all risk has this year, but it isn't like EM has outperformed S&Ps this year, which you kind of should have expected given the macro environment. Therefore, on a relative basis, my thesis would still be going into 2020 that EM is undervalued as a growth asset class relative to U.S. equity.

And I think the reason why we all need to discuss this today on the podcast is kind of bounce around what that means, how we want to be affected there, what it looks like to debt, to equity, but also what is unique about our view as emerging markets, equity investors. Brian, you've been with me the longest in this worldview. We've been invested in EM equity since the financial crisis. Do you feel any differently about the asset class now than we would have a couple years ago? It's cheaper. Yeah, it's cheaper. But no, the underlying thesis is the same, which is that we want to own companies, bottom-up companies in these countries, whether they're located in this country or that isn't all that important. It's more about the growth trajectory of that business and that that business is reliant upon the consumption of that country.

So that emerging consumer versus sort of an export-led type of business like a commodity play or an oil play or something like that, where really they're selling electronics or commodities across to the developed world. We want to own companies in the emerging world where that growth is based on the middle class growing in that area and consumption of that area. Yeah. Well, Dayad, we have met over the years with our emerging markets equity managers, and you've gotten a chance, I think, to be sort of evangelized the way that I was many years ago around the idea that a lot of people in the U.S. that are investing in emerging markets think they're investing in a different asset class, emerging markets equity, and are really

investing with leverage on investments that play the U.S. market, the way that certain companies in China or Taiwan or South Korea or Hong Kong might sell to U.S. market, the way that certain companies in China or Taiwan or South Korea or Hong Kong might sell to U.S., very commodity dependent, and the rethinking as to how we approach the asset class being more driven by domestic growth and domestic consumption. Do you believe that we've gotten anything wrong in that thesis that we've played out at Bonson Group over the last 10 years? That we've gotten anything wrong in that thesis that we've played out at Bonson Group over the last 10 years. That we've got anything wrong in the implementation of that? And in that philosophy that the right way to be invested in EM is for EM growth, not for EM selling things to Americans.

I think we've been very, very consistent in our application and belief. We've never strayed from it. We've never strayed from it. As far as really what we – like you and Brian said, what we're focused on, those are focused on those companies that are playing that consumer, that emerging consumer story, that are leveraged to that, companies that have good forward demographics where that growth rate is there. And the reason why we don't – And there's different ways to play that. I've looked at many different managers that might invest in companies that are domestically based

here in the US, but sell to emerging market consumers. And the reason why that's less attractive for us is that those are, yeah, they're still playing that same theme as far as the emerging consumer goes. But the valuations aren't there like they are for companies that are headquartered emerging markets. I mean, and that's – and the reason why those valuations are there is because of all those things you mentioned around volatility and geopolitical risk. It creates low multiples. You have – on a forward basis, I think EMs now are about 12 or 13, about 1.5 sales or something. So, I mean, finding companies that are compounding capital at that kind of rate, trading at those valuations only exist in EM. So, we've been pretty consistent

in managers that are biased towards that philosophy and putting capital with them. Julian, when you think about the risks in EM equity that are distinct from U.S. equity, what is at top of your list if you had to pick between one of these two, geopolitical or currency? That's a good question, I guess. They're probably correlated to each other

in the sense that I would say if you have geopolitical risk, you're probably going to impact the currency as well. So I don't know if they're really different or if you could say that they're the same risk at the end of the day in the sense that instability

will have a lot of impact on the currency of the country that's impacted. I don't know if you look at Chile at the moment, for instance. So I guess I would put them in the same basket. So that's a good point. They're not distinct risks. They manifest themselves differently,

but they're highly correlated to one another. What right now do you think is the headwind for EM that is, as Dale was talking about, the valuation not having kind of a normalized? Are people worried the dollar is going to continue going higher? I guess the way the Fed has been cutting rates, it should be the other way around, I guess. The dollar is based on rate expectation. You don't expect the dollar to be going higher. I think at the end of the day, the multiple discount

is probably just a reflection. Historically, it's always been at a discount. You don't even have to look at emerging markets. Look at Europe. Why is Europe at a discount to the US? Because you have less growth, because you have instability, and because I think there's always going to be, this is, I think, you know,

another thing we need to think about is the asset management industry is something that's done out of the U.S. by American people. And you're always going to put a premium on your, you know, the companies you know the best and you are based here and they have more stability. And I guess in the sense that

when you have like a correction, we all want to go back to large cap equities or we all want to go back to large-cap equities or we all want to go back to owning the treasuries. When there's uncertainty in the world, you're going to start selling emerging market first. You're going to start selling high-yield bonds and go into what you feel is safer, which would be large-cap U.S. equities.

And it's probably why there's this discount that I feel like will never disappear, maybe sometimes be less of a discount, but it'll probably always be at a discount. So, Robert, Julian brings up a really important point that I think is actually illustrated in the performance attribution within emerging markets. And we're not going to say any specific company names. But to his point that people are defaulting to what they're most comfortable with or what they know the best

we actually see that even within em that some of the very big mega cap names that are actually kind of now household names even though they're in china they're not trading at 13 times earnings they're trading at 35 to 50 times earnings so So even in EM, people are defaulting to the comfort level. Is there an opportunity that comes from people's fear of going to stuff that is new terrain? Absolutely there is, and I think that's why it's so important to have quality managers that have, in essence, kind of a boots-on-the-ground approach. The macro, the top-down approach to EM is, I think, inherently flawed because you're exposing yourselves, you know, call it 3x, 4x to the geopolitics, to the currency issues. The companies operating in those places are looking to do one thing, you know, sell their good or service and drive a profit. Something Julian also said briefly about geopolitics and currency issues. Yes,

they're certainly correlated, but I think in some circumstances, one leads the other. I think back to Turkey a little bit, right? They had a ton of foreign denominated debt right there. Well, that became a problem. And then it was perhaps suggestive of a shaky geopolitical situation and politics in that country as well. So I think being able to look at all these different things in tandem with each other is really good. And they certainly are tied into each other. No, that's a very good point. And I wonder if that is the risk premium that investors should be craving, not shunning. Yeah, and Day had touched on it earlier,

the valuations. There's certainly what we think might be a discount or our managers see as a discount. And it's because sometimes people look at the countries and they say, hey, maybe that country is shaky, this or that, or there's some issues on a macro level. But the underlying companies that we're investing and, our managers are investing in, are very solid. So there's a very good value play there.

I think that this day I want you to comment on it. I think it comes down – he said people are afraid of underlying shakiness in certain countries. You take a really huge U.S. mega cap company that might be based in Cincinnati, Ohio. take a really huge u.s mega cap company that might be based in cincinnati ohio would anyone ever say i'm a little afraid of the compounding of xyz company because i don't know the the landscape in cincinnati right we don't think that way it's based on all totally different trends and realities economically where their customer base is around the world you just intuitively know that where xyz company is based by by the way, can you think of some Cincinnati companies I might be referring to? But we're just trying to make things easier

for our regulators right now. Look, we would never say I like Minnesota or I'm afraid of Cincinnati, but as EM investors, we do it all the time. Is that logical or is it kind of the wrong way to think? Should people not be saying, I'm afraid of Chile, I'm afraid of Turkey, and instead focus on the growth multiples and fundamentals of the companies that are there? I think that you should absolutely, and we obviously have a strong bias towards managers that are focused on the fundamentals of the company. Now, that being said, every manager that we talk to does have some sort of macro view on the countries they're invested in. I mean, look, if you could have found some really

strong companies in Venezuela this year, but I mean, the currency is depreciated 90% against the dollar. So to an extent, you have to have some view about just the framework, the rule of law, just the framework, the rule of law, everything that goes into the system to be able to have companies that are able to be profitable and compound capital over high rates for a long period of time is really, really important. And another thing is also the corporate governance. It's one of the things that we focus very heavily on in EM relative to developed countries. be able to give those distributions back to the shareholders instead of unnecessary investments for whatever reasons that aren't going to generate that increase in a return to capital above their cost of capital. But as far as NEM, that's a really important facet to focus on there because it's a lot rarer to find boards and find companies that are aligned with shareholders.

It's a lot rarer to find boards and find companies that are aligned with shareholders. It isn't the exact same mentality here, mostly in developed countries. And not to say it isn't out there, DM, it is. But just it's one thing that you have to focus on a little bit more in your screening is the corporate governance in EM. I love that you brought that up, too, because in my opinion, the G in ESG is where in in emerging markets the fiduciary responsibility lines up with profitability and good motives right so you're not necessarily always worried about divesting from fossil fuels different aims that certain countries or companies might have right you're looking for not a lot of woke pension funds in ecuador that's right you're looking you're looking for for alignment of shareholder and and management interest in that situation you brought up it's great and the other thing maybe you should mention is you can achieve some of that risk of setting

with the diversification. Because when we talk about emerging markets, you really talk about two big countries, China and India, and then Brazil and Taiwan and Mexico. And so if you have some macro impact in Chile it's gonna it should be positively you know meaningless to your portfolio if you want an emerging market portfolio it's relatively small so the classification will should help you you know I think that begs the question a little should it be that way like should Chile be a small part should China be a big part if you're benchmark agnostic if you're focused on where great companies are, and China becomes over 50% of the index, which it effectively has become.

This was the issue of Brazil 7, 8, 9, 10 years ago. A couple of energy companies out of Brazil became a really disproportionate weighting in the index. And to me, it spoke to an inefficiency in index construction and an opportunity for bottom-up investors. I guess that's a really good point, and that's really one of the issues with investing in emerging markets is that you have a limited supply

or a number of large-cap listed companies that you can invest in. And so doing this bottom-up approach to find the pearl jewel you can find in each country, you think that's much more value than where it's easier because you have a lot of liquidity or a lot of companies listed. Sure. Yeah, and I think at the end of the day, it comes all back to fundamentals again. So when you look at the world and you look at demographics, you look at what's happening, where the growth is in different pockets of the world, whether it's emerging markets or developed, and you look at what you have to pay to buy that growth, we find value in the emerging world because you're getting a higher growth rate for a cheaper multiple, right? But as far as screening and focusing on

one country over the other solely based on macro worldview of that country maybe growing more over a period of time, you may be right, you may be wrong. It's a heck of a crystal ball to pull out of your desk to figure that one out. But what I can say is that 2.5 million people in India had more than $10,000 in discretionary income in 1990, and now 50 million people do. And so they're buying things like toothpaste, and they're buying beer and meat and all those sorts of things. And so focusing on those types of realities and investing in them is a very exciting paradigm, and I think that's what

we do. We like to choose managers that are going to focus on where that growth is happening and how best to exploit it. There's always sort of that macro overlay, like you mentioned, and we've talked about that quite a bit. Are there headwinds politically and geopolitical incidents and currency issues? There always are. And there's headwinds and tailwinds. But at the end of it all, and the currency will follow suit, it's the fundamentals that drive the result over time so Brian let's go back to kind of around the time period you and I were entering the business and beginning to manage money for clients and there was a fella who was head of equities at the time at Goldman Sachs and I caught him

Jim O'Neill James okay yeah he's the one who coined the phrase brick. Yeah. And I apologize to Mr. O'Neill if I'm getting his name wrong, and I apologize to that other guy if I'm getting his name wrong because it would be Mr. O'Neill, it would be someone else. Right. I think it is James O'Neill. But the idea was Brazil, Russia, India, China.

There was a secular thesis formed around this incredible investable opportunity in a new global economic paradigm of these countries being very commodity heavy that were going to be really useful in the next 50 years. And it was demographic driven and it was very commodity driven and particularly out of Brazil, Russia and China, more so than India. And he ended up being really right in the first 10 years. So this, I think his thesis on it came out right before 9-11. And then even kind of in a post 9-11 world, when you think to the really bad equity returns in 0-1-0-2, emerging markets equity were still performing really well. China's expansion was going on. There was this – Jim Rogers was writing all about the new commodity revolution, and it was working. George Bush was a weak dollar president.

Dollar – euro was really advancing, dollar declining. So all those things paved together as you and I were managing monies around EM's story. And I didn't really get it. I didn't really comprehend it. And I was a little bit afraid of it because it was post Enron, post Arthur Anderson accounting scandals. And I said, well, God, if we can't trust the accounting firms in the US, I don't trust the accounting firms in Moscow. And so then as we studied over the years, we've taken the thesis on that we've taken here now. But my question is, was the EM thesis of 2000 and what we believe was Mr. O'Neill's brick formulation flawed itself to be focused more on commodity growth and not population growth? Demographics. This is where I think people are missing when they get caught up into what

uprisings may have happened in chile over a weekend is back to your point on the reason i'm presenting this to you is you brought up the toothpaste yeah i think of america post-war and the incredible middle class opportunity for consumer products need to be bought as their sort of modernity was coming to middle America. Well, modernity is literally coming to billions of people in different countries. And I wonder if that's the buying thesis for emerging markets over the next 10, 20, 30 years. 1,000%, I would agree with that.

And on the fringes, there's probably a whole lot of other exciting things that will occur and they're investable. And I know that they'll work well too, but at the end of the day, if you could go back to, like you said, post post-World War II and in the U S and simply just invest in the staples of

this country, would they call it what nifty 50, you know, whatever, whatever it was, you know, Procter Gamble, you know,

you know, you know, companies that make toilet paper and toothpaste and, and just consumer goods and, and, and, you know, focus on just the growth of the inevitability

of people making more money, having more disposable income, wanting something better for their family than maybe they had, an improved standard of living over time. That is a trajectory that is very stable. It's very consistent in history. And if you think about the opportunity in the emerging world with the amount of that happening right now, that's what we're trying to focus on when we say consumption-led companies. We want to focus on companies that are producing those products that are fueling that uprising of the middle class from, like I said, $2.5 million in India to $50 million to a billion

at some point. It was Jim O'Neill, by the way, confirmed. He ran global economic research for Goldman Sachs back then. Julian, what about the idea that this population story could be true and there's this self-interest agenda that's going to play out for hundreds of millions of people in countries like India, various Southeast Asia countries? And, sir, when you say population, you're not meaning population growth, just the middle class story.

Is that what you're saying? No, I think it's both. I think it is population growth, then there is mobility of a growing population for more to go from the bottom decile into middle decile. Standard of living increase. I was assuming you meant the latter, but yeah, yeah. There's like an OECD research that says 80% of the growth in demand from the middle class in the next decades is going to come from Asia.

Oh, absolutely. It's like Europe and, mean developed world is you know growing single digit low single digit inflation and the big growth is coming from asia demographics and and uh new middle class but you you you were running money in the 90s and and and i want to ask you before o'neill wrote this paper on brickIC and before at Bonson Group, we formulated our thesis about the domestic growth opportunity. There was a Thai currency crisis in 97. There was a Russian ruble crisis in 98. There was a Mexican crisis in 94 that our own Treasury Secretary Bob Rubin played a big role in helping bail them out of. So there's been macro events that have rocked the boat before.

Does that need to play a role in how we think about the asset class? I guess it does. I mean, when you were saying earlier how, you know, it's hard to invest in Asia when you can't even trust, you know, accounting firms sometimes. Like there were some big scandals in the U.S. In my experience as well, on the buy side, for many years working in hedge funds, every time there was a Chinese or Indian company,

or even if the management was, you say, a European company with some Indian management or Chinese management, I say, oh, this is like a big red flag. We want to stay away, or we want to be really extra careful because it's not the same reputation. You have a bigger risk.

Russia's the epitome of that. I would say we'd never touch anything in Russia. But even in China or in India, we would be extra careful. So I think, I guess as you put 10, 20 years of

history in these companies and then you see there hasn't been any accidents so you get more comfortable, more confident owning them and I guess with the Westernize. But I think you're always going to have probably a bit of a discount. I'm going to have to do extra work to be comfortable with these companies. I agree. I think one of the things too,

on one of the managers that we focus on with the same type of thesis is more of a dividend manager, right? So there's an income component too. And the nice thing about that is it's hard to really fake a cashflow coming to you in the form of a dividend. It kind of solidifies the feeling that what you're seeing in the balance sheet and the income statement and things like that, it's obviously very true and legitimate because they're actually sending you the money versus just trusting that the company is going to grow and things. So we've got a kind of bifurcated approach to the emerging world. So speaking of bifurcated approach,

I always ask you guys questions that I already know the answer to, but everyone always gets it right because we're so coherent and cohesive in the way we view these things. But my view is that in the 90s, those events that were really disruptive, that the capital markets in countries like Mexico and some of the larger of the EM countries versus what we would call frontier markets, they're unrecognizable compared to where they were in 1993 or 1997. Then the 20 to 25 years that have gone by in our careers these things have categorically changed but i guess i'd ask you robert would frontier markets which for our listeners will define as not third world type countries but fourth world countries uh nigeria some of the more sudan oftentimes they're in africa there's some in South America. But they're almost kind of another level of risk.

Would you say that it's macro events that give us pause in frontier? Or is it company-specific governance and also liquidity? They're stock exchanges. I'd say the latter. I'd say access is the biggest problem there. You look at some of the frontier markets, and I know a lot of them do have, you know, ostensibly exchanges set up. There's perhaps one or two companies that trade on some of those exchanges. So we talked earlier about, you know, finding the right companies, that's, it's pretty hard to do even more so in frontier markets. Something you

touched on earlier with the question, David, is the population growth is middle class versus something else. In emerging markets, it is more emerging, emerging middle class growth, whereas with frontier markets, it's just, you know, increasing birth rates, things like that. They're getting access to medicine. So just there's greater population growth. That part of it, how much is investable? They're not necessarily spending as much money. They're trying to survive more so. I think what we're looking for more is the emerging markets where they're starting to spend money, rising standards of living, those types of things. Sure. Good. Something you touched on earlier too about the specific types of companies. What I love almost as much as the companies themselves is the anti-cyclical nature of consumer staples in these countries.

Right? So we deal with macro factors. We deal with, you know, perhaps some issues with currency at a broad level. But people, like you said earlier, they're still going to hopefully buy toothpaste, buy diapers for their babies, things like that. And short of, you know, an embargo like we see in Venezuela, those goods and services are hopefully still going to get access to the consumers in those countries. So I think that's a big differentiator. Yeah. Yeah, I think so too.

I think you can get quality growth in those countries. And I think the frontier world is difficult. It's difficult to invest in from the standpoint of there is a big macro unknowable there, more so than in some of the larger emerging world countries. And then also there's just technically not enough volume and liquidity for us to really access them anyway. Yeah. Robert, I think you have to jump out for a client call, right?

That's correct. Speaking of quality of life here, why don't we let you jump out and we'll keep the conversation going. If we say anything on the podcast after you're gone that you disagree with, you'll get a chance to rebut next week. Thanks, guys. Yeah, but as far as the frontier market is concerned, I mean you have to – I mean the country has to – there needs to be bare necessities. There needs to be something there to promote some form of capitalism.

Sure. Or else how can a company have any sort of reliable earnings or have any sort of relationship with shareholders? I really think that the issue – and we've had these meetings with both of our emerging markets partners over the years. At the end of the day, it's kind of a moot point because even if you found criteria that you believe was acceptable, the size of the emerging market investing world and the opportunity set in Frontier is so small that to keep your liquidity and your ability to trade in and out of a position reasonable, the percentage that you could acquire in a diversified emerging markets equity portfolio is so tiny that it can't move the needle. So you're sort of inviting some risk and some exposure without really any ability to enhance your return result, at least in any meaningful way. So you're saying it's a non-starter before you even look at the... The only case would be for someone with where is an appropriate risk appetite or appropriate

mandate. It would not be appropriate in my mind for the way we manage capital. There may be someone out there just says, I want to have a little window that's fully devoted to Frontier. And almost look at it like a private equity part of their portfolio where they said we'll have no liquidity. We're not going to be able to access. But, you know, you're mark to market and everything. I just think I don't get it. But what I'd like, both as just from kind of citizenship standpoint, but also an investor opportunity in the future, is I'd like to see those fourth world countries become third world

countries. And then I assume that when their governance and population maturity and economic opportunity and infrastructure in the country grows, then so would their capital markets and you'd have a better investable opportunity. Yeah, I agree. What is the viewpoint of our committee on EM debt? We spent some time with our manager on emerging markets, fixed income. We've enjoyed some wonderful returns, basically double-digit total return, low double-digit returns in emerging markets debt on the year. Is it a big play on currency? Is there actual bond fundamentals worth that can be bought with higher coupons so it's a nice

spread product in your taxable fixed income? How do we want to think about emerging markets debt, Brian? Yeah, no, it is an asset class that we have owned and own. And there is opportunity there for those reasons. There's a higher coupon, just like you get a lower multiple on equity side for the same amount of growth or more growth. You get a higher coupon for something because there's a credit component to it and there's geopolitical and currency and the whole thing. The risk reward skeww is kind of how you know we have to look at that and kind of base where those opportunities lie but it's funny we're talking about the frontier world and some of the lower tiered credit quality countries that are out there and if you look at something like an index like a like a you know an

emerging market debt index or you know on the on the debt side and then you look at an index on the equity side they're almost just shockingly different with the exposure the country exposure meaning that those lower credit quality companies have a lot more leverage out there that's available. And so we would avoid that, in other words. So we're selective on the equity side. We're selective on the fixed income side. We want to get paid. We want that extra coupon when we're going to buy an emerging market debt, but we're not going to do so if it doesn't pencil from a risk-reward standpoint. Do you have preference, hard currency, local currency?

I mean, I would say having the opportunity to own things in local currency is a good idea. And having managers be able to make that play based on having boots on the ground, having an office there and understanding what's best for either whether it's equity or debt to be in local currency or not. I think it's a good thing to do. It's not something that we would do in-house or anything. Yeah. Maybe it's also to discuss hedging, what we think about currency exposure or specifically why we don't hedge.

Well, I think, Julian, that's something we ran into, although it was Japan, not an emerging market, but it's something we ran into with our desire to get some dividend equity exposure out of Japan that we found the currency hedging costs were eliminating some of the dividend on an absolute basis. Is this a factor with EM as well, whether debt or equity, that some of the currency side of things is kind of taking away from the cash flow the investments are providing. Yes, for sure. I mean, if you want to hedge, you're going to have to pay for the cost of hedging, and that's going to take a chunk of your returns every year. So I guess, yeah, that was one of my questions is, I mean, I've seen when we look at Japanese equities, we decided not to hedge.

We own the ADRs, but the underlying price is in yen and the stock, and the dividend will move in yen. But probably not too much volatility in the yen to dollar, so probably not worth hedging. But I guess for the other products... Famous last words. But for the debt and emerging equity markets, I guess we own products that are trading in

dollars, but we take the underlying effects. I don't know of anyone in the EM equity space that hedges currency. Now, maybe an asset allocator might, on a top-down, throw in some dollar hedges. Too expensive. But it's way too expensive. And too many countries, right? By the time you look across the table. Because you have a basket of different equities.

Can't do it. Can't do it. Can't do it. But with EM debt, I think currency hedges, especially when you're very active as our manager is, you have local, you have corporate, you have sovereign. Look, when you're buying in local currency, sovereign debt, that's all you're buying is coupon and currency. There's not even a credit component to it like there would be with the corporate aspect. So I think that our diversified emerging market debt strategy is heavily currency driven, but not all currency beta, not all short dollar.

They're long and short around different currencies, which to your point earlier is in a lot of ways a macroeconomic forecast around geopolitics, around growth expectations, inflation expectations. They can be wrong, but that's what they're attempting to go about doing and either add defense or add value. There's also, as far as the equity versus debt goes, one of the reasons why it makes more sense to hedge on the debt is that there's this kind of counterbalance effect. If you do get a depreciation in the currency,

generally speaking, some of those equities might benefit a little bit more if they have an exporting side to them or, you know, as far as their business goes. Yeah, I would argue back to my kind of first decade of this millennium analogy that that, in fact, was a huge overstater of the em equity returns was that the depreciation current no well it depends what seat you're sitting in dollar currency depreciation but em currency appreciation that you basically had a fundamental earnings story that was providing x and you had a currency story that's providing another equivalent of x so you're getting 2x of the earnings story and now this decade you've gotten half of the of x even though the earnings are

higher this decade than they were last decade so there it's all it's been a currency story that is detracted from the return but the point being i had one hedge that out their 20 2000 to 2007 em equity return would have looked categorically different. And I think that's true on the Japan side as well, that the notion that let's get all the ideas out of Japan equity, yet hedge the currency, even apart from the cost of the hedging, I don't know. There's been a lot of years that the yen's movement was creating some of the return.

So I'm totally fine if someone says, I don't know. There's been a lot of years that the yen's movement was creating some of the return. Yeah. So I'm totally fine if someone says, I don't want currency headache. Just buy everything you buy, U.S. dollar, and buy it here in America, and just don't be exposed to the realities of international currency markets. But my view on this through a lot of trial and error is if you're going to take the risk of being an international global investor, then you've got to take the currency risk. Sure. I was going to say you're going to take the risk of being an international global investor, then you've got to take the currency risk. Sure. I was going to say you're going to be exposed anyway. I mean, if you buy S&P 500 companies, you're just giving – they're doing it for you.

That's right. That's a brilliant point. It's multinationals. We hear it in their earnings results every quarter. They come out and tell you we made $4 a share, but if it wasn't for currency, we would have made $4.20 a share. They're taking the currency risk of the way that they sell their products overseas. I think it's better to invest in fundamentals and currencies play out over time. And if you look at the data, there tends to be a diversification benefit from having different exposure in your portfolio.

So I think that it adds a benefit. There's more of a risk reduction if you have a portfolio with all these different exposures. But, yeah, like Julian said, about 47% of S&P 500 company revenues are from overseas. So, yeah, they're taking that risk for you. And so let me ask that question. You hear a few people more and more. I'm always – well, I'm going to wait to tell you what i think but um i have a theory but you do hear more people saying oh we don't need to go be investors in em because when we buy xyz and abc in america they're such huge

multinational global behemoths that so many of the customers for, let's say, the largest beverage companies and consumer product companies, they're selling to South America and Asia. So we're getting that exposure anyways. So I don't hide the ball. My theory is that's just a lazy investor's excuse for not doing the homework necessary in emerging markets. But what would you say, Brian, to why that is or is not a valid argument against EM exposure, the idea that S&P companies are giving it to you anyways? I mean, I guess I would say that they are because they're seeing the growth opportunity there as well. And so you get some kind of derivative exposure to the emerging market world as a small percentage of revenues or a percentage of revenues from an S&P 500 company.

But still, I mean, you're missing out on, you know, the opportunities that are actually in, you know, actually in those countries and able to produce goods and services that are in those countries. So there's just two different opportunity sets. One's a very big, large cap type of play.

One's a little bit more of a local approach. And I think that there's a reason you would own both of them is there a valuation argument yeah um i guess there is probably a valuation argument like the the discount uh thinking that over time you know as these countries become more like uh like us you know westerns and more you know uh with um more accountable board and maybe more transparent that you could see the discount shrink over time. And that would be another reason.

And more liquidity, more flows as well going to these markets. Maybe Chinese people are going to start investing, having 401ks in the same way. They're going to push their own stocks. So that's another way probably to get exposure being invested there directly. Yeah, it's cheaper. Yeah, there's generally more risk in EM,

so there's more attractive valuations in EM. So as far as investing in S&P 500 companies because they're doing that for you, I think one of the big things you're missing out is the opportunity from the revaluation from some of these low-value companies. And another thing is I don't have the exact data. I'm sorry. I just want to ask you.

Is that all it is, is a multiple arbitrage that you could have a company selling bottled water locally trading 13 times where a huge U.S. company selling bottled water in South America is trading 18 times, and so you just simply have a better valuation, or is there more to it than that? I think the main factor is the valuation. I think that another thing that you're getting, it's more of a pure play if you're investing in EM versus whatever company that you are invested in. And I'm not sure exactly what the revenue exposure from S&P 500 companies is to EM. I assume it's maybe around 25% or somewhere around there. Something in the range of half of half. So generally speaking, only 25% or so of the revenues is going to be from EM anyway.

So you're not getting – it's hard to – China distorts it so much because of the silly idea that China is still an emerging economy. Right. That's another thing. Classification is always a big issue. Yeah. But I really – I think it's valuation arbitrage and then the peer play aspect. But those two things come together in the sense that if 50 percent of your company is selling product to a customer base that's growing at 2% a year and 50% is

growing to a place that's growing the customer base at 20% a year, that's a different thesis than a company that is actually local and domestic in that EM where their whole customer base is growing 20% a year. So you get valuation benefits and then you, in my mind, have an entirely different set of growth initiatives out of the company. Yeah, I wanted to add one thing, I think, is maybe we should think about these countries, you know, are still being quite closed. And still, it's really hard for foreigners to come and, you know, and compete, you know, fairly. It's not like the U.S. or the U.K. where it's like, you know, you come with money and you can invest like anyone else. I think you still have the local advantage, you know, being a Chinese, being an Indian company, you get access or you get, you know, because of connection with government or because they're still, you know, opening economies.

You can get access to markets that, you know, American companies cannot get access to. We have an example of a pharmaceutical company buying a Chinese distribution company because they think with them, they have a much better chance of being able to sell their drugs in China. I think that's also a reason why you want to go directly by these companies and wear leaders in their own market. And it can be close to impossible to do without a manager that has relationships with brokers and these different local economies. I mean, if you were to open up a TD Ameritrade account and try to buy some of these companies, your universe would be ADRs and a totally different set of companies. ADRs and a totally different set of companies, then putting money with a trusted manager is able to have more selection in the entire universe. Well, here's another point that we haven't touched on that Von Tobel has really hit home to me in the last couple of meetings we had with them.

We have telecom exposure in our U.S. dividend equity portfolio, and we view telecom, the way we're invested in it, as part of the more defensive aspects of what we're doing. We don't expect high CAGRs in their growth, but we do expect strong balance sheet. We expect almost kind of monopolistic tendencies. There's not a lot of huge players, really good cash flows and really good dividend yield. And we've had a couple of different companies in the portfolio over the years. The one we have right now is, I think, one of the more defensive low beta names that we own. It's a great addition. But if you want growth out of telecom, and there's other sectors, certain parts of the financials you could say this about, emerging markets are going to have some local companies that provide a totally

different growth profile than you can get in the U.Ss you're not going to get a real sexy growth story out of telecom in the united states and we got that 20 25 years ago of course world cup the guy went to jail and everything but my point was those were hot right growing companies now in indonesia and in india and another em telecom is not a value sector or a boring sector or a utility. It's a growth sector. You've got to be an EM to participate in that. It's kind of like in the 30s in the U.S. where utilities were a growth sector. Totally.

Yeah. Again, it goes back to that emerging middle class. I really think that that consumer story of the multinationals are doing the job for you is a lazy person story. And if it applies anywhere, it's only in certain consumer products. Most of the people will use a certain very large carbonated beverage company as their example for it. But I think that's an exception, not the rule.

Really, you look at financials and all the growth drivers of a kind of diversified financial company, all I know was that when I first started investing in EM, the banks in India didn't have ATM machines. And I promise you that the big three mega banks in US were not in the market to go make ATM machines in India. So you had to buy an Indian local bank to sort of get that growth opportunity of what was going to scale

into more modernized financial system. So you just have to have the the broader universe to draw from and right and like you said sometimes it's how are you going to provide banking solutions to uh let's say like an indian growing middle class if you're not if you don't actually have a localized presence or maybe pack consumer packaged goods that might be a might be a bit different story especially at the end especially if you look at the trajectory of countries that are growing from frontier markets to EM to developed. The financial services is a huge component of that. That capital markets, having that capital markets presence in order to provide entrepreneurs capital and provide businesses the lifeblood

that they need to be able to produce these services. And the financial services is an interesting point because that's hard. That's hard to, if you're going to make the argument, you're going to own S&P 500 companies and then you're going to get exposure to emerging markets because they're going to, you know, they're going to have a percentage of revenues from there. And the financial services, I mean, to know the capital markets, to know geopolitical, to understand, you know, in financial markets, whether you're lending or investment banking or whatever you're going to do, to understand local markets, you need to be a local company that's going to do that. It's really hard for a real big company to come in and do that.

And so maybe they'll acquire other countries or companies there that already do it. That's fine. But I think that's an exciting paradigm there as well. Yeah, that's even possible. Julian, we did a podcast some time back about our philosophy at Bonson Group about active versus passive. We talked about ETFs versus individual stocks. And one of the things that we talked about was, sure, when the whole entire market's rising, the vast majority of index investors are getting a great return,

and most active guys are really hugging the index anyways. A lot of them don't outperform. Emerging markets is totally different. Emerging markets is one of the very interesting equity asset classes where even in a good market, the majority of active managers have outperformed. Why do you think that is? What's different?

Is it index construction problems? Good question. I guess I would say without really knowing, I would guess that there's much more money that's actively managed in emerging markets and it's probably because the majority is not index driven.

You have mostly stock pickers that the alpha or like that, they pick their own winners and I would say that's probably the reason why it's happening. But that would be a guess because I'm not sure. I have no idea. I mean I think knows and that's i would say that's probably the reason why uh why it's happening but that's my that would be a guess because i'm not sure i have no idea i mean i think it comes back to what we talked about on the on the commodity play of things too when you look at an index i mean it's

it's currency uh sensitive just because of the commodity exposure in the top 10 names you know it's it's oil and and and you know a lot of energy names and and and so on and so forth and so you get you know indexes that move a certain direction. But if you have an active manager, for example, the two that we use, you get this huge outperformance because they're able to sort of not focus on that and not have to be kind of a market-weighted index, and they can actually kind of invest in that consumer, the local consumer. Yeah, very export-heavy, very commodity-heavy index.

And especially, yeah, like the managers that we have, like you said, focus on something totally different. And also classification in EM is difficult. Frontier, like you said, China is still an EM. South Korea is still an EM. You know, I mean, the classification is very, very difficult. And who says exactly what an EM is or what a DM is or what a frontier market is, you may have a very different opinion being an investor in that space. And having a little bit of flexibility around being able to put maybe a frontier market in your portfolio as an EM manager might have a little bit of advantage of the index. But primarily, it's the story of... The EM index tells a whole different story than if you look at the composition of the managers. But primarily, it's the story of the EM index tells a whole different

story than if you look at the composition of the managers that we invest in, where it's mainly consumer-oriented. And obviously, the EM index is very commodity-heavy, export-heavy. Well, I will wrap us up with that. I think we've covered a lot of ground today and got a lot of good feedback. And for those of you listening, this has provoked some further questions, and we certainly welcome your questions, comments. We'd love to unpack this a bit more. Look, we're humble enough and cognizant enough of the geopolitical volatility, currency volatility that is correlated there, too, that we don't take a massive weighting in the asset class. that we don't take a massive weighting in the asset class. We probably overweight most global benchmarks, but in terms of even our own kind of absolute weighting, it's a single digit weighting for those clients we think it's appropriate for,

for the most part, maybe low double digits for certain more aggressive clients. We're not looking to go put 20, 30, let alone 50% of client capital in the EM, but we do think there's a growth story that has a value basis for investing. And it is fundamentally driven and it's company driven, bottom up. And I would like to conclude with something that was a fundamental game changing factoid in my understanding of this. And that was 1993, 2013, 20 year period covered a lot of geopolitical events, covered a lot of macro. And yet you had one country immediately to the United States South that had grown their economy at about one to 2% a year, had been in recession about half of that time. That was Mexico. Their stock market was up 18.6% for 20 years. Then you had a country on the other

side of the world that had gone through the largest CAGR, compound annual growth rate of economic growth of any country in history in that period, and that was China. And they had essentially grown something in the range of real GDP growth, net of inflation, 8%, 9%, 10% a year for 20 years, and their stock market was dead flat, maybe up 1% a year. The decorrelation between economic growth and company performance, stock market performance, earnings, is massive. It's true even in the US, where sometimes there's a big decoupling from GDP growth and earnings results, But it's

even more true in a lot of the emerging market stories. So simply saying, I like Minnesota, does not give you a good investment result. I like China, I don't like India, it doesn't mean anything. Investors need companies, because the point of investing is to compound your capital around earnings growth. Earnings growth comes from free enterprise. Free enterprise is the greatest gift for enhancing the quality of life and the results of your portfolio in human history. We're glad to be investing alongside this world-changing phenomena. Thank you for listening to this week's Dividend Cafe. We will come back to you next week with all of our best ideas and thoughts about whatever we can come up with, depending on the subject at hand.

Thanks so much. Thank you for listening to the Dividend Cafe, financial food for thought. LLC advisory services are offered through Hightower Advisors LLC. This is not an offer to buy or sell securities. No investment process is free of risk and there's no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors. All data and information referenced herein are from sources believed to be reliable. Any opinion, news, research, analyses, prices, or other information contained in this research is provided as general market commentary. It does not constitute investment advice. team in hightower

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