Finding Structural Growth with Massive Advantages in Emerging Markets
TWST: Please give readers a brief history of the Oppenheimer Developing Markets Fund and a snapshot of the current portfolio and investment strategy.
Mr. Leverenz: ODMAX has a sort of brilliant history as you can see in the performance numbers. The fund celebrated its 15th anniversary late last year, so we are on our 16th year. And the fund is unique in the context that many funds change over time and are very tactical in orientation. This fund was designed from inception to be an evergreen fund, so we consistently do the same thing year in, year out, market cycle up and down. We always do the same thing, which I think is one of the underpinnings of why the fund has been so successful over the years — that we take an approach which is unique and we never really change it. What does change, of course, are prices, and hence what's in the fund, but the approach has been very consistent over the last 15 years across a couple of managers.
In terms of investment philosophy, it was designed early on to be a very different emerging market fund. As you can appreciate, emerging market funds, in general, tend to have a relatively high velocity because these are very dynamic regions with what is often considered high volatility. What we decided to do from the origin was take an approach which was focused on extraordinary companies and avoid what we consider common pitfalls in the emerging markets.
If you look across the world at the developing markets, what one can see and what we avoid is that the markets tend to be very heavily dominated by two kinds of companies. The first, of course, is the much-famed state capitalist sort of companies. These are large state-owned enterprises, which are directed with some sort of national strategic thrust. You can think about the oil and gas giants in Russia, or the Chinese banks and insurance companies, straight across the world. Those represent a fairly significant part of the capitalization of the universe. We tend to never invest in those companies.
This is all by saying, before I talk to you about what we actually do, that we decided early that there are a lot of things we probably would never do. If you want to be successful, you need to exclude things.
The second flank that we tend to exclude is the large capitalization in the emerging markets universe committed toward companies that are both cyclical and capital intensive. If you look right across the developing world, about half of the capitalization is populated with either banks or commodity-oriented companies — so think metals and mining, energy, soft commodities and basic materials. These tend to be relatively rare in our fund. So our fund is, in many respects, not an emerging market fund. We, obviously, are focused on companies in the developing world, but we don't get so bothered about the benchmark, because we think the benchmark has a lot of problems.
We focus intensively on companies, not countries, and don’t get bothered about geographies. We are looking for extraordinary companies. And to put that in perspective, when the fund started in 1996, almost no investor could fathom what was the largest emerging market, where the benchmark told you should have over 15% of your capital. That was, of course, if you go back in history, Malaysia, which I can tell you 15 years on is almost completely irrelevant for most emerging market managers. Benchmarks get people in trouble.
So what kind of companies do we focus on? We are focused on companies with two characteristics. The first is, these are structural growth companies, these are companies with long-tailed, durable — and I emphasize durable — structural growth opportunities, which is resulting from some metanarrative in terms of something changing in the geography or something changing in the industry or subindustry, where there is a tailwind of very significant growth.
The second thing we focus on, because we are not just growth investors, is we want those structural growth companies, but we only want to participate when these companies have some of what I characterize as massive advantage, so some significant competitive advantage where the number of players, the market structures, are highly consolidated. Of course, what that permits is very significant profitability. These tend to be relatively capital-light companies, so not just significant profitability but lots of cash flow. Those are the companies that we invest in.
Across the developing world, like across the world, most companies are cyclical, commodity-oriented companies by nature. They tend to be highly influenced by the geographies, highly influenced by cyclical factors in their industries. Our companies tend not to have these characteristics.
We are growth investors in extraordinary companies, but we are very concerned about what the entry ticket is. We are very sensitive to price, which means, of course, that through time, to have extraordinary companies with long-tailed, durable growth and massive advantage, these companies usually don't come at an appropriate price. We have to wait for an appropriate price, and that's all about embracing controversy or embracing volatility. We tend to buy these things in a contrarian fashion.
TWST: Do you use a benchmark at all? How has the fund performed?
Mr. Leverenz: We are absolute investors in terms of looking for absolute returns. We are not so bothered about benchmarks or competitors. What we're trying to achieve in the fund is what we've been able to deliver in the long term, which is we are looking for compound returns in anything that we invest in, and we are, relative to almost all of our peers, extraordinarily long-term investors. A typical holding period for the fund is mathematically somewhere between four and five years, but in some cases is more than a decade.
We tend to be the long-term capital in the emerging markets. When we commit capital, what we really want to achieve is meaningful appreciation of our money over a five-year period. And, of course, mathematically that translates into about 15% compound, which, if you look at the last 10 years of the fund, is exactly that or more what we have delivered on a compound basis. Now, of course, much of that has come in a lumpy fashion because the world is not linear, but that's what we're seeking.
In terms of appraisal, however, and, of course, our investors always have to stack us up against something, we tend to be compared to the MSCI Emerging Market Index. If you look at what we've been able to deliver relative to that index, we’ve had very significant outperformance to the index. For example, on a five-year basis, we delivered more than 4% compound versus the MSCI Emerging Market, which was flat for that period. On the 10-year basis, we've delivered almost 19% compound versus an MSCI Emerging Market return of 15%.
TWST: What are the big-picture investment themes that form your investment decision making today? I believe you follow an approach you term MANTRA.
Mr. Leverenz: Yes. We are the manic investors in the context of looking for the big ideas, and the big ideas we clarified a long time ago. In fact, none of us can recall exactly when this MANTRA was developed. But the idea is that if one is sitting up in an airplane and looking down from 38,000 feet, what we're looking for is, from a distance, where are the big ideas located? What that really suggests is where are the opportunities within the global economy, which is relatively pedantic in terms of growth these days? We look for opportunities where there is structural growth and where those opportunities we are able to take relative share of the global wallet. MANTRA, which is an acronym for mass affluence, new technology, restructuring and aging, has been a prism by which we could look across the world and see some of the significant shifts going on, both in terms of the economy and demographics, around the world.
If you look at the developing world, I would say there are two very significant and interrelated themes. The first and most powerful theme is really about history. This is about the ascendancy of the emerging markets and the developing countries after decades, and in some contexts, centuries of relative underperformance.
If one looks at the last decade, we’ve had a huge transformation in the underlying economic growth trajectory of much of the developing world. Why is that? I think that's related to a structural phenomenon and to a cyclical phenomenon. The structural phenomenon is that many countries received their independence in the 20th century from colonial circumstances. Whether it was Nasser in Egypt or Nehru in India or, of course, Mao Zedong in China or Uncle Ho in Vietnam, the reality is most of these countries were very badly navigated in terms of economic policy.
I like to draw an analogy to economic slavery, which is these were not very productive economies. These were economies that, postindependence, really wanted to develop rapidly through rapid capital deepening, but they had very low productivity and extremely poor incentives. So the reason why the emerging markets are where they are now in terms of interest and development is because all those things led to a collapse. The Soviet Union, obviously, collapsed in the 1980s with the oil price, and subsequently, the breakup of the Berlin Wall leading to the final collapse of the communist system across Eastern Europe and the former Soviet Union in the 1990s; China in the late 1970s after a disaster associated with extremism and the cultural revolution; in the early 1990s, India faced a foreign exchange crisis and a significant economic reform.
The structural underpinnings of the emerging markets are really about massive economic restructuring and reform. China is the poster child for that. What we have seen in China in the last 30 years is a serial restructuring of an overcentralized, badly governed economy, and that will persist for a much longer period of time. The same thing has happened straight across the developing world.
So in essence, if you are an economist, what you see is that these economies, which were badly governed, have really embraced globalization, have really embraced economic reform, and what you are seeing are low-productivity economies starting to become more productive. With greater productivity comes greater wealth, with greater wealth comes higher levels of savings. With higher levels of savings, mathematically, capital formation can increase because it can be funded domestically, and mathematically, you get a virtual circle of economic growth. That's the big story in emerging markets.
What that's translating to, from an investment perspective — and you can see that not just in the developing world but just about any significant multinational company in Western Europe, Japan or America as well — is that the biggest theme in the world right now is not just the reemergence of the emerging markets, but also about the emergence of a very significant continental-size consumer class across many of these geographies, whether that's China, which is the most important, or whether that's places like India, which are much earlier in the development phase, or whether that's broad bases of emerging consumers in places throughout Latin America, like Colombia, Peru and Brazil. That's really the big opportunity in the long term, and why you want to be invested in the emerging markets, because consumers in these geographies, the much-famed middle class that has developed in the last decade or two, have very different behavior and significantly different investment opportunities than when they were stuck in poverty in terms of low incomes.
And that creates all sorts of interesting opportunities for exceptional companies, whether it's retailers that have massive advantages associated with economies of scale, whether that's branded products, consumer staples companies, consumer durables, where brand is able to extract meaningful economic rents, or just about any other sector that we're investing in. So I would say the most significant opportunity is clearly all about the emerging markets consumer.
TWST: Would you give us some favorite investment ideas and discuss why you like them? How do they fulfill the criteria you use in selecting investments, and how do they exemplify those kinds of opportunities you see in today's environment?
Mr. Leverenz: We could select many of them. A good illustration would be a company like Almacenes Exito (EXITO:CB) in Colombia, which is one of our largest holdings. Exito is a general merchandising food retailer.
I’m in my forties, and America's retail landscape is very different than it was when I was a kid. Big-box retailers are prevalent in every geography except New York City. In places like Cleveland or outside of San Francisco or in Texas, you tend to have the same big-box retailers. The reason for that, of course, is that retail lends itself extraordinarily well to the very massive economies of scale, which is what the Waltons discovered. And that's why in the developed world, outside of Japan, you tend to see oligopolistic competition in food retail and in many big-box formats, whether it's Tesco (TSCO.L) in the U.K. or whether it's Wal-Mart (WMT) in America.
Now, in the developing world, it's very different. Most of the developing world tends to be highly fragmented in terms of the food retail industry. What we're seeing because of those themes that I mentioned — the ability to extract higher levels of savings to invest more through intermediation, through either the equity market or the banking sector — is the development of modern retail throughout the developing world. It's the same thing that we witnessed in America, with some different permutations obviously, in the 1960s and 1970s, which is these very significant economies of scale associated with the back end of retail, which is about logistics, about distribution, about information technology, about better procurement terms, better working capital terms of a supplier, supply chain management, all those great things that make very large retailers successful.
We have a number of retail holdings in the fund. In fact, almost 10% of the fund is invested in this theme. Exito is one of the largest of the retail companies that we invest in. Exito is a good representation of that. As I mentioned, the big trend is away from informality, which is mom-and-pop shops with no meaningful economic advantage outside of perhaps paying no taxes, toward formal retail.
In the Colombian context, we're very early in terms of the formalization of retail. Relative to just about everything in Latin America, with the exception perhaps of Central America, Colombia is way behind in terms of the formalization of retail. Exito has a massive advantage. This is a company that has 42% of the formal market in Colombia, and that is growing like a weed in terms of new space growth, and, of course, organic growth associated with big improvements in terms of merchandising and pricing and those sorts of things. So that's a theme about the emergent consumer, who is looking for a format of better selection, better pricing, more convenience and enjoying those advantages that a company like Exito has.
TWST: Is there another example you’d like to give?
Mr. Leverenz: Another example would be one of the number of holdings that we have in the consumer staples space. If you look at the other side of that — which is again on this theme of the emergent consumer and changes in terms of behavior — as you might have witnessed if you've traveled around the world, alcohol is something that's consumed very widely. It's something that's greatly appreciated as a social lubricant, and whatever other function it has in terms of consumption. Alcohol in the developing world is often consumed badly as there is a significant difference between consumers who have stable and rising incomes, and those who have poor incomes that are highly instable.
If you go to places like sub-Saharan Africa or western China or large parts of India, what you recognize is that the dimension of choice in a consumer transaction is usually about price. As economies develop, as productivity improves and wealth is created, what tends to happen is that these emergent middle-class consumers change their behavior.
In the context of alcohol, there is almost a perfect correlation, if you look across the world, between the level of affluence, let's say, measured by GDP per capita, and levels of beer consumption. There are some notable exceptions to that, which tend to be the wine-drinking countries, so think Italy or Argentina, for example, but generally speaking, that correlation is extremely high all over the world. As people migrate away from subsistent living into more of a formal consumer setting, beer consumption tends to rise very rapidly.
Across the world, if you talk to companies like InBev (BUD), which includes the former Anheuser-Busch (BUD), or SABMiller (SAB.L) or Carlsberg (CBGB.F), they tend to associate with young people, because young people tend to consume beer with a sense of modernity or westernization. The modernity aspect is also because beer tends to taste better, I hear, cold than it does warm, and hence you have electricity and refrigerators in retail shops, which you don't necessarily have in the developing world. So you have this powerful social structure narrative, which is people tend to drink alcohol all over the world, but they tend to drink it poorly.
Now that tends to have consequences once in a while, in terms of things like improperly distilled alcohol, which can lead to blindness, it can lead to serious health problems. It can actually lead to death in some contexts. The reality is that beer in a developing country tends to be a growth business, because consumption is relatively low, and you're converting away from alternative things, whether it's sorghum or cheap unlicensed vodka in Russia, those sorts of things.
If you look at the economics of the business — which is about the opportunity for massive advantage, which is the characteristic of a good business — all around the developing world, with very few notable exceptions, the one big exception being China, beer tends to be either a monopolistic or oligopolistic business. The reason for that is the flip side of what I just told you in the context of Exito, which is these economies tend to have very informal, fragmented retail trade structures. As a result of that, the reason why the Brazilians now control InBev or Anheuser-Busch in St. Louis is because it's highly profitable and the barriers to entry to serving millions of points of presence from a distribution perspective are very, very hard. As a result, it takes years, sometimes decades, to try to change that competitive landscape.
In the meantime, the pricing power, the profitability and cash flow generation of these businesses is fantastic. So what you have in these places — whether it's sub-Saharan Africa or Brazil or other geographies like Eastern Europe — is relatively rapid growth in volumes coupled with some premiumization, so good growth in revenues and very high profitability associated with market structures, which are very attractive.
Companies that we hold in this context include SABMiller, which is London-domiciled, but an emerging market operator with strong presence in Peru and Colombia in Latin America, through much of sub-Saharan Africa and a dominant historic presence in South Africa — SAB is South African Breweries — and some emerging growth opportunities in places like China.
We also own Carlsberg, which is one of our largest holdings at a little over 2% of the fund. Carlsberg is a Danish operator, but its heritage is in the Scandinavian region. Its real growth engine, the real engine of profitability in cash, is Russia, which has been somewhat of a chaotic market in the last couple of years, but which is a very durable, long-term growth opportunity.
TWST: You mentioned earlier the two types of companies you seek to avoid. In addition to that, are there other areas you're especially cautious about right now?
Mr. Leverenz: Again, I want to emphasize the fund is strategic and not tactical. We're not mean-reversion sort of investors. We're not necessarily concerned, as is much of the market, with that sort of myopia of the next six to 12 months. What we're looking for is opportunities where there is a cyclical downturn in something, something, of course, that's extraordinary, something that's durable in terms of growth and extremely powerful in terms of competitive advantage. The tendency we have is to buy those things when there is a lot of controversy, because that's the only time we get appropriate prices. So we don't shy away from cyclical concerns.
If you ask me about what we are cautious about right now, I would say, the one thing many who were investors in emerging markets perhaps don't appreciate enough, or perhaps they have a misunderstanding in my mind, is the durability of growth across Latin America, and in particular Brazil.
Of course, if we rolled back 12 or 18 months ago, there was a huge amount of enthusiasm for Brazil. Just about every emerging market fund you could have witnessed, 18 months ago, probably their biggest single holding in the world was in Brazil. It was a period in which Brazil, coming off of a very difficult circumstance since the beginning of the century, all of a sudden witnessed a watershed change in terms of growth. And then, coming out of the great economic crisis all over the world, Brazil grew at rates we haven't seen Brazil grow at since the 1970s.
Now, the last six months have been hard and growth has stopped, but I would say in general, one has to be concerned about the durability of a place, like Brazil in fact, much of Latin America. The idea that Latin America has any prospect of achieving growth levels commensurate with other parts of the developing world — say, for example, China or areas of Southeast Asia, Philippines, Thailand, Indonesia — I think is pretty farfetched. And the reason for that is because, although Brazil did witness a very good decade, in fact the best decade since the 1970s, the reality is Brazil hasn't changed in the context of its ability to grow.
The ability to grow is really about two things in the developing world. One, it's about the ability to fund growth, which is all about domestic savings. The reality of Brazil, if you look at the last decade, is that although it was a wonderful decade, domestic savings levels in Brazil have not changed at all. Despite the fact that we beat inflation, that macroeconomic policy is perhaps better guided than it has been in decades, the reality is Brazilians don't save, and that is a real drag on growth.
And second, it's about the ability to, as I mentioned at the forefront, capitalize on restructuring and gaining productivity. Brazil for many reasons — one of which is an extremely powerful, heavy government — hasn’t had any significant change in productivity levels in the economy. Therefore, if you ask me about what am I cautious about right now, I'm cautious that people still ascribe a certain level of growth potential to certain geographies, particularly Brazil, that aren't sustainable.
TWST: What would you add in terms of how you approach risk management for the fund?
Mr. Leverenz: You can appreciate that OppenheimerFunds has a terrific risk department, like many institutions, that keeps us abreast of lots of data. But for me, risk really comes down to two important variables. The first is liquidity. I mentioned to you that the history of the fund in terms of returns is extremely good. Like I mentioned, we made almost 19% compounded in the last decade in dollar terms. The reality, however, is that very few investors have actually participated for 10 straight years — and this is not unique to ODMAX.
I think it's the reality of brain chemistry of investors that investors tend to buy when things are looking promising, which usually means they have done well, and they tend to sell when there's panic, which means they lost money. As a result of that, which is all about the investors' ability to navigate through volatility, what tends to happen in the developing world is we tend to see a fair amount of volatility, both in terms of share prices, and also in terms of flows. So an important part of risk management, in my view, is navigating through that countercyclicality, which is all about having ample liquidity. Ample liquidity, one, to capitalize on volatility, not having to sell something when everything is down, the risk-off environment that we've seen recently; and second, having ample liquidity so when investors herd out of emerging markets in a temporal fashion, I don't have to sell anything.
The second aspect of risk management from my perspective is about diversity, which is making sure that the fund has enough diversity that we don't create extraordinary volatility. And of course, being honest about yourself and knowing that you are going to make mistakes once in a while. Although we have a relatively excellent track record, like everybody else we do make mistakes.
Diversification is important in three dimensions. One is diversification across geographies. Although, I don't think about the world in terms of geographies, I think about it in terms of companies, the fact is that country factors still matter to some extent. Second is having enough diversity across industries. And third is having enough diversity across companies — not having a highly concentrated fund in terms of expressing strong ideas throughout the fund and making sure that no position is so meaningful that a bad idea could be lethal.
TWST: To wrap up, what is your outlook for the future? What are you concerned about and hopeful about?
Mr. Leverenz: There's a long term and a short term. I think long term is extraordinarily promising — and when I say the long term, I mean over my investment horizon, which is the next five years. If I look at the world at present, the reality is that the emerging markets — although we are witnessing a deceleration in growth across the emerging markets, which is to some extent structural and to some extent cyclical — are going to remain the most significant engines of growth for the rest of my investment career. And that is because of that circumstance of history that I mentioned.
Part of it, of course, is that in the short term — and I emphasize the short term — the developed world has real difficulties in terms of growth. But in the medium term, the reality is that the developing world, by and large — and there are exceptions to this — is absolutely committed to this economic restructuring, which is leading to structurally much higher levels of growth.
The way to think about the world is in the last decade or two we're at the early stages of a massive convergence around the world, which is about productivity. And if you look at the last 20 years, places like Shanghai and Beijing have converged to a great extent in purchasing power terms with many of the great Western cities. What hasn't happened, if we focus on China for a moment, is broader convergence across geographies. And we should witness this, I think, in a nonlinear fashion, because nothing is linear for a long period of time. Whether it's the hinterland of China, whether it's India, whether it's parts of Southeast Asia, whether it's Eastern Europe and Western Europe, convergence is the dominant circumstance. So the fact is, if you are looking for meaningful growth opportunities in the world, this is where you should be looking.
The second aspect is that the emerging markets, in terms of prices, are actually very attractive in the next five years in my view. Eighteen months ago, there was a lot of hyperbole, perhaps an excess of enthusiasm, about the prospects for emerging markets, and what we've seen is the world is now full of an enormous amount of fear and anxiety and uncertainty, which, of course, is why bond prices and bond yields, straight across the world, are where they are.
What we've seen is a lot of reservations associated with this deceleration of the emerging markets, whether it's India and the present problems they’re facing or the slowdown in China or the pause in growth in Latin America. What that has framed is this medium-term growth opportunity that I was referring to just a moment ago now coming at prices that are very attractive relative to what they were 18 months ago, two years ago, when the emerging markets could do no wrong.
That being said, we are investors in companies, and we seek to have a portfolio of extraordinary companies. I am always excited about that, but I think in the long term, emerging markets are very exciting. In the short term, what we are seeing is a continuation of a deceleration of growth that I mentioned before. I think we are more than midway through this, and that over the next six or 12 months, the emerging markets will normalize in terms of growth.
There's a lot of reservations about China, which to some extent is driving much of the emerging growth, and I think that in China, in the next six to 12 months, the growth will decelerate to a more normal level, which is 5%, 6%, 7%, which, if one mentioned a couple of years ago this was normal circumstance, there would have been panic on the Street. But when one looks at this in context, China is a $7 trillion economy. What we are talking about is almost $500 billion of incremental GDP being added every year at those sorts of levels, so it’s a very significant opportunity.
TWST: Thank you. (MN)
Justin M. Leverenz, CFA
Senior Vice President & Portfolio Manager
Two World Financial Center
225 Liberty St.
New York, NY 10281
(888) 470-0862 — TOLL FREE
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