Downside protection is key for EM investments
Carmignac fund manager Xavier Hovasse says that while emerging markets offer good growth opportunities, there are downside dangers awaiting unprepared managers.
Over the past two years, the world’s developing markets have done what investors hate – while the ‘macro story’ is very strong, the markets themselves have been weak and volatile. Since the end of 2010, the MSCI EM index, in euro terms, has fallen by 12.43%, while MSCI Frontier Markets lost 18.78%. What’s worse, investors suffered higher volatility in the MSCI EM (17.47%) than in the MSCI World (11.42%).
Xavier Hovasse, manager of the Carmignac Emerging Discovery Equities Fund, which launched in mid-December 2007, is acutely aware of these dynamics, and therefore focuses hard on downside protection and dampening volatility.
Since December 2010, Hovasse has limited losses to 10.64% for investors in his small and mid-cap fund, and the volatility of his portfolio (13.30%) has been lower than the index.
“We are proud to outperform the benchmark when markets are collapsing. Downside protection is key, because otherwise you get a scary fund,” Hovasse says.
He does not ignore the growth potential in his universe – indeed he notes it is an important reason to allocate to emerging markets (EMs), and to small and mid caps.
But he is mindful of building a portfolio that can withstand poor economic conditions, as well. In this regard he highlights the “main differentiating feature” of his process, namely focusing on companies generating healthy cashflows – or, more specifically, companies with “good free cashflow to equity before expansion capex”.
“We ask, what is the cashflow yield available to equity shareholders after payment of debt interest and before any additional investments? We want companies that can self-finance their growth, and we like companies that are not capital intensive and do not have large working capital requirements,” Hovasse says.
“If you buy cashflow-generative companies in developed markets, you may buy the ‘value traps’ or simply boring companies, but in EMs if you buy companies that want to grow too much, they will blow up their balance sheets.” He mentions here some infrastructure companies – part of an admittedly strong EM ‘investment theme’ – that are capital-intensive and must borrow heavily to grow. Hovasse avoids them.
Here lies another important aspect of Hovasse’s process. While the EM ‘story’ often rests on themes – which individual stocks may or may not fulfil – he “never buys a stock because the theme is good, that is not enough”.
But his team’s process does take account of bigger themes (top-down), as well as stock selection.