From Athens to Almaty

Few investment companies today have the tools at their disposal to take the highly active approach that Fidelity Emerging Markets (FEML) does. Managers Nick Price and Chris Tennant can invest off benchmark, across the market cap spectrum, and even take short positions in companies. It’s a mandate that means the managers can profit from many types of businesses across emerging markets, regardless of their size or whether they are successful or failing.

Such an approach would arguably be a boon to any active manager but its benefits are likely to be felt more acutely in emerging markets, where opportunities are often hugely disparate. A brief look at FEML’s portfolio illustrates this, with holdings in sectors and regions as varied as Greek financials and Taiwanese tech companies.

Emerging markets had their first positive annual return since 2020 last year and FEML delivered outperformance over the period. Looking at the investment company’s holdings today provides some indication as to how the company achieved that and gives some insight as to what Nick and Chris’s outlook is for emerging markets as we head into 2024.

Perhaps the most striking feature in this regard is China. The world’s second largest economy currently constitutes close to 30% of FEML’s benchmark, the MSCI Emerging Markets Index. Although that is down from over 40% in 2020, this still means that performance in emerging markets is heavily influenced by what is happening in China and wider sentiment towards the country.

This goes some way in explaining emerging markets performance in 2023. The China economic recovery many were expecting did not materialise as hoped, with many lingering fears about the state of the country’s economy and its growth prospects, with more muted levels of consumption. FEML was underweight the country (considering China and Hong Kong combined), which acted as the largest driver of outperformance at a country level.

However, this positive effect was offset by security selection in the country, as the high-quality names held in the portfolio derated more than the broader market. This negative sentiment has pushed some China and Hong Kong-listed stocks to attractive valuations, which Nick and Chris are seeking to take advantage of - while continuing to remain laser focused on assessing country risk.

For example, Hong Kong listed insurer AIA Group is currently a major holding in the portfolio. The company has been able to grow its value of new business over the year and is also currently undertaking an extensive buyback programme that has continued into the new year.

Similarly, dairy business China Mengniu Dairy has also been trading at attractive valuations, despite the fact that competition is easing and it is seeing positive growth trends in milk and chilled yoghurt. The portfolio managers are cognisant of weaker consumption levels in China but believe the companies’ fundamentals remain strong, and that there is growing evidence of shareholder friendly activity at many of these companies.

Another sector the team are seeking to generate returns from in China is real estate. FEML has a long position in a state-owned enterprise that is in a much stronger financial position than its private peers. At the same time, FEML is short several of those private companies, which have high levels of debt and are losing market share to SOEs.

Away from China, another feature of the FEML portfolio is its overweight exposure to financials. The trust’s portfolio had 39.3% net exposure to the sector at the end of December, compared to an equivalent weighting of 22.3% in the company’s benchmark.

However, that topline figure conceals the very different opportunities in the sector that FEML is seeking to take advantage of. For example, the company’s investments in Indian and Indonesian banks, such as HDFC Bank and Bank Central Asia, seek to benefit from the fact that the current uptake of financial services is low relative to developed markets, with growing demand for products like business loans, credit cards and savings accounts.

Other investments in financials include those in companies that have made use of technology to rapidly take market share. Brazilian company Nubank is one example of this, as is Kazakhstani firm Kaspi. The latter company has evolved into Kazakhstan’s dominant payments, ecommerce, and banking company and has been able to pay out dividends and buy back shares this year.

Greek banks are an example of where the investment thesis is based around the idea of structural change. Banks in the country came under pressure during the sovereign debt crisis but have improved markedly since then, meaning they now offer strong balance sheets but still trade at attractive valuations.

Looking ahead to 2024, the outlook for monetary policy will be one determinant of market performance. In this regard, it’s worth noting that emerging markets had a much better handle on inflation compared to previous cycles and also their developed market peers.

Central banks did not engage in the same largesse as many developed regions did during the pandemic and were quick off the mark to hike rates when signs of inflation appeared. Indeed, as we debate whether or not there will be rate cuts in the US and UK, countries such as Brazil, Chile, Hungary, and Poland have already started them.

Combined with more attractive valuations, we think this sets FEML up well for 2024. The trust’s extensive research capabilities, as well as the more flexible approach the managers can take to markets, means that we may see another year of strong performance.

The trust’s discount also stands at 12.1% as at 22/01/2024, tighter than the 16.1% high of the last twelve months, but still over 20% wider than its 10 year average. Assuming the underlying portfolio’s performance is strong then investors may stand to benefit from an additional uplift if there is a subsequent tightening of the discount.

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