Seafarer addresses key questions about emerging markets investing and how U.S. investors can integrate the asset class into long-term portfolios.
What role can emerging markets play in U.S. investors’ asset allocations?
The emerging markets asset class can serve two useful roles in a long-term investor’s portfolio:
- Emerging markets offer a prospective source of diversified growth within a long-term investor’s portfolio. During much of the last 15 years, the concept of decoupling was in vogue for the emerging market asset class, but was overstated and misapplied. However, Seafarer believes that two recent structural changes – reduced reliance on exports and independent monetary policy – might finally allow the markets to decouple from the developed world. Decoupling is now relevant, for the first time.
- A high-quality, income-producing portfolio of emerging market securities (dividend-paying stocks and bonds) can act as a useful source of diversification (or hedge) against the U.S. dollar. Seafarer believes that long-term investors should seek exposure to productive assets with meaningful growth potential, and that are capable of generating income in currencies other than the U.S. dollar.
How should long-term investors integrate the emerging markets asset class into their portfolios?
The emerging markets are likely to remain volatile for the foreseeable future. Risk appetite must dominate any consideration of the asset class. Seafarer believes that investors should consider two key factors:
- Long-term time horizons are essential. Given the volatility of the asset class, due especially to heightened currency risk, Seafarer suggests that investors adopt a minimum investment horizon of five years.
- Investors should manage U.S. dollar versus non-U.S. dollar exposures in their portfolios. Rather than initially allocating capital among traditional “asset classes” (e.g., domestic stocks, foreign stocks, bonds, real estate), Seafarer believes investors should measure the portion of their assets that are principally denominated in U.S. dollars versus those assets that are not. After matching U.S. dollar assets against U.S. dollar liabilities, a portion of the surplus capital (e.g., 10% to 30%) can be allocated to the emerging markets.
How can U.S. investors understand and address the risks of investing in China?
While China is now a major investment destination for global investors, Seafarer is acutely aware of the risks posed by the darker aspects of China’s modern development. Bottom-up research is the best way to mitigate these types of risks and identify mispriced securities. One aspect that differentiates Seafarer’s research process is analysis of control party risk – a prominent concern in China. Seafarer addresses these topics in several commentaries:
- In the commentary The Future of China within the Emerging Market Asset Class, Andrew Foster suggests that as China’s economic might is ever more fraught with political and moral dilemmas, it may be time to carve out China as an independent asset class.
- In a video discussion, Nicholas Borst, Paul Espinosa, and Andrew Foster explain that when evaluating emerging market companies, state control is a better indicator of corporate governance than state ownership. Through control party analysis, the Seafarer investment team aims to understand who is making key corporate decisions that affect foreign minority shareholders.
With many of the largest, growth-oriented companies facing headwinds, is there a rotation to value underway in the emerging markets?
Short-term prognostications of economic and market direction often fall flat. In the second quarter 2021 portfolio review for the Seafarer Overseas Value Fund (excerpted below), Paul Espinosa discusses how pondering such broad questions as “rotation to value” leads to consideration of factors that are not cornerstones of future investment returns. He also discusses how the Seafarer process identifies company-specific indicators of attractive valuations.
The majority of questions I receive about the future revolve around the following: a possible incipient “value rotation” in the market; whether emerging markets can finally outperform the S&P 500 Index when next year’s outlook for U.S. corporate earnings is very strong given the potential for a federal stimulus program; and whether emerging markets can outperform in the event of a market drawdown in the context of historically high valuations for the S&P 500.
The problem with the questions above, despite them being perfectly sensible, is that (1) they focus on the trend, or the next market move, (2) they grant undue importance to next year’s earnings, and (3) they rely on cross-market correlations to make allocation decisions. The issue is that none of these factors represent the cornerstone of future investment returns. These variables represent observable, ex-post outcomes, or a curiosity for the historical financial record, and nothing more.
- The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.