Revisiting Seven Sources of Value in Emerging Markets

Value investing and emerging markets are not often associated with one another. Conventional wisdom says that emerging markets, with their rapidly developing economies and rising consumer classes, are the hunting ground of growth-oriented investors. Likewise, value investing is often simplified to investing in stocks trading at low multiples as well as low-quality, cyclical businesses. Forgoing the former (higher growth) while pursuing the latter (higher business risk) might seem like a lose-lose proposition. Perhaps not surprisingly, there are few self-identified value-oriented emerging markets mutual funds.¹

Seafarer Capital Partners views “value investing” as an investment approach that seeks to purchase a security at a discount to its intrinsic worth. We eschew simplistic characterizations of value as stocks trading at “cheap multiples.” A low price-to-earnings ratio or low price-to-book value ratio can be a sign of potential value, but can also be a sign of low business quality and risk. An approach focused on low multiples alone might yield an overconcentrated portfolio in cyclical industries such as the materials, energy, and industrial sectors as well as low-quality state-owned enterprises and distressed companies.

Sources of Value

Instead, Seafarer’s Value team focuses on underlying “sources” of value in emerging markets where stocks may be systematically underpriced compared to their intrinsic value. In 2016, Seafarer published On Value in the Emerging Markets, a white paper that identified seven distinct sources of value that may give rise to viable opportunities for long-term, value-oriented investments. Each source, detailed in the following table, offers unique risk characteristics and avenues for prospective return generation, enabling a means of portfolio diversification that eludes strategies dependent on low multiples and overloaded with depressed cyclicals and commodities.

This approach to value in the emerging markets has served as the basis for the Seafarer Emerging Markets Value Strategy, launched on May 31, 2016. As the strategy reached over eight years of operating history, the Value team saw the importance of analyzing its practical experience in pursuit of the seven sources of value.

The goal of this introspective analysis was to examine candidly which sources of value have been productive, and which less so. We looked at the nuances learned in pursuing each opportunity set; the risks to which we have become more attuned; and commonalities in the types of stocks we have pursued and how their value has been realized that cut across all seven sources of value.

This research allowed us to draw and formulate clear lessons and present them in a newly published white paper Revisiting the Seven Sources of Value in Emerging Markets.

As an example of one set of the findings, the following chart presents all seven sources of value by their impact on the strategy’s performance since its inception.

Share of the Value Strategy’s Cumulative Total Return by Primary Source of Value

5/31/2016 – 9/30/2024

Percentages in the chart are based on the aggregate contribution to total return for portfolio holdings in each primary source of value divided by the aggregate contribution to total return of all portfolio holdings from the inception of the Seafarer Emerging Markets Value Strategy on May 31, 2016 through September 30, 2024. They exclude cash and other assets and liabilities held by the strategy. A portfolio holding’s primary source of value is defined as the intended driver of value Seafarer was targeting over the majority of a position’s holding period. Sources: Bloomberg, Seafarer.

The Asset Productivity and Structural Shift categories contributed the most to the strategy’s return since inception. These two categories were fruitful because they presented relatively abundant and scalable opportunities, and both offered relatively high rates of return.

By contrast, the Balance Sheet Liquidity category was relatively unproductive. The strategy placed little weight on this category, and its average return was poor compared to other categories.

Below we dive deeper into one of the sources of value, Structural Shift, to illustrate how it has manifested in practice, the lessons learned pursuing it, and an emblematic former portfolio holding.

Structural Shift: How Value Has Manifested in Practice

Structural Shift – highly cash-generative companies that have structurally shifted to a lower growth rate – has been a fruitful category, in terms of both the number of opportunities and the returns derived therein. In this category, the Value strategy focused on a mix of companies paying a high and sustainable dividend combined with former “investor darlings” that lost their luster when growth failed to live up to lofty expectations. Consumer-facing sectors were a common area of sectoral exposure. Likewise, China in 2016 and Brazil in 2020 offered multiple Structural Shift opportunities as corporate growth plateaued or fell and previously much touted “rising per capita consumption” growth stories fell short of historical rates of expansion.

Lessons Learned

The original 2016 white paper focused on the capital return potential from cash generative businesses that have entered a slower growth phase. While the Value strategy has found success investing in such opportunities, it has also made productive investments in companies reinvesting in their own businesses and seeking to expand margins through operational efficiency. This has enabled some to overcome perceived destinies as ex-growth stocks, and has provided the strategy with a company-specific source of return largely independent of the broader macroeconomic backdrop. While many investors may fret about economic volatility in emerging markets, the diversity of corporate growth slowdowns by geography and sector has yielded an ongoing source of Structural Shift opportunities.

Emblematic Stock: A Chinese Beer Company

China’s per capita beer consumption peaked in 2013 after two decades of rapid volume growth.^2,3 A major Chinese beer brewer emerged as the country’s largest brewer by volume during this period and saw its market capitalization soar as investors extrapolated continued revenue growth. As the company’s volumes plateaued at close to 12 million kiloliters from 2013 to 2016, a Structural Shift value opportunity emerged. The Value strategy purchased the stock in June 2016, recognizing the durability of the company’s underlying cash flow generation and the potential for the company to overcome its low margins. The company did so through two means. First, it rationalized its excess factory capacity, a legacy of its state-owned enterprise origins, by closing over a quarter of its plants from 2016 to 2020. Second, it achieved pricing gains through product premiumization, aided by a 2019 partnership with a foreign brewer. Operating margins expanded from close to 8% in 2016 to 12% in 2020 (the strategy exited the company’s stock in July 2020) and increased to over 15% by 2022. The company’s beer business reported operating margins of 19% in 2023, excluding the impact of a hard alcohol business it acquired. Even as its sales volume declined by 5% from 2016 to 2023, its beer business operating profits increased three-fold.⁴

Common Threads Across All Sources of Value

Both latent balance sheet value and future value creation matter. We focus not just on low-priced stocks but on businesses that can sustainably generate value over the long term. Assessing operational attributes and fundamentals helps us determine intrinsic worth and avoid value traps.⁵ We seek companies with sustainable competitive advantages to generate a positive spread between return on equity and cost of equity – or that have a credible path to do so. Notably, 37% of positions in the Value strategy as of June 30, 2024 were held for seven or more years.⁶ To us, value investing is not a short-term trading strategy.

Thoughtful capital allocation unlocks latent value. Many emerging market stocks trade at low multiples due to poor capital allocation. We analyze control parties to understand capital allocation priorities and assess their alignment with minority shareholders. Management teams that think critically about the cost of growth and carefully steward corporate capital are scarce and valuable in markets where family and state control are common. Discretionary capital returns – special dividends and share buybacks – by many Value strategy holdings may be evidence of such corporate maturity and is an area we intend to explore further.

We’ve also seen a surprising recurrence of tender offers for companies held by the strategy. These include acquisitions of large non-controlling stakes by other companies or strategic investors, as well as full take-private offers often led by the controlling shareholder in the company. While unpredictable, their recurrence – initiated by seemingly informed parties – validates the latent value we identify. Few seek it, but there is value in emerging markets. And seven good reasons to take note.

Brent Clayton is a Co-Portfolio Manager at Seafarer Capital Partners, LLC.

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer Capital Partners’ 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. 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.

Past performance does not guarantee future results.

^1. Seafarer notes only 13 such value-named funds in the U.S., based on Morningstar data as of August 6, 2024.

^2. “Beer Consumption Per Capita in China” (https://www.helgilibrary.com/indicators/beer-consumption-per-capita/china/) Helgi Library, October 29, 2023.

^3. “Around the World, Beer Consumption Is Falling” (https://www.economist.com/graphic-detail/2017/06/13/around-the-world-beer-consumption-is-falling) The Economist, June 13, 2017.

^4. Source: company reports. Based on reported earnings before interest and taxes (EBIT) excluding impacts from impairments, disposals, and special items.

^5. A value trap is a potentially attractive investment within the guidelines of value investing but one with mitigating (and often unforeseen) factors that may negatively impact its expected performance.

^6. Sources: Bloomberg; Seafarer.

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