Fidelity Emerging Markets suffered double-whammy from Russian invasion

Performance in the year to 30 June 2022 has been disappointing – what were the major causes?

Nick:

As set out below, the major reason for underperformance since Fidelity took on management of the Company was Russia’s invasion of Ukraine. Sadly, we underestimated both the likelihood, and the impacts of the invasion.

Reflecting on the war in Ukraine, how was the Company positioned before the invasion and what impact did it have on the portfolio?

Nick:

I’ve invested in Russian stocks since 2005; it’s a market with a chequered history, which has largely been reflected in the price. When the war broke out, the portfolio was exposed to a series of Russian businesses, which were cheap, offered the best dividends in the world, and operated in cyclical sectors such as mining or domestic industries such as banking which thrive when oil and gas prices are high. With inflation ratcheting up in 2021, these stocks played an important role in providing portfolio balance and had performed well against this backdrop.

As troops amassed, we had reduced the residual country bet using an index hedge, however, fundamentally the companies themselves were generating strong cash flows and the dividends payable to shareholders were more than sufficient to compensate for share price weakness. We debated the risks extensively in-house and with external experts, however, we did not conclude there was a risk of a full-scale invasion and all-out war in Ukraine. At the time, we felt the risks were similar to those in 2014 when Russia annexed Crimea and Russian markets remained functioning.

As events unfolded rapidly and sanctions were imposed the Russian authorities retaliated by preventing foreigners from transacting in the market. We had taken some immediate steps to reduce exposure, but the right to transact in the market for overseas investors was withdrawn quickly. The inability to trade meant that there was no price discovery, and as such Fidelity’s Fair Value Team stepped in to review the holdings as ‘Hard to Price Assets’. Given the complete lack of liquidity in these stocks, the holdings were written down to zero which was reflected in the NAV at the time. The impact on performance was significant, albeit the hedge served to offset some of these losses.

The effects were however more widespread than Russia, as a series of second-order impacts, such as a sharp and indiscriminate rally in specific markets. For instance, the rally in Saudi Arabia (a perceived beneficiary of Russia’s newfound pariah status) was detrimental because the portfolio had owned Russia in preference to the likes of Saudi. Consequently, performance issues were further compounded by an underweight to the Middle East.

What have the other implications been for the portfolio and emerging markets because of Russia’s invasion of Ukraine?

Nick:

Given Russia’s effective exclusion from the investable universe, we have recalibrated other parts of the portfolio. We sought new opportunities in areas such as Brazil and the Middle East, spending time on the ground meeting companies. The removal of Russia makes the focus on its commodity exporting ‘competitors’ more important. By design, newly added positions typically exhibit value, given persistent inflation and higher rates. Moreover, opportunities to invest in businesses with direct and indirect exposure to higher commodity prices has been a common trait, particularly where this is coupled with a compelling dividend yield.

The additional inflationary shock that arose from the conflict has meant that cash flows have been rising as buyers have sought alternative sources for key commodities. Whilst prices may be volatile, given fears of a global recession, one of the impacts of the war is significant supply disruption, in what were already tight markets and a greater focus on food and energy security which will, in our view lend a level of support to prices over the medium to long-term. With all these factors in mind, energy, nitrogen-based fertilisers, and financials in resource rich countries have been an area of focus.

Other than Russia, how did you set about transitioning the portfolio to Fidelity at the start of 2021?

Nick:

Following our appointment in October 2021, we took steps to ensure the Company’s portfolio was well-balanced and reflected those areas where we had the highest conviction. We built up exposure to leading, innovative tech companies which play a crucial role in providing the building blocks for processing power and storage in a world where there is persistent and structural demand for data. Similarly, we added positions in copper where there are long-term structural drivers. Tightening emissions regulations and government incentives are lifting demand for cleaner fuels and electric vehicles. Whilst these decisions are driven by a bottom-up, stock picking approach, increasing holdings in areas such as mining reflected our view that inflationary pressures were rising and as such these holdings could act as a natural hedge as commodity prices rose.

We also exploited the closed ended nature of the investment company and moved down the market cap spectrum to take full advantage of our research platform, adding smaller, under-researched stocks. We took a cautious stance on areas exposed to continued regulatory risks such as the Chinese internet stocks and businesses with activities exposed to the capital cycle, although as the months passed these have become areas of interest, as beaten-up industries provided good entry points to acquire attractive businesses at multi-year low.

As at 30 June 2022

Sector

(%)

The portfolio can use derivatives under its new policy. What can you say about how they helped the portfolio this past year?

Chris:

The closed ended structure and newly introduced investment policy allow us to employ a much broader set of strategies than a traditional long-only fund, to express both positive and negative investment views in an efficient manner. Having more tools at our disposal is particularly valuable in emerging markets which are more volatile, and valuations can move to extreme levels in both directions.

Long positions are focused on businesses which are dominant in their markets and short positions are targeted at the weakest stocks most exposed to competitive threats and financial distress. These weaker businesses can provide an additional source of performance. Whilst stock picking is our core strength, we recognise that country risk can be elevated in emerging markets.

As previously highlighted a country-specific hedge allowed us to build in some portfolio protection in Russia given growing geopolitical tensions in Ukraine. In early December 2021, we added an index short to reduce that country risk. When the war broke out the hedge served to mitigate some of the losses experienced at the stock level.

How will you position the portfolio going forward considering heightened geopolitical risk?

Nick:

Geopolitical tensions give rise to many discussions about how we, as stock pickers account for those risks. In a normal environment valuation will reflect concerns, but we are conscious that country risks became greatly amplified during the last 12 months, and so the use of country hedges can play a key role. We are not obliged to be invested in each market, and if we believe the risk is too high, we can of course avoid impacted industries/markets.

Our positioning in China has reflected this in practice; when the US ratcheted up pressure on China through various tariffs and sanctions, we avoided those areas of the market. More broadly, country bets are being maintained at more muted levels currently than historically. They are a residual of our stock picking approach, but we have been deliberate in maintaining more prudent active weights in recent times.

You’ve mentioned China on a couple of occasions, how do you feel about the market at this stage and looking ahead?

Nick:

We are now seeing opportunities in China following a litany of negative news over the past 18-24 months that has dragged the market down: the debt-crisis at property developer Evergrande, tighter regulations which wiped out sectors such as education, the halting of Ant Group’s Initial Public Offering (IPO) and the ongoing concerns about the ability of American Depositary Receipts (ADRs) to remain listed in the US.

More recently, China’s zero-tolerance Covid policy has resulted in the lockdown of millions of people. Valuations have fallen a long way and are in many cases at the cheapest levels we have seen in a decade, making certain areas of the market incredibly attractive.

Amongst property developers there are many with weak statement(s) of financial position, but that provides the strongest players with a good competitive backdrop. There will be less competition for buying land from local governments, boosting the prospects of companies like China Overseas Land, which boasts a solid statement of financial position, strong dividend, and trades below book value. I also expect the Chinese government to relax some of its regulations in property over the coming months which could spark a revival in some of the demand drivers in property in 2023.

The other area where I see value is the internet space, where we witnessed huge falls in stock prices. Alibaba the poster child of China’s tech industry has fallen by more than 50% from its 2020 highs. But when you consider its cloud business and Ant Financial, there is still a lot of value in this stock. Moreover, the company is currently buying back billions of dollars of shares as well as cutting costs. So, we could have a reversal of share price decline that we have seen over the past two years or so.

Chris, how about shorts? Are there any areas of the market you can pinpoint which speak to some of the big picture topics which have dominated headlines this year?

Chris:

Clearly the consumer is under immense pressure, as the cost of living rises this shines a light on more vulnerable retailers. We have added new positions to companies with stretched statement(s) of financial position where the cost of servicing that debt burden is rising, and demand looks more precarious. Elsewhere, silver has suffered in the wake of higher interest rates and concerns about demand for industrial metals. Silver is widely regarded as a precious and an industrial metal meaning that it is exposed to the impact of higher interest rates, as an inflation hedge, but also as an industrial metal, making it vulnerable to fears that demand will be weak. Given this, on a highly selective basis we have added shorts where operational challenges are evident, and leverage is high.

Nick, having invested through many unique and challenging market conditions in your career. What makes this year different in your view?

Nick:

Two aspects stand out to me. Firstly, at the highest level, we have seen a secular shift which has come about following years of declining rates and stimulus which have benefitted equity markets and growth assets. With the era of ‘easy money’ over, valuation discipline is more critical and stocks with little to no current earnings naturally lose favour. Whilst there are challenges ahead and a high degree of uncertainty, such an environment does lend itself to a more prudent, highly selective approach.

Secondly our inability to trade the Russian market for such an extended period is not something we would ever have anticipated. Whilst I have witnessed extreme market dislocation, the lack of price discovery is unprecedented.

How does Fidelity differentiate itself as an emerging markets asset manager?

Chris:

Differentiation is key. The enormity of the research engine at Fidelity sets us apart from our peers. The evolution of my role demonstrates this which has worked collaboratively in sector- specific, regional and global teams as part of an integrated research platform. In the early stages of my investment career, I was a mining analyst, distinctly covering companies operating in the EMEA and Latin America regions. To fulfil that role, I had to have intimate knowledge of a series of businesses operating in the sector. I spent time on the ground at production facilities so I could see for myself the extent of the companies’ operations.

To complement this, I was part of Fidelity’s broader natural resources team, with peers assigned to stocks as far afield as Canada and Australia. The nature of the sector meant that collaborative efforts were central to our work, as we examined supply and demand dynamics globally. In parallel we needed to understand the ‘customers’, such as the Chinese real estate developers, so here again your Fidelity network of research peers covering related industries in different markets is critical to building a holistic view.

In practice, the insights from the research team can play out through long positions and short positions, so as my career evolved, I moved to a role specialising in identifying shorting opportunities in emerging markets. In this context I was able to draw on the platform again.

Another key benefit of the platform is its large geographical footprint, which means that I can have my feet on the ground in Brazil, whilst my colleagues in India or Shanghai are spending face time with companies operating in those markets. With such a vast investible universe and in a world where mobility is still restricted in certain corners, this is of vital importance.

How do you think the fundamentals of Emerging Market economies of the last 10 years will compare to the next 10 years?

Chris:

Historically the most important driver was the Chinese real estate sector, which had far-reaching ramifications for emerging markets broadly and areas such as European industrials. Looking ahead energy transition will play a pivotal role, in a myriad of ways. The move to renewables is likely to result in a structural underinvestment in fossil fuels meaning that energy prices remain stubbornly high for some time which will help incentivise renewables. Renewables are very capital intensive, which is good for certain ‘future facing’ commodities like copper which are vital to the build out of infrastructure and technological advancement. This latter is critical given that to date the ability to store energy between seasons has historically proven difficult. Deglobalisation can take hold over the next decade, fuelled by concerns about security which at first centred on technology but more recently have anchored on fears about food and energy security. Looking ahead onshoring and near shoring can bring benefits to a wider range of developing countries such as Thailand, Vietnam, Mexico, and parts of Eastern Europe.

What are the implications of global inflation, debt in emerging economies and the risk of stagflation in the western world?

Nick:

This is a massive topic, and one that all investors are having to factor into their thinking. The western world is already in a phase of very low growth, with recession coming late in 2022 or early 2023. Inflation, in the medium term, is likely to persist for many reasons. The focus that has been put on climate change (the risks of which are undeniable) by many investment portfolios has driven low levels of capital expenditure in Oil & Gas when energy prices are spiking. Climate change itself is impacting soft commodities (such as crops and livestock) and high levels of unsustainable sovereign debt in the west require quantitative easing. This adds to structural shifts such as a fall in cheap exports from China and changing demographics in the western world reducing the labour pool.

Debt in emerging economies has also grown. It may still be lower than the western world, but nevertheless requires scrutiny. The good news is that many emerging countries have been disciplined in raising rates, and developing countries may attract investment based on their relative strength.

How do you view the current risks and rewards in frontier markets and smaller companies?

Nick:

Although there are always stock specific opportunities, the issue with frontier markets in general is that the economies are extremely fragile, with populations frequently living on the breadline. The stresses of a strong US Dollar and higher energy costs create a difficult mix. It is well-documented that countries such as Ghana, Nigeria, Egypt, Sri Lanka, Bangladesh are all experiencing economic stresses both at a sovereign level and amongst the population. Pakistan was already in this mix and has seen unprecedented flooding widely linked to climate change (a risk which will only increase with time). I am also conscious that liquidity in these markets is very tight. My experience is – a lot like The Eagle’s song “Hotel California” – you can check in but can never check out.

Smaller companies, conversely, can be very attractive. They are often overlooked, and you can find great companies with good management teams and cheap valuations. The Company looks to take advantage of these opportunities.