An excerpt from an interview with Matthew Benkendorf, Vontobel’s chief investment officer and portfolio manager of the Virtus Emerging Markets Opportunities Fund.
How has your recent transition been to Chief Investment Officer and Lead Portfolio Manager on the Emerging Market, Global, and International Equity strategies?
It has been a rather smooth transition, because it was a long-established plan and our process has been in place for many years. Our business is exactly as our investors should expect. Some of the roles have changed, but the investment philosophy, process, and team remain entirely intact. We are continuing to push forward, investing the way we already have been doing for a very long period of time.
Please discuss the recent organizational changes, where you have promoted long-time analysts and Deputy Portfolio Managers of the firm.
We promoted highly qualified, capable individuals that have been with the firm for a long time to the next step in their careers. The moves have been well understood by the marketplace because they were well telegraphed and made a lot of sense. Brian Bandsma and Donny Kranson accepted new lead portfolio management roles and other senior, proven members of the team stepped into deputy portfolio management roles.
2016 was off to an interesting start where lower quality stocks were in favor and global cyclicals did extremely well. In the first quarter, our Emerging Markets Equity strategy underperformed the MSCI Emerging Markets Index. But in the second quarter, the markets turned around and the Fund significantly outperformed. Can you describe the performance in the quarter?
Generally speaking, I don't think we could have anticipated the market gyrations we've seen so far this year, especially with the uncertainty that resulted from the Brexit vote, the huge swings in volatility, and the risk on and risk off environment. But, that's indeed what we've had, and we're only halfway through the year. We can expect additional volatility for the remainder of the year. Fortunately, the environment this quarter has favored our high- quality style, and I am happy to say that we've delivered as our investors would have expected.
The second quarter was particularly strong for us because we were firing on all cylinders. Across the board, from individual securities, to sector and country allocations, there was a sharp reversal in the positions that hurt us in the first quarter. However, we do not want to extrapolate the magnitude of our outperformance in the second quarter because it was partly normalization, with the added benefit of our philosophy and style.
What were the key drivers of performance over the second quarter?
Our longstanding overweight to the consumer staples sector was a significant contributor to returns over the quarter. The stability and consistency of earnings of tobacco companies were well sought by investors after the risks and uncertainty that resulted from the Brexit vote. Our investments in British American Tobacco and ITC were drivers of both absolute and relative performance.
The financials sector also contributed to returns, where our stock selection has been critical in this space. We are holding only 7% of our approximate 20% financials exposure in retail banks. Our focus in non-bank financials, such as insurance companies (BB Seguridade in Brazil), exchanges (BM&F Bovespa in Brazil), real estate investment trusts (Link REIT in Hong Kong), and holding companies (Remgro in South Africa), has helped our Emerging Markets Equity portfolio.
Our Indian financials holding, Housing Development Finance Corporation, has been a long-term investment in the Emerging Markets Equity strategy and we continue to maintain conviction in the position. The company’s share price also increased over the quarter as the market was relieved to see that its loan growth remained solid around 14%, as well as being reminded of the value of HDFC's other businesses following the sale of a 9% stake of HDFC Standard Life Insurance to its JV partner Standard Life and announcing plans for a possible IPO of this unit. We believe HDFC’s future growth will benefit from the long-term demand growth for mortgages as India urbanizes and incomes rise.
Many opportunities in emerging markets are uncertain. Are you having difficulty finding companies with a sustainable five-year earnings growth pattern?
We have no greater challenge today than we have had historically, which is why we are similarly positioned now as we were at the start of 2016 and going into 2015. Our opportunity set is strong. We're confident in our positioning, and the capital allocation amongst that positioning. We're finding some incremental names, but at the same cadence that we've found names historically. Those moves are more glacial, and evolutionary, as we optimize our capital. We're never recreating the wheel, so to speak, at the beginning of any quarter or year. We own a solid group of high-quality businesses, and we expect them to continue to deliver. And, if they don't, we'll make adjustments. We're not trying to give clients exposure to the broad-based emerging markets, but we are giving them exposure to individual stocks that we believe can create a high single-digit, low double-digit compounding effect in their portfolios.
Many emerging market equity investors are impressed with the euphoria of high GDP growth. Do you find any correlation between GDP growth and stock market returns in emerging markets or other places in the world?
We generally find little correlation. For example, in our opinion, India clearly is the fastest growing economy worldwide, and we've had sizeable investments in India historically and we continue to do so. Our investments are not based on any prediction for India’s economic growth. In fact, performance of Indian stocks over this year hasn’t fully reflected that. As you know, Indian equities were soft in the first quarter while the country was still growing strongly, and now the names have come back a bit in the second quarter because the underlying businesses continue to deliver, not because India has continued to put up a higher GDP growth number. And that's why we just focus on the businesses.
The Emerging Markets Equity strategy has approximately a 24% weight to India. Since the weight comprises only a handful of stocks, it would be misleading to say we like India from a top-down perspective. We like specific names in India that we think can deliver the expected returns we are looking for. Additionally, we look at the portfolio as a whole. We want to have a reasonable diversification of solid businesses, because we think there's value to be derived from owning great businesses that do different things. They all do them extremely well, with good managements in place and good economic returns in whatever they're undertaking. Our Indian holdings are examples of this philosophy, but also even in China, in the Internet space, we have found some great dominant franchises. Across Southeast Asia, we have found some banking franchises, and in Latin America, we have found some distribution franchises. We are always searching around the world to find great business models that are attractively valued, driven by the underlying earnings growth, where we can provide returns for our investors by buying and holding them over the long term.
Today, the strategy has approximately 7% invested in Brazil, while in the past, that exposure has been higher. Is that a byproduct of the investment process?
Absolutely. There are some businesses we would like to own again in Brazil, but given the deep recession that the country is in, we conservatively project the growth that should be expected from those businesses. We do think the sentiment is improving in Brazil, and we have added to some of our existing positions, although we think it’s too early to invest in Brazilian banks. Also, another factor is how we approach alternatives. When we consider Brazilian companies, we just find better alternatives elsewhere. We are going to put the capital to work where we find the best businesses at the most attractive valuations at that point in time.
Currencies in emerging market have seemed to stabilize. What impact does currency have on your portfolio?
Currency is the big question of the day that everybody's asking, but it's something that we compensate for in our investment process. When we evaluate a business, we look at the underlying currency exposure as part of that picture to make sure the business is strong enough to overcome any sort of currency volatility.