While the biggest “friend or foe” question is China, it remains an open one. A dramatic economic downturn in the world’s second-largest economy “is in no one’s interest,” Williams pointed out.
The second consequence of the stimulus in emerging markets has been “to provide the labor, technology and natural resources” that are supporting the green energy transition — including in the West — such as the development of new technologies for electric vehicles, said Williams.
This is a timely moment for investors to diversify into and find income in emerging markets that are seeing capital inflows as a reward for their orthodox policy approach and solid growth trends, according to Williams. In contrast, the U.S. Federal Reserve is nearing the end of its rate-hiking phase amid uncertainty around a recession and growing debt levels.
“As policy makers attempt to buffer the impending growth slowdown, there could be more debt growth in the U.S. and more inflation,” Williams said, “that we believe could lead to more investment, more capital transferring to emerging markets. Emerging markets have a lot more domestic dependency than they had before, so the importance of the U.S. in driving economic growth has been dampened somewhat.”
Several income-paying companies in the emerging markets are making use of a broad-based economic transition that has a level of capital expenditure these markets have not experienced in decades, probably since China was first being integrated into the global economy, Williams pointed out. “The opportunity and the catalysts are evident and quite a number of countries are able to participate,” he said. “It has the prospect of driving earnings growth over a multiyear period.”
“There will be a reappraisal of the asset class, but it’s going to take a number of years for investors to fully see the light.”
Williams pointed to logistics as an example of an underlying driver of investment opportunities in the emerging markets because of the labor, technology and natural resources needed to support the energy transition in the developed world.
“You need to have a logistics network. And to do that, governments have to invest in myriad technologies,” he said. “The logistics operation is like your train, and you need to invest in a railway network first to put that industry on top of those tracks,” he explained. “There are a number of really critical technology companies that are providing those bits of railway equipment, so to speak, from emerging markets countries that are very important to this economic transition that’s going on in the West.” For example, several companies in Indonesia offer low-cost production of critical natural resources, such as copper or nickel, that are essential for the green energy transition.
Follow the cash flow
Institutional investors seeking equity returns tend to focus “too much” on a stock’s rating potential, accounting profits and investor sentiment rather than “cash flow health in a business, and the ability to invest for growth which is essential to grow the dividend,” Williams said.
For abrdn, it starts with identifying the right companies. “We are bottom-up stock pickers,” he said. “The way we build the portfolio is first with an insight led by our interactions with companies.” Following that, he noted, the equity team conducts careful analysis with a focus on company earnings and cash flows that drive dividends.
“If you follow the cash flow through the financial statements, you’re going to get a much richer interpretation of the health of a business, and you can make more informed investment decisions. It leads you to more transparent companies, better governance practices and a shareholder return mindset,” he said.
Williams and his team identify investment opportunities by slotting companies in one of four corporate lifecycle quadrants.
- The first quadrant is when a company is new, establishing its brand and customer base but not generating much cash flow.
- The second quadrant is when a company is established, growing above market rates and generating high levels of cash flow.
- The third quadrant is when a company is fully mature and growing steadily, albeit more slowly than in the second phase.
- The fourth quadrant is when a company’s growth has slowed, and it is paying out an unsustainable level of dividends without investing capital back into the business.
Abrdn’s sweet spot is companies in the second and third quadrants. “We focus on high dividend-related companies that are backed by high cash flow streams, and then we focus on high-growth companies that are backed by growing income streams,” Williams said. “The combination of the two gives us a really wonderful dynamic.”
While the analysis can lead to a multiyear investment in a company, vigilance is critical. “There are so many dynamics — competition, new pricing, new regulation — that you just have to always be vigilant and not take anything for granted,” he said.
Finding the right companies to invest in, however, is one part of the investment equation. The other part is the portfolio. Once a company has been identified as meeting the teams’ earnings, cash flow and dividend criteria, it has to meet the client’s investment portfolio’s overall risk-return considerations.
“We think a lot about risk, and we try to make sure that we’re prioritizing our clients’ active risk in our stock-specific insights, and then we want to orient that budget toward where we’ve got the highest conviction,” Williams explained. “The portfolio has a couple of functions. One is to drive returns and the other is to provide diversification to achieve a cleaner exposure to the stock drivers that we identify and away from factor- or macro-related shocks.”