Extraordinary Potential

It's the extraordinary growth potential, but there's a long story and there's a short story. The long-term narrative is about a massive structural shift that has happened in the last 10−20 years. In the early '90s, emerging market equities were considered somewhat like frontier markets are today. There was the potential for exceptional absolute returns and low correlation to everything else in a global investor's portfolio. Now, they have become mainstream. There are two drivers. First, the majority of global economic growth will come from the developing world, which represents 90 percent of the world's population. Second, the developing world is more economically resilient. We no longer see the repeated banking, balance-of-payment, and currency crises of the 1980s and '90s, and governance has changed dramatically. Populations are also much better educated, they have access to information because of technology, and they no longer follow political pretenses and biases—they are demanding economic deliverables. The one caveat here is that the world has become integrated—emerging and developed markets trade in sync, and the low correlations are behind us.

The short-term story is playing out in the headlines, and it has to do with two cyclical concerns. The first is about the cost of capital and global liquidity. There is a lot of anxiety about the Fed's tightening and impact it will have on emerging markets. My view is, please, please bring it on—and the sooner the better. Get it done because, by and large, after some brief turbulence, these markets will walk straight through it and will be better off on the other side. The second has to do with growth rates of the more prominent emerging markets. China's GDP growth has slowed to about 7 percent, more sustainable from the double digits a few years ago, and it will probably get closer to 5 or 6 percent in the next five years. This has had a huge reverberation in terms of commodity prices and commodity economies, like Russia, South Africa, and Brazil, which have taken a short-term hit. The composition of China's growth is also changing, moving away from infrastructure and real estate towards more sustainable areas like domestic consumption. The other factor is that over the last three years, we have seen the worst global export trading environment in the post-war period. Many emerging market companies are on the frontier of productivity in their individual countries and are globally competitive. But we're in the advanced stages of these cyclical headwinds, and I expect to see a meaningful shift in 12 months. This will be driven by improved employment, consumer demand, and industrial investment in the U.S., which will have a pronounced impact on major manufacturing centers in the developing world. Japan's efforts to build a more sustainable growth environment will help, as will the corporate restructuring and quantitative easing in Western Europe.

I follow the basic themes of global change, which create opportunity. These themes include convergence, mass affluence, technology, and restructuring, but I'm also very interested in disruption. For example, e-commerce continues to develop profoundly. Also the changes in media are felt differently in the developed and developing worlds. I'm interested in the emerging market consumer and how he or she is expressed in luxury goods, health care, and education—whether it's about social mobility or other aspirations. Within all of that, I look for the companies that have massive, durable, and sustainable competitive advantage. I also believe that advantage compounds over time, and that the distance between those extraordinary companies and their competitors expands exponentially. I am also willing to run against the crowd and be controversial—because I have to. Most of the time, the extraordinary companies I invest in are richly priced, and I can acquire them only when there is a lot of controversy in the market. Take, for example, private-sector, entrepreneurial Chinese companies. They tend to have unusual ownership structures, and a few years ago, a handful of accounting scandals led to SEC investigations and short selling. There was a mass exit because nobody wanted to be associated with them. Some were companies I had coveted for many years, and I had been unwilling to pay the high prices, but when there was a sell-off, we moved in and bought as much as we could. Shortly after, the concerns vanished and they have been among our greatest performers.

Extraordinary companies have competitive advantages which are expressed through profitability. These are companies which earn significantly more than their cost of capital for a long period of time, because they have something unique about their economic models that is difficult to replicate. The analogy is creativity, which I think of as the ability to do something different that has enormous value. Advantage comes in many stripes across many different industries, but we're looking for real durable advantages and they can be quite different in the developing world than they are in developed markets. In the developing world, the way to win is to find the inherent economic advantage of the company. For example, brands, while fickle, are much more powerful than in the developed world, and they resonate for a long period of time. The reason for that is, across the developing world, there is an historic fundamental trust problem of governance, delivery of services, being cheated and having no recourse. As a result, brand conveys a sense of a trusted outcome for which people are willing to pay more. Also, in the developing world, you also tend to get really fragmented market structures and poor infrastructure. Some companies are able to build a backend advantage in logistics and distribution and IT that are almost impossible to replicate.

I believe that in times of difficulty, the strong get even stronger, and this is how I structure this strategy and approach risk management. There are three components to this sense of resilience. The first is diversity, meaning a diversity of ideas and positions. One way that I check against risk is to have enough diversity in the portfolio—across countries, across industries, and across single companies. It's important—we have the ability to take measured risks, because no single theme or single stock will completely overwhelm us. We also have stop limits on maximum positions in a geography, an industry, and a particular company. The second is liquidity. It is critical to stay liquid, particularly when things are going well and you want to keep adding to positions. As a long-term investor, I care a lot about winning over three or five years or a decade, and the one thing that could unwind is a liquidity problem that turned us into forced sellers. We will never get in that position because I build in at least 10 percent liquidity into the portfolio and I always hold way too much cash, but we can react quickly to a systemic shock to emerging markets or to global equities. The third part is not quantitative, it's the ability not to fear being wrong, the willingness to admit when you are, and the skill to correct it immediately.

We have the Emerging Markets Equity Strategy, which is one of the largest actively managed emerging market strategies, and we just launched the Emerging Markets Innovators Strategy. I have a great aversion to bureaucracy, and I keep the team small—only nine people while our peers might have 40 or 50 people. We will never get there. We tend to employ people who are really curious by nature. Exploration is something everyone on our team likes to do, but it's only one part of what makes us successful. Each of our analysts have three things they're supposed to do. First, they should have three new ideas a year. This can be challenging when you consider that we might commit half a billion dollars to one of them. It's really the maintenance part that's important—we need to understand our companies and constantly reappraise them. I try to make it as creative and alluring as possible. My view here is that it's okay to have been wrong, but make sure you keep asking questions about whether you're right, and it should occupy a lot more of your time than exploring new ones. I borrowed the third from Google, which is each individual should spend 30 percent of his or her time doing something completely novel: learning; building up for the future, and being able to share those experiences of learning. That could be about building networks in a particular geography or spending the year learning about a particular country that one doesn't know very well. That could be doing something that isn't responsible for investing but taking on an industry that one has never known before. We spend a lot of time learning.