Assessing the Foundation

For these reasons, we complement our bottom-up, business-model research with macroeconomic frameworks, seeking strong businesses in countries where they have a good opportunity to realize their potential. The combination of a favorable business model and a positive macroeconomic backdrop can create powerful opportunities for growth investors. Our macroeconomic frameworks also help us mitigate risk in this volatile, heterogeneous mix of countries that collectively represents roughly half of global gross domestic product (GDP).

How We Use Macroeconomic Research                            

We consider macroeconomic research as secondary to our fundamental analysis on individual businesses. Macroeconomic research complements our bottom-up analysis by measuring a country’s relative attractiveness, providing insight into the economic context in which a business operates.

Our individual country frameworks draw on deep research into the key macroeconomic drivers and trends that tend to determine the sustainability of the country’s economic growth rate, its fiscal and monetary health, and its political governance. They help us zero in on the factors that affect a country’s long-term economic outlook and the ways those factors change over time.

We then classify countries as “attractive,” “stable,” or “vulnerable.” All else being equal, we prefer companies operating against what we view as attractive or stable macroeconomic backdrops, in addition to fitting well with our six investment criteria. In our experience, these businesses are better equipped to sustain long-term fundamental growth.

Below are some of the factors we consider when classifying countries:

Growth Sustainability

Emerging markets on the whole are known for having faster-growing economies than more-developed nations. Yet growth rates can diverge significantly across individual countries, and not all factors driving growth are equally sustainable.

We look for secular drivers that we expect to be most effective at promoting growth over the long term and that are unlikely to be derailed by short-term developments, such as trade wars or fluctuations in oil prices. For example, we favor countries with:

• Positive demographics, including an increase in the skilled working-age population and an increase in urbanization
• Development of domestic industry, including robust manufacturing and service sectors
• Increased digital connectivity, with more services moving online
• Prudent credit expansion
  
  

We tend to avoid or limit our exposure to countries with more cyclical or unsustainable economic growth drivers, such as commodity exports or spending by highly indebted consumer or corporate sectors. In our view, companies domiciled in—or deriving the majority of their business from—these countries often face significant headwinds that can lead to slower growth and/or more-volatile earnings.

Economic Strength

A country’s economic strength is necessary to fund sustainable economic expansion and support a stable currency. Countries with high savings rates, healthy current accounts, relatively low budget deficits and debt, and ample foreign currency reserves are usually less vulnerable to capital outflows. These qualities tend to be particularly relevant when higher U.S. interest rates lead to capital outflows from the most vulnerable countries. When countries run deficits, we explore whether those deficits are structural or cyclical, which helps indicate how persistent they’re likely to be. We also examine how much the country relies on foreign countries to finance its deficits. Finally, we look at both the direction and rate of change in the country’s finances.

Governance

Governance factors can play an important role in sustaining secular growth. As part of our framework, we examine factors such as government stability and the ability to transfer power peacefully. We also look at factors such as regulatory structures, health of the banking system, policy direction, corruption levels, and political risks, among others. And we consider cultural characteristics; for example, preferences for education and entrepreneurship can be constructive.

Many of the emerging market countries in which we invest have relatively low GDP per capita. These countries have opportunities to increase productivity rapidly by adopting technologies and practices from more advanced economies. We believe strong, healthy institutions make it much more likely that a country will be able to exploit this “catch-up” opportunity.

Short-Term Disrupters 

We continuously monitor various other factors that can create short-term disruption. These include market sentiment levels and direction, extreme market positioning and liquidity, and external factors such as the strength of the U.S. dollar, U.S. Federal Reserve policy, oil prices, and commodity demand from China.

What Our Frameworks Tell Us

Our frameworks aren’t precise forecasts. They aren’t designed to help time the market or to dictate our investment decisions. Rather, they provide insights that help us gauge risks, opportunities, and the direction of change in a market over our investment horizon. They help us identify multiyear structural trends that can potentially support above-average earnings growth and stable-to-increasing local currencies, which in turn can help lay the groundwork for special businesses to create wealth over long periods.

The practical applications of our macroeconomic frameworks include:

Portfolio Construction: Generally, we seek to own businesses that meet our fundamental criteria and that are located in countries with attractive or stable macroeconomic climates. It’s possible that the merits of a business will outweigh a weak macroeconomic landscape. Businesses in economically vulnerable countries have a much higher hurdle to overcome before we will invest, requiring more support from secular trends, higher growth potential, and/or lower valuations. We will never own a business solely based on its exposure to an attractive macroeconomic landscape.

Measuring Addressable Markets and Identifying New Opportunities: Our frameworks can help assess a business space’s relative attractiveness and can lead to new ideas and/or help prioritize research.

Risk Management: Avoiding or limiting exposure to vulnerable countries can be a useful risk mitigation tool in times of stress in emerging markets. Significant local currency depreciation can erode returns for investors in emerging market companies whose profits are converted to U.S. dollars. (Figure 3)