Assessing the Foundation
At Sands Capital, we complement our bottom-up business-model research with macroeconomic frameworks to seek outstanding businesses.
We believe emerging market equities are likely to be an important source of wealth creation in the years and decades to come. Decades-long secular trends are creating new markets and disrupting old ones, and in our view, some businesses are well-positioned to benefit.
The long-term opportunity in emerging markets may be powerful. But growth is not linear (Figure1), and emerging markets may be volatile and susceptible to shifts in investor sentiment.
Moreover, not all emerging markets are created equal. Macroeconomic differences can affect wealth creation in specific markets. For example, certain currencies tumbled over the past few years (Figure 2) amid heightened risk aversion, declines in economic growth, shifting interest rates, and other factors, while other currencies were more resilient. Likewise, we believe some countries are more pro-innovation; in others, structural imbalances threaten to overwhelm even the strongest corporate earnings growth potential.
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:
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.
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 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.
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)
Our Macroeconomic Frameworks Serve as Powerful Portfolio Construction Tools
Our macroeconomic frameworks complement our fundamental, business-focused research. We believe our frameworks are powerful portfolio construction and risk mitigation tools that can enhance our ability to seek to identify exceptional businesses while mitigating risk.
Volatility is inherent in equity investing, and mainly reflects short-term sentiment. This short-term focus can obscure what matters over the long term. We believe cyclical forces like currency depreciation or slowing economic growth won’t derail the massive, potentially decades-long secular trends that we see evolving in key countries.
The views expressed are the opinion of Sands Capital and are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. The views expressed were current as of the date indicated and are subject to change. This material may contain forward-looking statements, which are subject to uncertainty and contingencies outside of Sands Capital’s control. Readers should not place undue reliance upon these forward-looking statements. There is no guarantee that Sands Capital will meet its stated goals. Past performance is not indicative of future results. All investments are subject to market risk, including the possible loss of principal. Differences in account size, timing of transactions, and market conditions prevailing at the time of investment may lead to different results, and clients may lose money. A company’s fundamentals or earnings growth is no guarantee that its share price will increase. You should not assume that any investment is or will be profitable. GIPS® Reports and additional disclosures for the related composites may be found in the Sands Capital GIPS Report.
The MSCI Emerging Markets Index (MSCI EM) is a free float-adjusted market capitalization-weighted index that is designed to measure the equity market performance of emerging markets. The MSCI Turkey Index is designed to measure the performance of the large and mid-cap segments of the Turkish market. With 12 constituents, the index covers about 85 percent of the equity universe in Turkey. Investments cannot be made directly in a broad-based securities index.