Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
How Pzena is ‘picking up gems’ from the China wreckage
India has outpaced the rest of its emerging market peers in recent years, and is one of the few global markets to almost match the performance of America’s tech-heavy bourse off the back of rising corporate profits.
But value house Pzena Investment Management is casting a skeptical eye over the boom in Indian stocks in the belief that their valuations don’t match their prospects.
“At the end of the day, India has generally been expensive, and nowadays it’s quite expensive,” said Akhil Subramanian, principal and portfolio manager for Pzena’s Emerging Markets Select Value strategy. “You have to believe sustained double-digit earnings growth and margins higher than they’ve ever been – for selling shampoo and KitKats – to justify earning a return on that business.”
“Stock prices can go up and down, but an owner of a business thinks about how much is coming out and how much is going in. And for a lot of these Indian companies today, unfortunately, based on the valuations, you have to assume a lot of growth and a lot of margin expansion to believe you can earn an adequate return on paying 60 times earnings.”
For that reason, Pzena has been trimming its India exposure and is fairly substantially underweight, though companies still come through its research pipeline. But in some sectors it would have to buy “the worst company that’s losing the most market share” and underwrite high growth and earnings because the starting point is so high. It can instead find an equivalent business in another country that’s trading at a quarter of the multiple. Case in point: China.
Since 2020, Pzena has substantially dialed up its weighting to China as valuations have come down; GDP growth is slowing, the population is declining, the property sector is in trouble and unemployment is high – but “that’s not enough”.
“We need to have all of that pain, plus some company specific pain, to really get excited,” Subramanian said. “The reason we’ve gone from 20 points underweight to nine points overweight is we’ve found good businesses, often leaders in their sectors, that are undergoing an industry downturn or a company-specific mishap. We think it’s temporary; they act like people that want to take advantage of a crisis, and we can buy at six times normalised earnings.”
Pzena thinks of it as “picking up gems from the wreckage”, with the added boon that there’s plenty of places to pick them up in. The biggest companies in the average EM country tend to be in financials, energy, telecommunications or beer. But China has much more sectoral diversity.
“When we look at investing in China, we can own a collection of businesses that are very, very different, and each of them has their own sector-specific or company-specific issue,” Subramanian said. “We own a company that makes diesel engines for trucks, a company that makes kitchen appliances, one that make sofas; a property developer, a wealth franchise… That’s very energising for us.”
Subramanian is keenly aware of the risks of regulatory action in China, especially for stocks in politically-sensitive areas like gaming, but considers the possibility of those actions to be a potential inflection that would push the stock into the quartile where Pzena hunts.
“We stayed away from Alibaba because it was 30 times earnings; the government regulated it, competition came in, they paid a fine, and then we got involved because it was trading at 10 times earnings. We are overweight China, overweight Brazil and underweight India. And not because we have a view on where India or China are going, but just because our fundamental research has pointed us to a group of 50 stocks that happen to be in Brazil and China because they’re so compelling and cheap.”
