Investment Adventures in Emerging Markets

The Discipline of Buy and Sell Decisions

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The thought of giving up a once-treasured possession can be an emotional exercise for anyone, even if the object of affection has outlived its use. As investors, we can find it difficult to sell a once-favored holding — even more difficult than the decision to purchase it. But sometimes, you just have to let go.

I’ve often been asked about my team’s process, not only in selecting potential opportunities, but also when and how we determine a particular holding may not be worth keeping in a portfolio and bears replacing with something we deem to be a better opportunity. Emotion simply can’t play a role in our decisions. Instead, we pair bottom-up, rigorous research with step-by-step analysis, first identifying potential bargains within a dataset of more than 25,000 securities, then conducting deep quantitative and qualitative analysis to assess each company’s long-term value potential.Our quantitative analysis includes five-year historical audited financial statements and five-year forecasts based on projected future normalised earnings, cash flow, or asset value potential. Qualitative analysis covers understanding of the company’s business, management quality, ownership structure, corporate governance and commitment to creating shareholder value. That includes an understanding of who owns and controls the company, how it operates, and in what markets. As you can see, our research approach is extensive.

As I’ve said time and again, we firmly believe an on-the-ground presence is necessary to provide local, first-hand understanding of investment opportunities. Our Templeton Emerging Markets team currently numbers 53 investment professionals spread across 18 global offices and visits as many companies as we can—approximately 1,500-2,000 per year— to tour facilities and conduct management interviews. I personally travel more than 250 days a year.

Deal Breakers

Our ongoing fundamental research drives all buy and sell decisions. Our analysts set a target price for particular stocks based on the intersection of their research and our overall investment philosophy. We review all our holdings regularly to ensure our analyst recommendations are as up-to-date as possible and accurately reflect changes in company fundamentals. As value managers, we seek to invest in companies that are trading at a discount compared to our five-year valuation projections, and we adhere to a strict sell discipline based on valuation thresholds. Any one of the following triggers may cause us to sell stocks:

• The current security price exceeds our estimation of full value

• We believe significantly greater value potential exists in another security

• A fundamental change occurs at a company to alter our forecasts

One of our deal breakers includes unhealthy corporate governance. Corporate governance is a very, very important issue to us; we want to ensure the interests of shareholders are being addressed. So the first things we look for are a strong culture and ethical conduct.

Getting into the guts of governance means we conduct analysis of ownership structures, the management team’s track record, the company’s corporate governance history and its commitment to creating shareholder value. We look for managers who know the business well and have experience in a given field. We track management’s ability to cope with a rapidly changing business environment, and evaluate whether the risks a company takes seem rational and have the potential to be properly rewarded.

Understanding risk is core to our process. A dedicated Performance Analysis and Investment Risk Group (PAIR) team regularly examines our portfolios and analyses the risks.

Collaboration is critical, so the members of our investment teams communicate on a daily basis. We also hold weekly peer reviews in which we examine company weightings,  valuations and price targets to ensure a portfolio is managed in accordance with its investment objectives. In addition, the Templeton Emerging Markets Group holds semi-annual meetings to evaluate investment methodology and portfolio performance, optimization of resources, and to discuss portfolio-related themes such as company-specific issues, country-related issues and global industry trends.

Volatility and Valuation

Emerging markets have traditionally been volatile and can be dominated by retail investor flows and sentiment changes, but we seek to use this volatility to identify potential bargains. We believe strong growth prospects in many emerging markets aren’t always recognized in equity valuations, and can lag those of developed markets by a considerable margin. As such, select companies or sectors in our portfolios may not perform as we’d like in a given month or year, but we are long-term investors, not short-term traders and we abide by our sell discipline.

Sometimes a falling market tide will drop even the soundest of ships, and that’s when bargains can be born. But there are times when stocks are priced cheaply because they are distressed. We may invest if we believe these sorts of companies can turn things around, given some time. Even good companies can fall on temporary hard times.

We think the best indicator of whether a stock is a good value or has completely lost its luster (what one might call “a value trap”, or fallen but still expensive relative to its intrinsic value) boils down to growth. If we don’t see any future growth potential, a company isn’t worth investing in; but if it’s inexpensive and earnings projections look good then there can be a case to invest. Of course, when a particular stock market is rapidly rising, it can be harder to find individual values. If a stock approaches what we deem to be fair value, we may consider reducing a position.

For all our stock-specific analysis, I should add that we do also examine macroeconomic factors in a particular country that support our investment themes, but don’t tend to be more bullish on one country or region than another, since we focus on individual companies. We believe there are great companies in all countries around the world, and that most markets have at least some attractive stocks.

We have maintained the same investment strategy for more than 25 years, and don’t expect to change. Our team inherited the same investment philosophy and methodology from our founder, Sir John Templeton, who summed up his thinking well with these words: “To buy when others are despondently selling and to sell when others are buying requires the greatest fortitude and pays the greatest ultimate rewards.”

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