Fund Manager Q&A: Somerset Emerging Markets Dividend Growth
What is the underlying strategy behind the management of the fund?
At the core, we look to invest in companies that demonstrate prospects for long-term cash flow and dividend growth. Stock selection is driven by a bottom-up, fundamental process. We screen companies for profitability, returns, debt and valuation, as we seek companies that we think will be able to generate superior returns sustainably. The dividend is in some respects one of the last things we look at, as it should be a symptom of a good company rather than a cause of one. Hence we may even invest in companies that do not pay a dividend if we expect them to pay one in future.
We prefer to hold companies for a long period and let the companies generate compounded returns, though we have also, occasionally, taken shorter-term (1-2 year) decisions. A position will be sold if the valuation becomes too onerous; if there is a major corporate governance breach; if the investment thesis no longer applies; or, occasionally, if there are particular macroeconomic concerns for the company.
What are the biggest challenges facing Emerging Markets over the next twelve months?
The prospect of a hike in US interest rates is one potential headwind for emerging markets over the coming months, though the timing and magnitude of the effects are uncertain.
The fortunes of China, as it manages its gradual transition from an investment-driven economy to a consumption-driven one, are another potential challenge facing emerging markets. A ‘hard landing’ would have knock-on effects for many other emerging markets. A devaluation of the currency may be the most logical option. The conditions that China faces are: rising external debt balances; export of capital; and tight monetary conditions of its domestic and export companies. A devaluation would help to address all of these factors: domestic companies would be hindered from raising more foreign debt, capital export (e.g. Chinese purchases of London property) will be made more expensive, and domestic liquidity will be eased, starting with the cash-starved export sector.
A continuing low oil price would represent a challenge for certain specific emerging markets – Russia, Venezuela and Nigeria for example – but it would meanwhile benefit others such as India and Indonesia. In these countries, it is important that governments take the opportunity for fiscal consolidation by removing fuel subsidies.
Why should investors hold an allocation towards Emerging Markets?
Although we are not optimistic in the short-term because of weak trade and the aforementioned China risk, longer-term we are more positive. The bear market in emerging markets is now 4-6 years old and vital restructuring of some economies has taken place. Although the consumer story in emerging markets is overvalued, there remain areas where we are finding more opportunities, such as industrials, technology and exporters.
Overall investors should allocate to emerging markets because they significantly increase their universe of stocks and the available opportunities, and diversify some risk. There will always be some opportunities in these markets not available elsewhere, despite globalisation.
Which market conditions favour a dividend-focused fund such as this?
We think of dividend payment as symptomatic of sound capital management, so the portfolio has a natural quality bias. Therefore, we would expect to underperform in a strong bull market, but to outperform a weaker market. Having said that, our Dividend Growth strategy is not solely focused on dividends; we try to provide quality growth from emerging, international markets, and remain adaptable to long-term changes in the market environment. For example in the last couple of years, in the ultra-low interest rate environment , traditional dividend strategies have done badly; to compensate we have focussed a little more on growth, and turnaround stocks (which may have a longer-term dividend or capital management potential).
With the fund approaching its five year anniversary, how do you see the fund evolving over the next five?
We hope the quality core of the portfolio can remain largely unchanged (for example we still have 11 stocks from inception). But at the margin see some potential in areas of the market which are currently perceived to be deep value or turnarounds but may have strong long-term dividend potential.
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