«It is not like that Tencent and Alibaba were handed a monopoly license from the government – else they wouldn’t need to be as innovative as they are.»
Mr Leverenz, investments in emerging markets are often promoted with the argument that these countries are converging with the developed world. Do you agree with that rational?
Such narratives are sexy. And they maybe had a point in the 2000s. Emerging markets were growing faster back then as there was a policy shift after learning lessons from financial crises in Russia, Mexico, and Asia. Exchange rates became flexible, governments adhered to fiscal discipline, and banks were recapitalized. There was new economic stability which brought new growth. Also larger international capital flows and higher commodity prices helped temporarily. There was less poverty, but no growing middle class – except in China.
China is an exception and not a model for other developing countries?
China is such a large market that it created a distorted view that the middle class is growing across the whole developing world. But there are very few countries – like Japan, Korea, Taiwan, and Eastern European countries – which were embedded in the international trading system and were able to converge to the developed world. But it is a complete impossibility for many developing countries, including India, to enter a development path like China.
Why is that?
Most developing countries suffer from economic inequality and very limited social mobility. They do not generate enough savings to develop. Also to have political inequality and economic inequality at the same time is a very dangerous mix: there will be manipulators who exploit the frustration of the masses. Leftist populism will lead to crises as we see now in Argentina and Venezuela. Following a crisis you might get a reform government, but most of the time it will not last long.
But investors praise the current Indian government.
India’s Prime Minister Narendra Modi implemented a number of important policies, like the general sales tax which harmonizes the different sales tax regimes in individual states. Also the lower corporate tax is a positive step. But much more needs to be done and that is the current political system not possible – also because of the tension between elites and the masses.
If you don’t trust the convergence story, what is your reasoning to invest in Emerging Markets?
There are good companies with sustainable advantages all over the world – they do not depend on their home country having superior economic growth. We like companies which have real options thanks to new opportunities and projects. Many analysts just extrapolate the growth of a company’s past into the future. But you need to have the courage to model nonlinear growth which might arise from such real options.
Two of your largest positions are the Chinese internet companies Tencent and Alibaba. But isn’t it the case that the government protects them from foreign competition?
This is a popular notion in Silicon Valley, but it is not true. The online competition in China is extremely high. Google, Uber, and Amazon decided to leave China as they couldn’t compete with local companies. Tencent is the most innovative social network in the world. The idea of payments in a chat application originates in Tencent’s WeChat, an idea Facebook wants to copy now. Silicon Valley is looking now in China for innovations. It is not like that Tencent and Alibaba were handed a monopoly license from the government – else they wouldn’t need to be as innovative as they are.
Your real option approach seems to emphasize growth and not valuations.
I’m not a value investor, but very concerned about valuations. I’ve bought Tencent 14 years ago. If I would have not sell parts over time, it would now be 10 to 20 per cent of my portfolio – not around 4 per cent. But regarding Alibaba I think it is deeply undervalued at a market capitalization of $400 billion. It undervalues even the core business which will grow more than 20 per cent annually over the next years. And there are new initiatives in retail, Fintech, and cloud computing.
With your focus on companies you seem to discount the importance politics.
I still have to think about politics. My opinion on the trade war between the US and China is that it is not only about trade, but a larger conflict about the rise of China which the US is unwilling to accommodate. It is a confrontation of two very different philosophies of life. It will also affect intellectual property, finance, and geopolitics. And it will be a permanent feature of geopolitics for the next decades. This US-China confrontation is not specific to the Trump administration, but is supported by a broad consensus in US politics.
How does your real option approach fit with investing in Taiwan Semiconductor Manufacturing TSMC and Russian gas company Novatek? They seem to be very cyclical.
I’m not a dogmatist. These companies operate in cyclical industries, but they are very different to other competitors. Novatek’s management proved its long-term orientation and achieved enormous growth in the past. Thanks to proprietary technologies it is now in a position to develop gas liquefaction operations for other gas companies. TSMC is leading in its foundry business and has almost a monopolistic position. As it produces now AMD chips, it will benefit from demand in datacenters due to cloud computing. These centers are less based on Intel architecture, which is an opportunity for AMD. TSMC will profit from the long-term trend of cloud computing, even if the semiconductor industry will probably only grow in line with GDP growth.
One of your positions outside of emerging markets is the Paris-based luxury conglomerate Kering. Are luxury companies not too expensive to have future potential?
We included Kering as probably half of its business stems from emerging market customers. In terms of earnings and cash flow multiples it is actually very cheap. There is skepticism if the growth of its Gucci brand can be sustained. There was never the transformation of a luxury brand like when Alessandro Michele took over as chief designer 4 years ago. But we think this transformation is sustainable: the company decided not only to change design decisions, but also to change logistics, the distribution channels, broadening of the collections, and stores. Kering was a messy conglomerate and is now focused on its main brands.
But did you also identify real options for Kering?
Thanks to its cash flows, Kering has now a net cash position and can use it for acquisitions. There would be even more cash available, if it would sell its stake in Puma. Fashion media underwent tremendous changes recently. Many other luxury brands are struggling with a new environment where not large fashion magazines but the fragmented voices of social media influencers are crucial for consumer decisions. Kering has the capacity to its brand management and communication skills to rework other brands like it changed Gucci.