Northcape focuses on countries with young and growing populations that have markets with a growing labor force, rising wealth, and a generally positive approach to innovation and change. “We like markets where young people are beginning to work, building homes, and starting families,” he says. “These are massive economic tailwinds.” Asked which countries are benefiting most from these demographic tailwinds, Russel points to India, Indonesia and Mexico. Northcape uses a suite of sophisticated analytical tools and data to distinguish these promising markets from others, such as the number of people employed multiplied by average weekly earnings. “They are beautiful environments to trade in for any business, and they pay the best demographic dividends,” Russel says. However, Russel is less optimistic about the demographic future for China. He believes the country’s changing population profile will become a significant headwind in the years to come. “There’s a whole raft of reasons not to favour China’s market, but the poor demographic outlook is a big factor,” he explains.
Governance
While Northcape is attracted to youthful demographics in places like India and Indonesia, the firm is careful to highlight the importance of good governance. Companies and their investors need assurances they will be protected by clear laws and independent courts. “We want to see governance improving,” Russel says. “And to get that, you need an independent judiciary. If the state can override the law, they can requisition private property, and that stifles innovation and growth.” Unsurprisingly, the legal landscape for emerging markets presents a wide range of opportunities and challenges, with some countries moving in the right direction toward clear governance while others are starting to relapse. India and Indonesia both continue to improve Russel says, “We’ve seen really significant improvements in South Korea.” But he has concerns about South Africa, where good governance is starting to fray, and Northcape has decided to avoid China due to the lack of protection for private property.
Despite this mixed bag of progress, he believes good governance is generally improving. “Some countries are eroding the important institutional pillars that support capital markets, but others are strengthening them. It’s getting better.” This general improvement is partly due to the role played by investors like Northcape, which use their influence to raise corporate standards. “Substantial foreign investors like ourselves put significant pressure on companies to pull their socks up,” Russel says. “They realize better governance can create a better valuation and lower cost of financing.”
Industry leaders
We’ve seen Northcape assess demography and governance to help define their investment targets. Asked how the firm identifies individual companies within emerging markets, Russel says Northcape is very selective with their investments, focusing on no more than about 40 stocks at a time. “We look for an industry leader. We’re looking for a company with a very strong balance sheet and a defendable market position that may provide downside protection.”
This is important for companies operating in more volatile emerging markets, Russel says, because exogenous shocks can force highly geared companies into selling assets at the bottom of the market and risk permanent capital loss from which they never recover. Northcape therefore focuses on companies that generate a lot of free cash flow that provide a buffer during unpredictable market movements. “When a downturn hits asset prices, they’re the ones that end up buying the beachfront property at the bottom of the market. That’s the company you want your capital in.”
