Backing a sector winner is a logical strategy but identifying its heirs is a more challenging alpha generator. Detailed analysis of stock return profiles shows that companies improving their return on equity (RoE) to amongst the top quartile tend to outperform in the long term.
Selecting these businesses involves identifying certain characteristics, but even if they are found, the maturity of the sector in which the company operates is an important factor.
In more maturing ‘new economy’ areas, such as e-commerce in China, it may make more sense to identify the players that are taking market share from the incumbent.
But in more emerging industries, such as electric vehicle components, often it proves more fruitful to back the industry leader because of the inherent uncertainty during the early stages of fast-moving, burgeoning sectors.
Incumbent errors
Leaders in more established sectors can be hampered by several pitfalls, such as losing their focus, and engaging in so-called ‘di-worse-ification’ – whereby they try, often unsuccessfully, to enter adjacent or new sectors.
Even though dominant players often benefit from a first-mover advantage in their infancy, as their sector ages, it becomes more segregated, with new niches emerging, providing opportunities for new rivals to pick off these areas as their own. An example of this is the current China ecommerce incumbent whose dominant market share has been significantly eroded in the past few years due to emerging competitors.
This is why we focus especially hard on particular attributes to help us identify the next upcoming winners within our concentrated 40-50 stock Asia Future Leaders fund, which over three years has delivered nearly three times its benchmark, the MSCI AC Asia ex-Japan index. The fund has been awarded with a 5 star rating by Morningstar.
Innovation focus
The core of our strategy relies on three pillars: quality management, scalability and innovation, with the latter a clear differentiator to traditional investment frameworks.
We harness the deep experience of our Future Leaders panel, which benefits from the experience of a range of prominent professors, including French business school INSEAD’s Nathan Furr, a pre-eminent voice on innovation, to help us identify tangible traits that are often indicators of inventive companies.
Combining the panel’s insight with our proprietary research allows us to pinpoint innovative companies at an earlier stage in their life.
As these companies grow older, we continually assess their competitive edge, which is re-evaluated frequently to see if aspects such as its forward-looking corporate culture and ability to enter new markets remains.
Analyzing the extent to which companies prioritize R&D, and incentivize innovation, are two key metrics we study.
Key characteristics
A common denominator of an innovative company is a decentralized organization that gives middle management meaningful responsibility and rewards them for their success.
One such Chinese materials company compensates its R&D team with 15% of the profits of successful new products and 30% of increased revenue from process improvements.
Another important element is how the R&D side of a business is driven. Firms that rely solely on senior management for their inspiration can often begin to struggle, whereas ones that actively engage with their customers for feedback to influence their R&D are much more likely to prosper.
And beyond this, the ability to gather, process and react to data will drive the winning firms of the future.
Accelerating away
It’s this skill in harnessing data, through the likes of machine learning and artificial intelligence, that has influenced some of our holdings. One such stock is a Chinese electric battery (EV) maker, which harnesses AI and machine learning to apply the latest technology to its production process. The company is a leader in an emerging industry, and its focus and success in R&D is a key attraction for us.
Similarly, another stock we own is a leading China EV manufacturer that has managed the recent supply chain shocks better than peers, in large part due to their superior vertical integration, producing their own batteries and power transistors – two key components of an electric vehicle.
These two companies play into a broader theme of China winning the EV race, especially given its market is already four times larger than the US, there are eight times as many charging points in China than America, and much of the world’s lithium is in China.
This makes us optimistic for these companies as we enter 2022; however, there are other sectors and other countries that we’re bullish on.
Emerging opportunities
The prospects for real GDP growth in the likes of India, Indonesia and Vietnam appear stronger for 2022. In India, we see the potential for huge opportunities, with the pipeline of IPOs doubling in the past year. The pace of innovation in India is remarkable, and it now has the third most unicorns – a private company valued over $1billion USD – in the world.
The pandemic has forced many people in southeast Asia towards e-commerce and other digital services, most first-time users, which means that the opportunity for companies to access a new, larger audience is potentially huge.
EFG Asset Management (EFGAM) is an international provider of actively managed investment products and services to financial intermediaries and institutional investors around the world.
EFGAM’s New Capital funds and strategies offer a focused range of actively managed, specialist strategies across equity, fixed income, alternative and multi-asset within both developed and emerging markets. The strategies are available in a variety of structures including AIFs, CITs, SMAs and UCITS, and are available through vehicles domiciled in Ireland, Luxembourg, Switzerland, Hong Kong and the United States.
Overall Morningstar rating as of 12/31/2021 rated against 730 (O Inc) Asia ex Japan funds on a risk-adjusted basis’.
EFGAM manages approximately USD 32.9 billion (as of December 2021) on behalf of clients.
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Past performance is not indicative of future results. The opinions herein are those EFGAM as of the date of this article and are subject to change at any time due to market or economic conditions.
For Cecilia Prieto
For Funds Society, Madrid
For Fórmate a Fondo