Emerging markets value investing not about catching falling knives: expert

Value can mean different things to different people. “Some people think of value as catching falling knives — so very deep value. That can be highly cyclical often,” adds Miller, noting this can lead to more volatile returns compared to a defensive value approach.

It’s important to not just buy stocks that look cheap, since stocks can sometimes be cheap for a reason. A key element of being a successful value investor is the ability to be able to distinguish what’s cheap for a reason versus what’s fundamentally undervalued, he says.

To illustrate this, Miller points to the dividend discount model, which he believes is a good tool to value a business on its key fundamentals. It’s a way to value an equity by determining what’s the net present value of the future flow of income from that security.

“But to get to that future flow of income, you’ve got to analyze a company’s profit and loss statement — its balance sheet and ultimately its cash flows,” he says. “And then having understood the cash flows and what the free cash flow is — and how sustainable that free cash flow will be — then through discussions with management, through understanding that business and management goals, you can forecast what you believe they will pay you at the dividend.”

An investor can also look at the skew around the base case valuation to understand risk. “We say, if there’s a very wide skew around that base case, the risk is probably quite high. If the skew is relatively tight than the risk is somewhat lower.”

For that reason, Mondrian typically prefers to buy companies where the skew is relatively tight and/or a stock is trading close to its worst-case valuation, notes Miller.

However, this approach presents some challenges, he acknowledges. For one, not all companies pay dividends.

That said, the dividend discount model can still value a company that doesn’t pay dividends as long as it’s assumed that it will pay dividends in the future, Miller says. “We do have one or two companies on the portfolio that don’t pay dividends. What we have done in that situation, of course, is do what we’d do with any company: we’d forecast its future earnings, profit, cash flow and, over time, if a company’s generating substantial cash flows, we’ll assume that that starts to come back as dividends.”

Another challenge for value investors is avoiding value traps, he adds. Investors can be allured by high starting dividend yields, but if the dividend is cut over the next few years, it isn’t a good investment. “We need to be good at our jobs to make sure that we’re buying companies where we believe that those dividends are sustainable and can grow.”

One approach to avoiding value traps is active management versus a quantitative approach, emphasizes Miller, noting quantitative approaches may also miss companies that don’t currently pay dividends.

In emerging markets, it’s also important to know what companies to avoid. “Where we see poor governance, or a company with a history of poor governance, I think you have to be extremely circumspect,” he says.

As well, Miller suggests that investors look to avoid companies with high leverage and be mindful of disruption that may impact the sustainability of businesses.

Negative free cash flows are also unattractive, he adds.

And, from a macroeconomic perspective, certain areas of the emerging markets have greater volatility. For instance, Latin America and Europe, the Middle East and Africa have seen greater economic, political and social disappointment than Asia, for the most part. “One needs to be realistic about the development of certain countries and certain regions. And, without question, Asia has developed and grown in a much more stable and successful way, I would argue, than Latin America and the EMEA region.”