Emerging Markets Equity Strategy—2024 Semi-Annual Investment Review

Matt: Welcome and thank you everyone for joining us today for our Semi-Annual Emerging Markets Equity Audiocast. We are covering the year to date through June 30, 2024. By way of introduction, my name is Matt Beck. I’m a Client Portfolio Manager here at Dodge & Cox. I’m joined today by my colleague, Robert Turley. Robert is a Portfolio Strategist as well as a member of our Emerging Markets Equity Investment Committee. Robert, as always, thanks so much for joining me today.

Robert: Thank you, Matt. It’s great to be here with you.

Matt: As we’ve done in the past, and this can be seen on the agenda on slide four, we plan first to talk about the environment in emerging market equities throughout the first six months of 2024. So within what conditions was our team operating in in terms of our emerging market equities? We’ll then move on to talk a little bit about the Fund itself, how it fared during the first six months of the year, and what worked, what didn’t, a little bit of detail around that. Then, we’ll really dig in a little bit and discuss where the Committee is finding opportunities, how you’re positioning the portfolio, as well as our outlook for the asset class. Maybe beginning with our first slide on number five here, and taking a look at the market conditions for the first six months, Robert, as I think about past conversations we’ve had on calls like this with clients, even before the launch of this Fund, we’ve always talked at Dodge & Cox about how emerging markets is not just one simple asset class. It’s not a monolith. It is certainly a varied set of regions, countries, [and] influences that we see. It’s very heterogeneous, and as I see page five here, looking at the first six months of 2024, it appears that that kind of thinking around emerging markets has really played out in terms of performance and conditions so far.

Robert: I think that’s exactly right. It’s overly simplistic to sometimes make statements about emerging markets as one group because there’s so much going on there. There are dramatic differences across countries and across the industries we’re operating in, which makes it exciting but also provides for substantial diversification.

Matt: I’m just highlighting some of the top portions of page five. We’ve seen Information Technology (IT), as it has here in the United States, take off and lead the way so far in 2024. Defensives have fallen behind. We’ve also seen a good deal of regional diversification so far in 2024. Anything to make of what we’ve seen so far in the first six months of the year?

Robert: Yeah, a few comments on that. I would say that this pattern that you identified, where the IT (Information Technology) sector and especially the hardware names have really been a driver of returns both within emerging markets but also true globally in developed markets. So, when you see some of the regional differences, and you can see on this chart where you see the strong performance of Asia ex China, that is largely also a reflection of the fact that many of these hardware names are there in Asia. Most prominently, I think it’s important to point out TSMC.¹ So Taiwan Semiconductor [Manufacturing Company] is based in Taiwan, of course, and it had terrific performance. It was up 55% for the first half of the year, and I think that was typical for some of these names that people are attaching to the excitement around AI (artificial intelligence) and some of the things that are going on with the technology space.

Matt: Thanks for those observations. Maybe we can look at slide six, which details the performance of the Fund within the environment over these past six months. Going back a little bit further, the Emerging Markets Stock Fund is up in terms of performance, but we are on a relative basis, slightly behind our major index, which is the MSCI Emerging Markets Index.² Over the past year, we can see very good absolute conditions and just slightly nosed ahead of the Index over the one year. And then, really happy to, for the first time on this call, report that we have a three-year number. This three years looks a little bit different than the last year. It looks similar in that we have outdone the Index over this time, but certainly more negative absolute conditions over the three years since the Fund came into public inception in May of 2021. Robert, maybe just to take a step back, three years into this, it must feel like we’ve reached somewhat of a milestone here. Still a long way to go, but how would you characterize these first three years and what you’ve seen and how the Committee’s gotten along with managing the portfolio?

Robert: Yeah, thanks Matt for highlighting the three-year birthday. That’s a really fun milestone for us to celebrate. Really, I like to look back even longer. If you think about it, it was about 25 years ago when a number of our colleagues here started this initiative to say we would like to focus on international investing and especially in these opportunities in emerging markets. Even then we were looking hard at Latin America and some of the exciting opportunities we could see in Brazil and other places in Asia, of course. So that effort then continuing on is what gave rise over time to being able to build the research depth we needed to think that we had a portfolio we could build that would be focused entirely on emerging markets. If you look at that three-year period, I’ll just make a a couple comments.

One is that over that three-year period, when you see that strong performance, a major contributor is actually the category of small positions that we have in this Fund. So, a little bit unique, some of our Dodge & Cox Funds, if you know our Dodge & Cox Stock Fund or the International Stock Fund, you’ll see that very few positions in those Funds are less than half a percent. Whereas, in the Emerging Markets Stock Fund, we truly believed that we wanted to offer the breadth of opportunities you could get by having a larger number of these small positions. That thesis really played out, both in terms of the performance contribution but also [in] harnessing what we talked about in this introductory remark about the diversification across the various markets and industries that we could be investing in when we took advantage of these very small opportunities.

Matt: When we look at kind of what worked, what didn’t in the first half of the year, there are indeed some small positions which played a role in in how we’ve done. Moving on to slide seven, perhaps, and looking at attribution for the six months ended June 30. As I noted at the top during some of our initial comments, markets have been positive so far in 2024. We have slightly trailed the Index, as detailed here, by roughly 70 basis points³ on slide seven. In terms of what worked and what didn’t, this is really interesting, Robert, because I think it’s going to bring us back to some of what you said just a moment ago about smaller positions, but the positive side of the ledger. So in terms of return impact versus the Index, you can see Consumer Staples and Energy, in particular, being some of the stronger sectors.⁴ And we’ll go into those in just a moment. And then maybe bringing up the tail end of performance and detractors: Information Technology [and]Consumer Discretionary. We know there’s some technology there and we can talk about that. You’ve referenced it a little bit earlier, Robert, in terms of your initial remark about Semiconductors, et cetera, as well as Financials, which is an interesting sector, which oftentimes we’ve seen on the top side of the ledger in three-year history of this Fund. But nonetheless, this six-month period shows it as a detractor. So with that as a kind of a long introduction and moving into slide eight where we look at current positioning, we look at some of our holdings, our country weights, as well as some investment portfolio characteristics. Let’s go back to that top side of the ledger, Robert, and think about Consumer Staples and think about Energy. First of all, maybe starting with Consumer Staples and just consumer names in general. Talk a little bit about how the Committee has treated consumer names, defensives in general, and then maybe some of the success stories that we’ve seen within Consumer Staples that have led us to positive performance effect from that particular sector so far in 2024.

Robert: First, I’ll contrast. Part of the benefit of the diversity opportunities is that unlike the United States, where some of our Research Analysts struggled to find Consumer Staples that had a valuation that was low enough where we could really pencil out a long-term return that was attractive, we’ve always had Consumer Staples within the Emerging Markets Stock Fund and in a variety of geographies. There are markets in which it was difficult to find inexpensive companies. India is the prime example of that, where there’s some really good franchises in India that we studied, but we couldn’t make the valuation work. Especially during the year 2023 as interest rates were rising, we saw a number of opportunities. I’ll highlight three of them. We had, in Turkey, Anadolu Efes, a bottler, drink manufacturer [that] also does some alcoholic beverages. That company was probably one of our strongest absolute returns year to date. Although it’s not a large position, like I said earlier, the aggregation of a lot of small positions has really been one of the strengths of the Fund. Also in the beverages space, we have Coca-Cola HBC, a very interesting company. They’re a provider of the Coca-Cola products for a lot of Eastern Europe, also Egypt and Nigeria. That’s been a very strong business [and] had a great performance for the first half of 2024. Maybe I’ll highlight one more. They’re also in that category that outperformed, and you mentioned Energy too, both of those, there are some special stories that happened. Within the Consumer Staples aspect of the Fund for the first half of the year, we also were able to accomplish the disposition of some Russian assets. So, there were a few holdings that you may not have seen in the Fund because we marked them at very low prices after the Ukraine invasion. We had hoped for a while to be able to get rid of these assets and no longer hold them in the Fund. And so, we were able to actually find a buyer for those that ended up being also a positive contribution on the [Consumer] Staples side.

And on the Energy side, there was another special story. There is a company NESR, stands for National Energy Services Reunited. It’s a company that does oil field operations in the Middle East and that’s got a terrific story. It started off as one of these small positions that we spoke about. As we looked at that company and our analysts dug in, we had some concerns. One of the reasons why the valuation looked cheap was because they had failed to to file their financial statements in a timely fashion and were having some disagreements with their auditors, which is usually a big red flag. So normally that means that there’s some malfeasance going on or other issues we wanna be wary of. But the more we looked into it, the more we saw that this was actually some run-of-the-mill kind of confusion and disagreement and nothing that actually reflected poorly on the business that they were operating. After we did our research, we initiated a small position, and then as our conviction grew, we increased the size. Ultimately, during the first half of this year, that’s when they were able to file their financials. They had been de-listed, but it looks like there’s a re-listing on the horizon. And so, this ended up being a very good investment for us as the thesis played out.

Matt: Thanks for that, Robert. I can’t believe we’ve made it this far into the conversation without talking a little bit about China. We have on the edges mentioned technology, some of the performance in IT [and] Consumer Discretionary. There is certainly some relation in that detraction portion of the attribution to our China-related holdings. Over the longer term, over the three years that we’ve had this Fund since inception, the first half of this year has been quite an interesting one in terms of a little bit of a slump and then a little bit of a rebound for China. Can you talk a little bit about how we’re viewing China right now, where we’re exposed within the Fund, just how was the Committee thinking about those positions currently?

Robert: Yeah, and within China, both over that longer period you’re speaking of and year to date, we’ve seen that some of both our top performers and our worst detractors from performance have been in China. It’s an area where we find it incredibly important to be looking at the companies and then also as you’re hinting at, to be aware of the risks. These risks are not only company-level risks, but there are a lot of geopolitical risks that we’re facing right now, and we spend a lot of time on that. So to give you these examples, one of the companies that underperformed and that’s also in this kind of consumer category is Yum China. It has attractive performance for the first half of the year. It’s a business that we still have a lot of confidence in. You may be aware of the Yum brand. If you’re in the United States, they are the franchise owner of the Kentucky Fried Chicken brand and a few of these other brands. So, they started a very successful Yum China business in mainland China. The business had some struggles, both in terms of some of their operational returns as well as stock price performance for the first half of the year, but we continue to have confidence in it and have a position there. On the other hand, you’ve seen some of the technology companies and software internet businesses that we’ve invested in, which had struggled for the first two years of our holding period there. Now, as we hit our third year in the Fund, they’ve finally shown some positive contributions. There really is a lot of individual stories that comprise China. And as a final comment on the risks going forward, it’s something we spend a lot of time on, not just for companies that are based in China, but even those on the periphery. You can imagine that a conflict in China or some kind of economic struggles that they may face internally could have repercussions across the world. And so we spent a lot of time on that. We handle it through position sizing. We look at devil’s advocacies, and in the Fund, we currently hedge two currencies that we think are related to those risks: the Taiwanese dollar and the Chinese renminbi.

Matt: Robert, let’s go ahead and start a discussion on Financials. As I noted a little bit earlier on the attribution page, we’re used to seeing that as a contributor to performance over the first three years of the Fund. However, for the first six months of 2024, it’s been on the negative side of the ledger. So I’m intrigued by the underperformance and what’s gone on here. But also, just as intrigued by the Committee’s reaction and your behavior with respect to some existing Financials holdings during this period of underperformance. Can you talk a little bit about what we’ve seen and how the Committee’s thinking about Financials in this current time?

Robert: Over the first few years of this Fund, Financials have been a major contributor. We’ve seen a lot of benefits from both the positions in Latin America as well as within India. I’m going to highlight those two places year to date so we get a sense of what’s going on. Within Latin America, two of the companies that have had challenging performance were in Brazil. We had Itau [Unibanco]. Itau is the premier bank within Brazil. Our analyst who covers it argues that it is the best banking franchise probably in Latin America, not just Brazil, and has a lot of respect from their peers and competitors. Similarly, the company XP is a Brazilian brokerage firm, and both of those companies had a challenging first half of the year. I’d argue that a lot of that has to do with external factors. It was not just these two individual companies. Brazil as a market had a rough first half of 2024. In contrast in India, we have a number of positions in the banks there that had very strong years, both for the first half of 2024 and also over a longer horizon. But I would also argue equally for them, if you look at those holdings, and they would include companies like Axis [Bank], ICICI [Bank], and HDFC [Bank], but they were benefiting from the fact that India has had a lot of positive economic news and investor enthusiasm that drove up that market. I highlight both of these because I think they reflect the fact that Financials are often driven not just by the internal decisions of those companies, but also by external factors. And these over the short-run may cause fluctuations up or down, but they typically would not change our enthusiasm for the investment, unless we saw there was some permanent degradation in the economy. And so, for each of those companies I mentioned, they continue to be holdings in which we have a lot of conviction. In some cases, when we think that the valuation is even more attractive, we’ll add to those positions. That’s certainly true for HDFC [Bank] for the first half of the year. Although HDFC [Bank] in that case was more a reallocation of weight as opposed to a case where we’re adding on a lower valuation. In each of those cases, we focus a lot on what is the fundamental business that we’re investing in, and to what extent can we see through the volatility that’s happening from the external environment.

Matt: Great. Thanks for all that, Robert. Could you share with us the Committee’s outlook on emerging market equity as an asset class?

Robert: I’d say there are two key aspects. Number one is to become enthusiastic once you see all the opportunities there. One of our former Chairman used to always highlight the quote that you’ve got billions of people that for the first time are coming into global markets. For the first time, they’re engaging with the world through a cell phone, through commerce, through exiting what previously may have just been subsistence farming and actually getting education and being a part of the global workforce. So that part’s very exciting and you can see that emerging markets will be the primary driver of global growth, certainly in GDP⁵ data at both looking backwards over the past decade or two, and then also in our expectations going forwards. The second part I’ll say is for most of these countries, they are currently less developed for a reason, and those reasons are sometimes due to their own mismanagement. Sometimes there have been issues where they’ve had issues with their political organization, their regulatory regimes. Sometimes there have been geopolitical catastrophes that have been there. These are markets that have had problems and their risks remain. And so I think risk management’s very important. We will expect that there will almost always be some parts of the world within the portfolio where they require substantial attention. And we certainly have seen, since the Fund began, individual positions and even regions of the world where we need to put in extra care. And I think that’s going to come along with the opportunity and that’s gonna be a characteristic of this asset class going forward.

Matt: Thank you so much, Robert, for your time today. [I] always enjoy these discussions, and thank you everyone for joining in. As always, we appreciate your interest and we thank you for your ongoing support of Dodge & Cox.