Brazil Ends the Year on a High Note

Quarterly emerging markets equity insights from David Semple, Portfolio Manager and Ola El-Shawarby, Deputy Portfolio Manager, featuring their unique views on emerging markets. An expanded PDF version of this commentary, including fund specific information can be downloaded here.

In the fourth quarter of 2023, emerging markets equities largely extended trends seen throughout the year. Taiwan Region, India and South Korea boosted benchmark returns, while China underperformed.

On the whole, emerging markets equities saw positive performance driven by valuation re-rating and currency strength. As noted in prior commentaries, emerging markets valuations remain a focus. Price-to-book values for emerging markets equities did tick up in the fourth quarter and sits just below 15-year averages, but the valuation differential between emerging markets and developed markets remains well below its historical range.

The U.S. Federal Reserve (Fed) continues to remain on pause for future hikes, with the December meeting leaning decidedly dovish. An accommodative Fed potentially bodes well for emerging markets equities, which would benefit from currency tailwinds if the dollar continues to slide. The dollar fell throughout the fourth quarter and is expected to continue lower if the Fed begins to implement potential cuts in 2024.

Strategy Performance

Brazil remains the Strategy’s largest country overweight (14.1% for Strategy, 5.5% for Benchmark average weight over the quarter). The Strategy’s allocation and stock selection in Brazil were the biggest contributors to relative performance for both Q4 and the entire year.

The Strategy’s largest country exposure, China, contributed negatively on both an absolute and relative basis for Q4.

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On a sector level, Industrials, Financials and Real Estate contributed to relative performance, while Information Technology, Consumer Discretionary and Health Care detracted. On a country level, Brazil, Mexico and the Philippines contributed to relative performance, while Taiwan Region, Turkey and South Africa detracted.

Top Contributors

Top contributors to Strategy return on an absolute basis during the quarter:

• JSL S.A. (“JSL”) (3.6% of Strategy net assets^*): As Brazil's largest logistics platform, JSL showed strong performance this quarter, marked by operational improvements and successful repricing efforts. Its acquisition of IC Transportes and effective management of inflation contributed positively to its financials. With new contracts continually being secured, JSL is solidifying its market leadership. The recent acquisitions present significant opportunities for margin improvements, and the company is expected to maintain its momentum following its impressive quarterly results.
• MercadoLibre (“MELI”) (5.3% of Strategy net assets^*): MELI, the leading e-commerce platform in Latin America, is also making significant strides in fintech. The company's performance this quarter exceeded expectations, with significant market share gains in Brazil and rapid revenue growth in Mexico, despite new competitors. Contrary to expectations of margin pressure due to heavy investments, strong sales volumes have led to substantial operating leverage, diluting costs. MELI continues to invest in logistics, and the Black Friday sales figures from 4Q23 indicate sustained growth.
• Taiwan Semiconductor Manufacturing Co. (“TSMC”) (7.1% of Strategy net assets^*): After a period of downward earnings revisions, TSMC reported better-than-expected results in 4Q (3Q FY23). Forward-looking guidance suggests a rebound in demand, with strong unit sales growth anticipated for 2024 and 2025. TSMC, with its focus on advanced edge lithography and AI chips, is expected to regain its competitive edge, particularly against Intel. The company’s growth prospects remain strong, justifying its significant portfolio position.

Top Detractors

Top detractors to Strategy return on an absolute basis during the quarter:

• China Education Group (1.8% of Strategy net assets^*): While still demonstrating solid revenue growth from a combination of organic growth in the number of students and tuition increases, the growth has been modestly below consensus. Additionally, the absence of M&A news negatively impacted the share price.
• Wuxi Biologics (0.9 % of Strategy net assets^*): The company revised its revenue growth expectations downward due to weaker funding for its clients and regulatory delays. However, the long-term outlook for outsourcing in biologics research remains positive.
• Chroma Ate (1.1% of Strategy net assets^*): Faced with demand pressures in key industries such as EV batteries and solar inverters, Chroma’s share price declined. The company, operating in a niche market, is affected by factors like EV manufacturers’ backward integration and geopolitical pressures on solar modules.

Top Buys & Sells

During the period, we established new positions in the following:

• Galaxy Entertainment Group (0.4% of Strategy net assets^*): We have reinitiated our investment in Galaxy Entertainment Group, one of the six gaming concessionaires in Macau. The company's prospects look promising due to a robust recovery in visitor and gaming revenue, which recently surpassed expectations. Galaxy Entertainment is well-positioned to increase its market share, supported by an expansion in capacity and a proven track record of successful operations.
• BYD Co (0.5% of Strategy net assets^*): As the world's leading manufacturer of battery-operated electric vehicles by volume, BYD Co has faced share price challenges from pricing pressures and increased inventory. Despite these issues, we believe the company's current low valuation adequately reflects these concerns. Furthermore, BYD is expected to benefit from its new product cycle launching this year.

During the period, we exited the following positions:

• Zhejiang Huayou Cobalt Co, Ganfeng Lithium Group, Hoyuan Green Energy Co (not held by Strategy): We significantly reduced our investment in these companies, which are focused on upstream renewable materials. We anticipate ongoing pressure on their share prices due to cyclical overcapacity in the market. While we foresee potential recovery in their share prices in the future, our current strategy is to remain on the sidelines.
• Doosan Fuel Cell Co (not held by Strategy): Our decision to divest from Doosan Fuel Cell Co was influenced by delays in the advancement of hydrogen energy projects. Despite the company's advantageous position to benefit from sector developments, the uncertain economic prospects compared to other energy sources, challenging project financing conditions and high valuation prompted us to exit this investment.

Emerging Markets Opportunities

We're currently watching several promising developments that could benefit the broad emerging markets asset class:

Declining Inflation Trends: Globally, inflation has been on a notable decline, impacting both emerging and developed markets. A continued decrease in U.S. inflation could prompt the Fed to adopt a more dovish stance. This might lead to more significant interest rate cuts and a softer dollar, positively influencing emerging markets currencies and U.S.-dollar-based returns in EM equities. Interestingly, emerging markets often precede the Fed in monetary policy trends, and we've already seen rate cuts in several EM countries during the latter half of 2023.

China's Economic Recovery: Over the past two years, China's domestic economy has been a drag on the broader emerging markets segment due to various factors such as high consumer savings rates, geopolitical tensions, declining demand for its manufacturing and real estate challenges. However, there's potential for improvement. If China successfully stimulates consumer spending and reduces its dependence on the real estate sector, it could provide a significant boost to the largest player in the emerging markets sphere.

Stabilizing Geopolitical Climate: The past couple of years have been turbulent geopolitically, with events like the Russia-Ukraine conflict, tensions between China and Taiwan Region and renewed conflicts in the Middle East. Any resolution or de-escalation of these issues could greatly enhance investor confidence in emerging markets. Additionally, elections in key emerging markets such as India, Taiwan Region and Mexico in 2024 could lead to market-friendly outcomes, potentially driving positive market movements.

Emerging Markets Risks

We're currently monitoring several risks that could hurt the broad emerging markets asset class:

Delay or reversal of anticipated rate easing cycle in the U.S. and/or EM. While the U.S. is currently on pause, and some EM countries have begun to ease, it’s possible that the interest rate cuts that the market is predicting will fail to materialize. This could happen if inflation begins to trend higher in the U.S. or abroad and would most likely lead to a 2022 scenario: a strong U.S dollar and weak EM equity returns.

Geopolitical Tensions and Elections. Should these situations escalate or remain unresolved, it could adversely affect investor confidence in emerging markets. Heightened geopolitical risks can lead to market volatility, impacting investments in these regions. Upcoming elections in key emerging markets, notably India and Mexico in 2024, bring a degree of uncertainty. If the elections result in less market-friendly policies or administrations, this could lead to negative market reactions. Political shifts can significantly influence economic policies, regulatory environments, and foreign investment flows, all of which are critical to the health and stability of emerging markets.

U.S. and China Tension Escalates. The U.S.-China relationship, marked by trade and technology disputes, plays a significant role in shaping global economic dynamics, with the issue of Taiwan Region adding a critical dimension to this complex scenario. Taiwan Region, as a major technology player and a strategic point of contention between the U.S. and China, is central to these tensions. The repercussions of this strained relationship are far-reaching, impacting supply chains and causing market volatility that extends to emerging markets, particularly in Asia. These markets, often intricately linked to the economies of the U.S. and China, face the risks of supply chain disruptions, policy shifts and currency fluctuations. The uncertainty surrounding U.S.-China relations, especially concerning Taiwan Region, heightens investor caution, leading to potential capital outflows and volatility in emerging markets, underscoring the importance for investors to remain vigilant and informed about these international dynamics.

Strategy Positioning and Outlook

We remain grounded by our investment process and our positioning reflects our convictions from a bottom-up basis heading into the new year. Our process has created some positioning differentials versus the benchmark. Brazil remains overweight to start the quarter (15.1% Strategy weight versus 5.8% Index weight), as does the Philippines (5.0% versus 0.6% Index weight).

South Korea, Taiwan Region and China are underweight versus the benchmark.

The Strategy’s objective is to find long-term structural growth companies at fair prices (S-GARP). Investments are chosen based on individual company analysis, focusing on quality, governance, innovative business models and low disruption risk, with active management and detailed research guiding our selection process.

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