Valuing the long-term opportunity in emerging markets

Arisaig’s core belief is that purposeful growth businesses will deliver compound returns in emerging markets. They do this by focusing on multiple stakeholders and in doing so earn the right to grow over the very long term. As an investor trying to value this long-term opportunity for the last two decades, we have built tools and processes to help us do this.

One of the most important is our internal valuation tool, the Arisaig Crystal Ball (ACB). Beneath the tongue-in-cheek name lies a more serious raison d’être. Stripped down to basics, the ACB is simply a 20-year discounted cash flow model. However, its design, inputs, and role in our process are all crafted to cultivate a long-term mindset among our research team. The model reinforces our behavioural advantage over other investors, it forces us to focus on what really matters in identifying the best purposeful growth businesses. It distracts our gaze from the noise of short-term price-earnings multiples and near-term forecasts which are irrelevant to making an effective long-term investment decision.

In designing the ACB, we observed four key principles:

 

1.      Focus on Long-term

The ACB was borne out of our frustration with the market’s practice of valuing businesses using myopic valuation approaches, ignoring the long-term potential of high-quality businesses. These include 5-year DCF models in which the terminal value accounts for up to 90% of the ‘present’ value, or even applying a one-year forward ‘exit multiple’. Our focus on a specific subset of companies gave us an opportunity to rethink this. These companies, courtesy of the products and services they sold (frequent, repeatable, and predictable purchases), the business models they had built (deep-moated and hard-to-replicate), and the long runway for growth (due to the low penetration rates within emerging markets) provided us with an unusually clear picture of what the future might hold.

We set about building a 20-year model. One could argue that it is impossible to forecast that many years ahead, while others might say 20 years is a blink of an eye in terms of the untapped potential of emerging markets. What we know is that if we are struggling to paint a picture of the opportunity for any company on a 20-year timescale, then we should be asking serious questions about its place in our portfolios of purposeful growth companies.

An immediate outcome of this approach is that we attribute significantly less value to the terminal period: we typically see it account for 10-30% of the value of a company. The 20-year horizon also helps to explain the primacy of ESG considerations within our investment process, as often it is only when taking a multi-year view do issues such as access to scarce human, natural and capital resources become material. To identify the specific effects of such factors, we construct a separate ‘ESG scenario’, which integrates the ESG insights gleaned from our proprietary corporate governance and sustainability risk management assessments.

 

2.      ‘Approximately right rather than precisely wrong’

Following the advice of John Maynard Keynes, we have strived to keep the model as straightforward as possible. In practice this means developing a standardised and transparent tool that ensures visibility over all assumptions (minimising major errors) and limited scope for hidden ‘fudge factors’. In this way it can deliver the maximum credibility and therefore value to investment decision-makers across the firm. This statement is also an acknowledgement of how it is impossible to know what will happen next year, let alone next 20 years. We don’t boil the ocean trying to come up with precise estimates; we are happy as long as they pass the common-sense test.

 

3.      Focus on what really matters

Delivering on (2) means eliminating ‘noise’ to focus on what matters. This minimises the number of variables and therefore scope for misjudgements. Keeping things simple also facilitates more in-depth peer comparison between companies. Key aspects of this include:

  • Focusing purely on the core operating business, where the real value creation will originate;
  • Ignoring the capital structure of the business. We ‘price’ the business in terms of its enterprise value (less minority interest) i.e., the value of its equity plus debt and model the free cashflow to the firm. This removes another unpredictable variable in the model (interest rates) and one that should not be material for either the nature of the businesses we seek – unlevered, highly cash generative, high return on capital – or the long holding periods we aspire to.
  • Avoiding fixation on what discount rate to use to derive the net present value (usually the weighted average cost of capital). This tends to be another major source of confusion within valuation models. With no clear consensus on how this should be calculated, it detracts from the efficacy of the model for decision-making. Instead, we focus on the inputs that help estimate future cash flows which we have better visibility over – namely price and fundamental forecasts – and let the model compute the internal rate of return (IRR). This ‘Arisaig Expected Return’ indicates the rate we might earn via a long term “buy and hold” strategy based on the inputs provided.

 

Input-Output view of the ACB

4.     Thoughtful decision-making

The Expected Return output is not a silver bullet that dictates where capital should be allocated. Indeed, we are sceptical that any such number really exists. We repeat the forecasting process to consider both the realistic upside (bull) and downside (bear) scenarios as well as ESG scenario(s). This gives us a range of possible outcomes, the variance of which indicates the predictability of returns. We view the entire analysis as akin a picture painting exercise, not as a confident prediction of actual returns.

Alongside ‘Growth’ (potential to grow long-term), we appraise each company’s ‘Quality’ (ability to capture this growth based on its competitive advantages) and ‘Alignment’ (licence and intention to grow over the long-term), assessed in depth in our Investment Case Reports on each holding. We also consider risks relating to ESG, liquidity, macroeconomic and FX indicators. We consider all this information holistically to generate a level of conviction in the returns of a business. We often find that we would rather invest in a business that delivers us a lower projected IRR but in which we have a much higher conviction (i.e., perceived lower investment risk).

Arisaig Partners is not in the business of clairvoyance. But our Crystal Ball does help to see past the ‘FOMO’-driven behaviour that increasingly grapples others in our industry, allowing us to better deliver on our mission to maximise long-term returns.

Disclaimer:

This material is being furnished for general informational and/or promotional purposes to professional investors only. The views expressed are those of Arisaig Partners and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact, nor should any reliance be placed on them when making investment decisions. This material does not constitute independent research and is not subject to the protections afforded to independent research.

The statements and views expressed herein are subject to change and may not express current views. Arisaig Partners makes no representation or warranty, express or implied, regarding the accuracy of the assumptions, future financial performance or events. Emerging markets are generally more sensitive to economic and political conditions than developed markets and may be more volatile and less liquid than other investments.

All information is sourced from Arisaig Partners and is current unless otherwise stated. Issued by Arisaig Partners (Asia) Pte. Ltd. Not for public use or distribution. Arisaig Partners (Asia) Pte. Ltd is licensed and regulated by the Monetary Authority of Singapore.

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