Standard Life Investments

Focused Insight

Cash is King - GEM Equities, China

  • Finding opportunities in emerging markets
  • Companies are putting cash to work
  • Lenovo’s shopping spree

The relative underperformance of emerging markets in recent years because of slowing growth, macroeconomic headwinds and fears over quantitative easing has resulted in nervousness among investors. A recent improvement has been referred to as nothing more than a dead cat bounce. However, the diversity across emerging markets creates opportunities for active, bottom up investment managers. Against the current backdrop, there are many companies with a clear strategy, a strong balance sheet and both the confidence and financial means to invest in their business.

An important consideration in our research process is balance sheet flexibility, with financial health particularly relevant in turbulent markets. Some companies have become cash rich in recent years and there is increasing pressure from shareholders for that money to be put to good use. Stockpiling cash carries an opportunity cost and if there are sound expectations of a good ROE, then holding excess cash in the bank makes little sense. This is particularly relevant for software, media and services companies, among others, that do not necessarily have high levels of expenditure or capital intensive businesses. Such companies can also grow rapidly and cash is often accumulated faster than management can put it to good use at times.

Chinese PC manufacturer Lenovo fits this description by utilising cash to achieve a strategic advantage over competitors. Lenovo has dominance in the domestic Chinese PC market, from where two-thirds of operating profit is derived. However, it is also growing its share in overseas markets at an impressive rate, particularly since the acquisition of IBM’s PC business in 2005. Furthermore, Lenovo is looking to extend its market leadership in terms of cost as well as improving brand value and awareness in a number of markets where innovative designs are receiving positive reviews.

More recent acquisitions have included the purchase in January of IBM’s server business where Lenovo has the ability to exploit synergies. For example, it can reduce operating costs by leveraging its presence in China and take advantage of the the strong sales and distribution built up around the PC business. A week after the announcement of the IBM acquisition came the purchase of Motorola’s handset business from Google. It is currently too early to fully appreciate the merits of this acquisition. However, Lenovo claim that the cross licensing of patents with Google in developed markets will prove advantageous and in China the Motorola brand will be resurrected for high-end smartphones where Lenovo lacks a presence.

Many emerging market stocks are currently cheap, relatively speaking, and hence provide good entry points for investors. The key is to look for those companies with the financial means and business strategies to become the success stories of the future.