Wealth creation in equity markets often comes from a small subset of stocks. This phenomenon holds true both in the U.S., where tech giants like Apple, Microsoft, Amazon, and Alphabet have fueled much of the recent growth, and in emerging markets. Although emerging market indices have trailed broader markets in recent years, active and focused stock pickers such as the team at Cusana Capital highlight the significant opportunities these markets present through effective stock selection.

“Emerging markets are a very heterogeneous asset class,” says Rob Marshall-Lee, Co-Founder and CIO of Cusana, before correcting himself: “actually, it’s not really an asset class.” Instead, he describes emerging markets as “an opportunity set where we can discover quality businesses capable of making us as much as 10 times our investment.” Emerging markets “is a rich investment universe for an active stock picker,” reiterates Marshall-Lee, who designed and managed an emerging markets strategy at Newton before re-launching the strategy at Cusana Capital in partnership with Sector Asset Management in 2022.

Emerging markets “is a rich investment universe for an active stock picker. An opportunity set where we can discover quality businesses capable of making us as much as 10 times our investment.”

Rob Marshall-Lee, Co-Founder and CIO of Cusana Capital.

Emerging market equities have lagged U.S. equities in recent years, but performance has varied across regions, notes Marshall-Lee. “Even during the past five years, investors could get excellent returns from markets like China (up until 2020), Southeast Asia, and India. In dollar terms, India is probably close to matching the U.S. over this period,” he points out. Strong performance, he adds, “gets obscured by regions like Latin America underperforming, and, of course, the Chinese government intervening in the market from late 2020.” While the MSCI Emerging Markets Index posted a net return of 7.5 percent in 2024, Cusana’s Sector Emerging Markets Equities Fund returned 22.7 percent. Marshall-Lee underscores that benchmark returns in emerging markets “get diluted by some of the weak companies,” highlighting how careful, active stock selection can deliver outsized returns.

The Cusana Approach: Benchmark-Agnostic and Concentrated

Emerging markets offer access to rapidly growing economies, younger demographics, and untapped consumer markets with a growing middle class, all of which can potentially drive substantial long-term returns. At first glance, broad-based exposure to these markets might seem an obvious choice for equity investors. However, the Cusana team takes a more selective approach, operating on the premise that 95 percent of stocks will ultimately destroy value.

“There are these impressive companies compounding at very attractive rates with relatively low risk, strong governance, and other positive factors,” explains Marshall-Lee. “But then you have all these others – state-owned enterprises, firms run by oligarchs, or companies that are simply not well-managed. Unfortunately, these weaker companies are often large components of the benchmark,” he elaborates. State-controlled enterprises typically account for 20 to 25 percent of a benchmark, and these businesses frequently show little concern for minority shareholders or value creation.

The key to avoiding value-destroyers lies in adopting a benchmark-agnostic approach with a concentrated portfolio of 25 to 35 stocks. After managing the strategy for a decade, Marshall-Lee paused to evaluate its performance – which had already become the top-performing EM fund over that period – to identify lessons and areas for improvement. “There were some very clear patterns,” he recalls. “One of the standout findings was that the top 15 stocks consistently delivered much better returns with lower risk compared to those at the bottom of the portfolio,” says Marshall-Lee. “In hindsight, we should have increased our focus on these high-conviction ideas and reduced the portfolio’s tail.”

“It’s not the hit ratio that drives returns; it’s the slugging ratio – getting your big winners right and making sure they have sufficient weight in the portfolio.”

Rob Marshall-Lee, Co-Founder and CIO of Cusana Capital.

Cusana’s emerging markets strategy typically allocates around 50 percent of its portfolio to its top ten holdings, while maintaining a modest tail to access smaller-cap companies and support scalability to approximately $3 billion, up from the current $340 million. “The goal is to maintain concentration while ensuring some level of diversification, but not excessive diversification,” explains Marshall-Lee. “If we get the best picks right, they can deliver returns of hundreds of percent with lower risk than the broader index.” He emphasizes that success isn’t about the number of correct picks but rather the magnitude of their impact. “It’s not the hit ratio that drives returns; it’s the slugging ratio – getting your big winners right and making sure they have sufficient weight in the portfolio.”

Key Ingredients to Finding Fat Right-Tail Outcomes

The team at Cusana Capital follows a time-tested approach to identify “fat right-tail” opportunities for its concentrated portfolio. “Our strategy is to invest in long-term compounding companies,” says co-portfolio manager Trygve Toraasen. The selection process is centered around three key factors: superior corporate governance, high-quality businesses that generate strong returns on invested capital, and long-term structural tailwinds.

“Investing in companies in emerging markets or developed markets is fundamentally the same in many ways, as we are still evaluating the value of future cash flows,” he explains. “However, there are a few additional factors to consider, such as politics and the macroeconomic environment,” he warns. To address these, the team has developed a framework for investing in emerging markets, with corporate governance being the first critical question for any long-term investment. “We place much more emphasis on governance than we would if we were managing a UK, US, or European-focused fund,” says Toraasen.

“We place much more emphasis on governance than we would if we were managing a UK, US, or European-focused fund.”

Trygve Toraasen, Partner and Portfolio Manager at Cusana Capital.

“The governance is important because we want companies that are genuinely run for the shareholders, where we are treated as equals and are along for the ride on an equal footing,” explains Rob Marshall-Lee. Around four out of every five companies in the emerging markets universe are immediately ruled out. The process involves “understanding what drives the decisions, who is making them, and why,” he adds. “We evaluate the capital allocation decisions a company has made over the past decade, determine whether it’s state-owned, and closely assess management’s incentive structures,” Marshall-Lee describes the elimination process. State-owned entities are eliminated from consideration right away because they are managed for the state, not for shareholders.

The second key ingredient is assessing the quality of businesses and their ability to generate high returns on invested capital. “Many in the market place too much emphasis on revenue or EBITDA growth. You need to think about cash flow per share and how that compounds over time,” explains Marshall-Lee. “If the cost of capital is, say, seven percent, and the business is consistently generating 20 percent returns, there’s a substantial gap that enables much higher compounding on a per-share basis, even if top-line growth isn’t as strong.

Equally important is evaluating whether businesses can sustain high return rates and capitalize on opportunities to reinvest capital. “This comes down to the economic moats around the business,” explains Toraasen. “What enables a company to maintain high returns is its pricing power, which drives strong profitability and allows for reinvestment of cash flows at returns well above its cost of capital,” he elaborates. “When you identify those exceptional businesses with a long growth runway, they are absolute gems that are often overlooked by the market due to a shorter-term focus.”

“When you identify those exceptional businesses with a long growth runway, they are absolute gems that are often overlooked by the market due to a shorter-term focus.”

Trygve Toraasen, Partner and Portfolio Manager at Cusana Capital.

Another crucial aspect of investing in emerging markets is considering the macroeconomic and political environment of a specific region. “It’s important not to overlook the macro and political backdrop. If those factors are challenging, it becomes harder for even a good business to thrive,” concludes Marshall-Lee. “This is where the alignment between governance, the business model, and the reality of the marketplace comes into play.” The opportunity set in emerging markets – driven by favorable demographics, low credit penetration, and stronger productivity growth than in the Western world – presents substantial potential for stock pickers like Cusana to uncover attractively valued compounders.