Investment Focus

Diversification and Flexibility in Emerging Markets Over the past decade, assets under management have grown steadily in the emerging markets (EM) equity asset class, driven by strong fundamentals and growth prospects for EM countries. However, these assets have mostly been allocated to benchmark-aware strategies in exchange-traded funds (ETFs), passive benchmark tracker funds, and lowtracking-error active funds. In reality, the MSCI Emerging Markets Index—the benchmark for nearly all passive and low tracking-error funds—represents a shrinking portion of the EM opportunity set. In this paper, we discuss how the EM investment universe is much broader than the large-cap equity space, and how different parts of the EM equity and EM fixed income universes are attractive at different stages of the economic cycle.

2

Opportunity Sets Within the Emerging Markets

Emerging-market economies are currently in a more favorable macroeconomic position than their developed-market peers. EM countries, in general, have stronger GDP growth prospects, lower debt levels, and are in better fiscal condition than the developed world. Assets under management have grown steadily over the past decade in the asset class, as retail and institutional clients align their portfolios with this wider economic story. However, despite the huge growth in assets, the market has not been as sophisticated in allocating capital as it has been in developed markets.

Small and Profitable Companies In our view, smaller companies in the emerging markets offer a differentiated investment opportunity. Smaller companies tend to focus more on domestic consumption and profitable companies tend to borrow less: the combination makes smaller companies generally less susceptible to global shocks compared to larger firms.

Emerging-market equity assets are mostly allocated to benchmarkaware strategies in exchange-traded funds (ETFs), passive benchmark tracker funds, and low tracking error active funds. This naturally leads to a large-capitalization bias and sector concentration, with many investors holding similar companies. Exhibit 1 illustrates that as the emerging-market universe grows, the MSCI Emerging Markets Index, which is the benchmark for nearly all passive and low tracking error funds, represents a shrinking portion of the opportunity set. We believe the opportunity is much broader than the large cap equity space and that different parts of the investment universe are attractive at different stages of the economic cycle.

Furthermore, analyst coverage is relatively low as few investors are able to commit specialists to the task of fundamental research in this area. By isolating profitable firms from the myriad of small companies in the emerging markets, investors can focus on management teams that have delivered on their primary objective—something which must next be vetted with extensive fundamental analysis. Because of the higher level of stock-specific risk, investing in small-cap stocks requires specialized knowledge of the company, country, and the competitive environment, as well as a detailed assessment of company management that can be sourced through on-site visits and a forensic examination of financial reports. When investing in small and profitable companies:

In this paper, we examine why company fundamentals drive return patterns that can be harnessed to generate favorable risk-adjusted returns and how, by adding flexibility in terms of styles, investors can take better advantage of the opportunities presented in different economic settings. Aligning a portfolio with macroeconomic views is no trivial task, but it is achievable by examining the fundamental drivers of performance for various securities in emerging markets.

• Focus on financial productivity and valuation • Use relevant metrics including: earnings, return on equity (ROE), price to earnings, and price to sales • Conduct on-site visits and accounting validation of financials to evaluate companies that are not well-researched by sell-side analysts

Exhibit 1 The MSCI EM Index Represents a Shrinking Portion of the Emerging Markets Opportunity Set 2,785

Number of Securities in MSCI EM Index Number of Securities in MSCI EM IMI Number of Securities in the MSCI EM Index as a Percentage of the Total Number of Securities in the MSCI EM IMI 52%

2,419 2,205

2,187

1,787 41%

41%

39%

42%

41%

679

656

2002

2003

731

2004

827

850

925

2005

2006

2007

31%

30%

746

767

2008

2009

As at December 31, 2012 The information in the chart above is for illustrative purposes only and does not represent any product offered by Lazard. Source: MSCI

2,616

2,015 1,582

1,315

2,725

2,576

30%

31%

802

820

821

2010

2011

2012

29%

3

Growing Companies We believe growing companies offer the highest return potential and, commensurately, pose the greatest risks. To manage these risks, we believe investors should focus on companies whose future earnings growth is not already reflected in consensus estimates (and stock prices). Put another way, they should focus on those companies with under-appreciated growth potential. These companies will typically have higher and more stable levels of earnings growth and higher capital expenditures on their balance sheets. Growing companies tend to be more expensive on a Price-to-Earnings basis as they often require debt to fund their growth. Poor security selection in this segment of the market can be particularly costly, and selecting “winners” can be extremely profitable, so, investors must carefully assess management’s ability to execute on their plans. We believe that opportunities in growing companies provide a “high octane” complement to a broad portfolio of emerging markets investments. When investing in growing companies: • Focus on growth of revenue; earnings before interest, taxes, depreciation, and amortization (EBITDA); and net income • Place value on high or improving returns on invested capital (RoIC) • Consider relevant metrics including: earnings-per-share growth, RoIC, enterprise value (EV)/invested capital, EV/EBITDA, and free cash flow to the firm (FCFF) • Conduct on-site company visits and accounting validation of company financials

Established Companies Established emerging-market companies are often global companies that have successful franchises. These companies generally have sustainable profitability, free cash flow, attractive valuations, and high dividend payout ratios. When investing in established companies: • Focus on financial productivity and valuation • Identify high, improving, or sustainable returns on equity and dividends • Assess relevant metrics, including ROE, EV/EBITDA, price to book, dividend yield, and free cash flow to equity (FCFE) • Conduct on-site company visits and accounting validation of company financials

Currencies Emerging-market currencies can be valued as a broad reflection of a country’s macroeconomic fundamentals. Compared to equities, they generate an uncorrelated return stream, even though volatility can be high at times. Shifts in government policy and changes in currency regimes across the emerging world drive performance in this asset class, meaning an investor needs a detailed understanding of the fiscal and monetary policy conditions across the full spectrum of the emerging world. When investing in emerging-market currencies: • It is necessary to have expertise and knowledge of country balance sheets, policymakers, and central bank policies in order to take advantage of the differential in monetary and fiscal policies

• Analyze long-term and short-term drivers of economic activity in a particular country • Establish drivers of inflation • Conduct yield curve and implied currency volatility analysis

Debt The emerging-market debt universe spans a broad spectrum of local currency, hard currency, corporate, sovereign, and quasi-sovereign bonds. Investors have a wide range of instruments to use in this asset class; thus, the keys to success lie in identifying where market or pricing inefficiencies exist and capitalizing on those inefficiencies across several different instruments. When investing in emergingmarket debt: • Analyze global economic conditions, including liquidity, funding, supply and demand, and global prices • Assess country-specific factors and risks, such as real GDP growth, economic recessions, currencies, and exposures • Research company-specific factors and risk, including leverage, financing, fundamentals, and counterparty risk, in order to assess the causes and the likelihood of default

Investments for Different Environments Small, growing, and established companies all benefit from different business environments. Small companies in the emerging markets benefit from periods of favorable domestic demand dynamics in their home country and rely less on global economic growth rates. They are therefore less susceptible to today’s slower growth in the developed world where they are unlikely to generate revenue. While small companies’ earnings are not directly tied to global growth, their returns are still correlated to global market performance. In particular, they are subject to swings in risk aversion because they tend to exhibit a high beta relative to the market. However, the resulting volatility in share prices creates opportunities for investors who have a more nuanced understanding of company fundamentals and domestic economies. Growing emerging-market companies will benefit from periods in the business/economic cycle of high liquidity and expansive monetary policy. In this setting, companies with aggressive growth strategies via high capital expenditures will be able to find more favorable financing terms. As growing companies are expanding capacity, either domestically or internationally, by focusing on capex, there needs to be a high conviction about future cash flow to sustain growth. Conversely, under tighter liquidity, requiring a high level of debt is a negative attribute. In this environment, we believe growing companies will face difficulties financing further capex and sustaining growth. Investors in growing companies must be attuned to dramatic swings in asset prices and understand the factors that are driving these volatile moves. Opportunities are created when the market’s reaction is not aligned with the fundamentals of the company and particularly the sustainability of the growth profile. Growing companies will generally outperform during rising markets when visibility into future cash flows is high. Established companies tend to gain an advantage over growing and small companies when liquidity tightens, as they can use their stronger

4

take at Lazard, we encourage specialization not only within an asset class but also more narrowly in an investment style or sub-asset class.

balance sheets to increase market share. In general, we expect established emerging-market companies to outperform during periods of uncertainty and when there is elevated dispersion in EM equity market fundamentals. An emerging markets currency portfolio benefits from periods when government policy in EM countries has significant influence and when there is clear differentiation between the policy agendas of different emerging-market nations. Currencies suffer when monetary policy in emerging markets eases, local interest rates fall, and there is a low level of policy dispersion in emerging markets. Emerging-market debt benefits when there are idiosyncratic inefficiencies in credit spreads, local and external yield curves, and exchange rates. EM debt suffers when companies are having difficulty obtaining debt financing, in the case of corporate debt, and when systemic factors in emerging markets are driving credit spreads and yields, which applies to all categories of EM debt assets.

Exploiting the Opportunity—Lazard Emerging Markets Multi-Strategy

As mentioned on page 1, Lazard Emerging Markets Multi-Strategy invests across five broad strategies, which serve five distinct roles within the portfolio, with the help of five dedicated teams, as summarized in Exhibit 2. Simply dividing and then blending the emerging world’s investment landscape in this way is no guarantee of success. Different market conditions call for different portfolio configurations, so the next step is to align the portfolio with the EM economic environment. Given that there are no clear delineations between economic stages, at Lazard we forecast the economic environment over the next 6 to 12 months by assigning weights to four economic contexts: Panic, Differentiation, Expansion, and Mania. We utilize a set of macroeconomic considerations and hundreds of indicators associated with each one. Then, we perform a qualitative analysis of quantitative information to determine a probability-weighted estimate of the four economic contexts. This Economic Context Assessment determines the most appropriate portfolio positioning. In simple terms, if our analysis shows that liquidity will likely improve in six months, increasing exposure to growing companies might be appropriate. On the other hand, if the probability of a double-dip recession in the United States increases as a result of fiscal policy developments, the equity exposure will likely shift to established companies that can weather the storm and emerge stronger than competitors.

In our view, as capital markets become broader and deeper, it is increasingly difficult for an investment professional to simultaneously research global mega-cap names, fast-growing domestic players, currencies, and fixed income. While there are definite synergies between the work that our emerging-market investment professionals under-

Exhibit 2 Investment Strategies in Lazard Emerging Markets Multi-Strategy Initial Screen

Typical Number of Stocks Requiring Fundamental Analysis

Typical Number of Positions

4

~2,800 Companies

300–350

35–45 stocks

6

~800 Companies

400–600

35–45 stocks

Value

6

~800 Companies

400–600

35–45 stocks

Debt

Debt

9

~70 Countries

N/A

60–80 securities

Currencies

Currencies

5

~60 Countries

N/A

15–25 currencies

Opportunity Set

Strategy

Small Companies

Small Cap

Growing Companies

Growth

Established Companies

Number of Lazard EM Investment Professionals*

* Vice president and above, as of March 31, 2013

Exhibit 3 Hypothetical Portfolio Allocations Bullish

Currencies 15% Debt 10%

Small Cap 4%

Growth 42%

For illustrative purposes only.

Neutral

Value 29%

Currencies 25%

Debt 25%

Defensive

Value 22%

Growth 22%

Small Cap 6%

Growth 7%

Value 10% Currencies 30%

Small Cap 8% Debt 45%

5

Increasing Volatility

Exhibit 4 Expected Performance Across Asset Classes Asset Class

Opportunity Set

Strategy

Focus

When Expected to Outperform

When Expected to Underperform

Equity

Small Companies

Small Cap

Finding value in markets where there is considerably less analyst coverage

With favorable domestic demand dynamics in EM

When domestic demand in EM is subdued, external factors are buoying global growth and exports are driving economies in EM

Growing Companies

Growth

High and stable levels of earnings growth, capex

In periods of rising markets when visibility into future cash flows is high

In periods of cyclical slowdown when markets penalize high levels of capex and the environment is more challenging for new entrants looking to gain market share across industries

Established Companies

Value

Sustainable profitability, free cash flow, attractive valuations, high payout ratios

In periods of uncertainty and elevated dispersion in EM equity market fundamentals

When markets are optimistic about growth prospects in EM and capital is flowing freely to higher yielding assets, allowing new entrants across industries access to financing, thus taking market share from more established companies

Debt

Debt

Local currency, hard currency, corporates, sovereigns, and quasi-sovereigns

Where there are idiosyncratic inefficiencies in credit spreads, local and external yield curves, and FX rates

When companies in EM are having difficulty obtaining debt financing and systemic factors in EM are driving credit spreads and yields

Currencies

Currencies

Shifts in government policy and changes in currency regimes across the emerging world

When policy in emerging markets exhibits significant influence and when policy dispersion is high

When monetary policy in emerging markets is easing, local interest rates are falling, and there is a low level of policy dispersion in EM

Fixed Income

Exhibit 3 details three broad portfolio stances and how the underlying strategy allocations change in line with our assessment of the market. Embracing a flexible asset allocation approach in the emerging markets can equip an investor to take better advantage of, and protect against, market fluctuations. Understanding the business cycle and where individual companies fit within it is an advantage when building strategies from the bottom up and when allocating capital between strategies. Exhibit 4 summarizes various asset classes in the emerging markets and the circumstances that we believe are most and least favorable to their

performance. This knowledge gains in practical value when aligned with a thoughtful macroeconomic forecast, as the combination can help an investor identify an optimal asset allocation mix at any point in time. We apply these principles in our emerging markets multiasset portfolios, allowing us to adapt our equity exposure and blend in a combination of debt and currencies to suit the opportunity. We believe this flexibility is an essential quality that enables investors to keep pace with changes in the business environment across the globe and within the emerging markets.

Important Information Published on June 7, 2013. Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the date published and are subject to change. This paper and all research and materials enclosed are the property of Lazard Asset Management LLC. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one’s home market. The values of these securities may be affected by changes in currency rates, application of a country’s specific tax laws, changes in government administration, and economic and monetary policy. Small- and mid-capitalization stocks may be subject to higher degrees of risk, their earnings may be less predictable, their prices more volatile, and their liquidity less than that of large-capitalization or more established companies’ securities. Emerging market securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging market countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in emerging market countries. Investments in global currencies are subject to the general risks associated with fixed income investing, such as interest rate risk, as well as the risks associated with non-domestic investments, which include, but are not limited to, currency fluctuation, devaluation and confiscatory taxation. Furthermore, certain investment techniques required to access certain emerging markets currencies, such as swaps, forwards, structured notes, and loans of portfolio securities, involve risk that the counterparty to such instruments or transactions will become insolvent or otherwise default on its obligation to perform as agreed. In the event of such default, an investor may have limited recourse against the counterparty and may experience delays in recovery or loss. The strategies invest primarily in emerging market debt positions. The strategies will generally invest in debt investments denominated in either US dollars or local emerging market currencies. As such, an investment in the strategies is subject to the general risks associated with fixed income investing, such as interest rate risk and credit risk, as well as the risks associated with emerging markets investments, including currency fluctuation, devaluation and confiscatory taxation. The strategies may use derivative instruments that are subject to counterparty risk. The strategies will invest in securities of non-US companies, which trade on non-US exchanges. These investments may be denominated or traded in both hard and local currencies. Investments denominated in currencies other than US dollars involve certain considerations not typically associated with investments in US issuers or securities denominated or traded in US dollars. There may be less publicly available information about issuers in non-US countries that may not be subject to uniform accounting, auditing, and financial reporting standards and other disclosure requirements comparable to those applicable to US issuers. A strategy’s ability to achieve its investment objective depends in part on Lazard’s skill in determining a strategy’s allocation between the investment strategies. Lazard’s evaluations and assumptions underlying its allocation decisions may differ from actual market conditions. Past performance is not a reliable indicator of future results. Certain information included herein is derived by Lazard in part from an MSCI index or indices (the “Index Data”). However, MSCI has not reviewed this product or report, and does not endorse or express any opinion regarding this product or report or any analysis or other information contained herein or the author or source of any such information or analysis. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any Index Data or data derived therefrom.

Lazard Asset Management LLC • 30 Rockefeller Plaza • New York, NY 10112 • www.lazardnet.com

LR22738