Investors probe deeper into developing economies

Collectively, global emerging market (GEM) equities returned 18.6 per cent in 2012, according to UBS, outperforming developed world counterparts.

Investors have flocked to GEMs as China’s rebound, and the stabilisation of Europe, fuelled demand for riskier assets. Emerging market equity funds recorded their biggest-ever weekly inflow in January, a net $7.4bn (€5.52bn) in the week ended January 9, after some 18 consecutive weeks of net inflows, according to funds research company EPFR. The last time there was such enthusiasm for the asset class was the second half of 2010 which notched up 29 consecutive weeks of inflows.

While many investors in global emerging markets are expecting great things this year, parts of some markets may have become overheated. Asset managers are therefore switching away from popular, over-owned parts of the market, and are looking instead for undervalued stocks in the large markets of China, Russia and South Korea, and at less mature markets such as sub-Saharan Africa.

One cause of the scepticism is that much of the gains in emerging market equities over the last two years have been the result of P/E expansion while earnings growth has been relatively stagnant.

“In the last few years, consumer staples such as food and tobacco have become the stars and the ‘must-have’ companies, so they have become way too expensive,” argues Vincent Strauss, chief investment officer at Comgest. He cites subsidiaries of Unilever listed in India and Indonesia on a PE of 35 times.

“At these prices it is no longer a defensive investment, though it is a defensive business,” says Mr Strauss.

Consensus earnings expectations in emerging markets look too high, even assuming a rebound to growth in the low teens this year. Profit margins have been in almost linear decline, falling by 22 per cent since 2005, and are particularly depressed in the capital-intensive resources sectors of energy and materials owing to wages growth.

“One of the general challenges in emerging markets is high wage growth putting pressure on margins,” says Dhiren Shah, a director and portfolio manager at BlackRock. He points out this presents a competitive advantage to countries such as Indonesia where labour as a portion of GDP is low, and the average return on capital is 23 per cent.

“One sector that notably faces this margin challenge is the materials sector and we think that will continue. The costs of projects have risen in recent years,” he adds.

Many managers are looking for undervalued sectors – preferring, for example, consumer discretionary over staples. Julien Seetharamdoo, senior macro and investment strategist at HSBC Global Asset Management, points out that while consumer discretionary and energy sectors in emerging markets are on a 10 per cent discount to their long-term P/E ratios, favoured sectors such as healthcare are 24 per cent above its long term PE ratio. “There has been a bit of narrowing in the valuation discount but cyclical sectors in emerging markets still look attractive,” he explains.

Return on invested capital still remains well below the pre-crisis level, according to UBS, having fallen from 18.2 per cent in 2004 to 12.3 per cent in 2012. The position is exacerbated by capital expenditure at record highs, at around double the depreciation of assets. Many fund managers are therefore adopting a stricter discipline with regard to capital metrics, and are focusing on return on equity, as well as earnings per share growth and a preference for companies with PEs lower than the index.

Small is beautiful

The Bric (Brazil, Russia, India and China) bourses’ slowdown last year obscured the outperformance of many smaller markets. Mexico, Turkey and the Philippines benefited from the increased competitiveness of their labour forces.

According to Goldman Sachs, some smaller emerging markets behave like “defensive” blue-chip Western companies used to, despite their cyclical nature. Goldman analysts attribute their strong recent performance to their resilience to the problems of the eurozone. In contrast, Poland and the Czech Republic have both faltered, despite being seen as robust and fiscally prudent members of the European Union.

Many countries are exposed to Chinese growth, and much depends on the Politburo’s attempts to grow domestic consumption. Current signals from leader Xi Jinping indicate a serious intention to move the country forward in a reformist and liberal direction.

Furthermore, the National Bureau of Statistics recently revealed that the new superpower’s reliance on investment may have been overestimated. In the first three quarters of 2012, consumption contributed 55 per cent of China’s growth, nosing ahead of the contribution from investment, and there is evidence this was also the case in 2011. Challenges remain in the areas of rising labour costs, excess capacity and inventories and poor financing.

Europe is a larger export market for China than the US, but Mr Seetharamdoo believes China has the ability to cope with weakness in Europe, helped by policy flexibility allowing reductions in interest rates and bringing forward initiatives such as infrastructure spending. He also points out that house prices have risen, export growth has stabilised and the HSBC China manufacturing PMI (Purchasing Managers’ Index) business survey has improved for four straight months. Countries that are closely linked with China, such as Korea, Hong Kong and Taiwan will continue to benefit from its soft landing, he says.

Africa is very much flavour of the year. Alex Homan, head of emerging markets equity product at Fidelity, says the Fidelity EM equity fund has material exposure to sub-Saharan Africa where they look for stocks with a liquid local market listing, which are a pure play on that geography.

“Nigeria’s wealthy and growing population will be roughly the size of Europe over the next 10 to 20 years – with growing spending power and low levels of credit penetration,” says Mr Homan. “Another market where there is adequate liquidity is Kenya where we like a number of the consumer and banking stocks. In these countries we can find companies without much competition who dominate their markets and enjoy strong pricing, while the population’s growth and rising wealth affords good visibility.”

Breweries are a good example of businesses benefiting from the region’s structural growth, believes Mr Homan. Those particularly favoured have a controlling stake from a parent in a developed nation, such as Heineken in Nigeria and Diageo in East Africa, “because the corporate governance framework affords a degree of comfort”.

Many fund managers prefer sub-Saharan Africa to South Africa, and are particularly nervous of South Africa’s mining sector, which is bedevilled with production issues and inferior ore grades.

Not so the JPM Emerging Markets Equity fund which has 12 per cent in South Africa, its biggest holding alongside India. Portfolio manager Claire Peck says this is an endorsement of the region’s high quality management teams. Apart from one holding in iron ore, the fund holds retailers such as Tiger Brands and Shoprite which are looking to expand out of South Africa and into the rest of Africa.

“They have governance, liquidity and operating history, and are tapping into the massive growth potential of sub-Saharan Africa,” says Ms Peck. For example, the fund recently bought Mr Price, a value fashion retailer targeted at the young and growing middle classes, with a market cap of $4bn. The fund has also generally been rotating out of large cap names.

The price of raw materials is another factor that will be reflected in the diverging performances of different countries. “Recently there has been a dramatic move in certain raw materials prices which might lead you to believe the demand outlook is rosy,” argues Fidelity’s Mr Homan.

“But our detailed work on the supply of new raw materials capacity suggests that if iron ore stays at or even near the current price then, with the amount of additional capacity coming onstream over the next two to three years, there could be significant pressure on iron ore pricing.”

Certain emerging economies’ past successes were built on export of raw materials to the likes of China, he explains, and should demand there dwindle, as China’s new government increasingly puts more emphasis on the role of consumer as the driver of future economic growth, then that is a material risk for shareholders in these raw materials businesses – and not just in Brazil, but also other exporting countries.

“Where an economy has benefited from exporting to China over the last decade, that tailwind is likely to be eroded,” he adds.

Although assets under management in emerging market equity funds have reached an all-time high of $781bn, emerging market stocks still lag their developed market peers by 20 per cent.

“Once the West’s deleveraging process has ended, confidence has been restored and interest rates begin to climb again, conditions will be perfect for a sharp rally in equities and in such an environment emerging markets should perform well, owing to their better fundamental growth prospects and lower risk,” says Wim-Hein Pals, head of emerging markets at Robeco. 

Time to think outside the box

“It used to be the case that regional and market cap decisions were principal drivers in asset allocation decision making in emerging markets,” says Sandro Antonucci from the open architecture team at Lombard Odier.

“Today alpha can be generated by focusing more on individual stock-picking across these markets as the number of stocks has increased dramatically over the past few years. As most emerging markets remain inefficient, the question today is less one of large cap vs small cap or Brics vs N-11 (the next 11 emerging economies – Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, Philippines, Turkey, South Korea, and Vietnam – identified by Goldman Sachs’ Jim O’Neill ). It is more important to find strong managers able to select the right stocks at the right time.”

The more flexibility a manager has, the freer he is to pursue high conviction ideas which should lead to the best long-term result, he explains. “Also, size remains an issue in the emerging markets space and managers who are cognisant of this and who keep their assets under management at reasonable levels should, over time, post better returns than their asset-gathering competitors.”

Exchange traded funds (ETFs) can be useful to an active trader, and for cash management, but liquidity can be an issue, so it is best to limit allocation to the most liquid markets. But Mr Antonucci warns the increase in globalization means correlations have risen between the largest listed emerging market companies such as Samsung and Gazprom, thereby reducing some of the implied benefits of buying ETFs across different countries and regions.

“Emerging markets should not be seen as universal commodity players,” Mr Antonucci warns. “If an investor wants to be successful and reduce the correlation within a global portfolio, it is imperative not to be exposed exclusively to the largest emerging market companies as the diversification benefits from these large players is much less pronounced than many investors believe.”

Although Mr Antonucci  believes China, Thailand and India should offer the most interesting opportunities this year, it does not mean that focusing on the largest listed companies within these markets will necessarily generate strong alpha, he explains.

“As an example, the most common Chinese indices are highly geared toward financials, energy and telecoms which are not necessarily the sectors that offer the best opportunities,” he says. “Stockpicking and a willingness to think outside the box will be key.”

Jonathan Clatworthy, senior investment manager at Arbuthnot Private Bank, agrees that clients should not focus on where a stock is listed, as there is a disconnect between economies and their stock markets.

He likes the Templeton Emerging markets team, led by Mark Mobius in Singapore, as he thinks a local team of analysts can add value, and First State Asia Pacific which is weighted to defensive blue chips. He also likes the $200m Copeland Cardiff fund which specialises in companies trying to tap the domestic consumer in Asia.

Mr Clatworthy is cognisant of the danger of wild swings in fund flows, pointing out that perversely the very investors who went into emerging markets for diversification purposes are often the first to leave, such as when they were spooked by the European crisis.

View from Morningstar: Wide disparities

Global Emerging Market (GEM) equities continued to attract assets in 2012 and, over the long term, are claiming a larger share of equity investors’ portfolios.

Funds in the GEM peer group returned 3.95 per cent on average from February 1 2012 to February 1 2013, with a wide dispersion between the highest-performing (21.5 per cent) and the poorest (-2.35 per cent). This is due partly to differences between countries: Turkey was one of the top performers, while Brazil and Russia underperformed. Furthermore, funds exposed to small and mid-cap stocks outperformed their large cap counterparts.

One of the top performers was First State Global Emerging Markets Leaders (15.32 per cent). Managers Jonathan Asante and Glen Finegan are supported by a well-resourced team of analysts. They invest in companies where they have identified sustainable drivers of earnings growth, and which are run by quality management teams with high standards of corporate governance. In 2012, the quality of stockpicking paid off, particularly within Taiwanese equities, where the managers preferred Delta Electronics to HTC. Conversely, the fund held no exposure to Russia, and was underexposed to Brazil.

On the other hand, Comgest Growth Emerging Markets returned only 3.83 per cent. Comgest’s focuses on highly profitable companies which the team believes can continue to grow independently of the economic cycle. The fund’s lacklustre performance in 2012 can be explained by the underweight in financial services and poor returns of some of the managers’ long term bets. Over the longer term, however, the managers’ investment discipline has delivered good risk-adjusted returns for investors.
Mara Dobrescu, senior fund analyst, Morningstar France