Emerging markets: take your pick
Written by Christine Senior
July / August 2010
Emerging markets (EMs) are attracting lots of attention. No longer are they regarded as lacking the experience and infrastructure of their developed counterparts. Their economies have advanced in leaps and bounds over the last few years and the global downturn has demonstrated their robustness compared to the devel-oped world.
Several factors come into play and underline how much these economies have changed. They have favourable demographics, with a high proportion of young and well educated in the population; the wealth of the rising middle classes is driving retail sales; infrastructure is being developed; political stability has increased; and standards of corporate governance and in finan-cial markets regulation have risen. More emerging markets are moving to IFRS reporting standards.
The weighting of emerging markets in the MSCI All Country World Index has reached around 14%, up from around 4% just a decade or so ago. It seems certain to continue rising, as IPOs in the EM space outpace those in the developed markets. But pension fund allo-cations on average are well below this weighting, though allocations are rising.
“The more aggressive pension funds do make benchmark allocation of 14-15%,” says Wim-Hein Pals, head of emerging markets equities at Robeco. “I would say the average is high single digits, 7-8% is the average weighting in global equity portfolios in all pension funds. That is quite a big risk. Emerging markets have better prospects going forward than mature markets.”
Jerome Booth, head of research at Ashmore Investment Manage-ment, is more radical. He advocates that pension funds should be allocating 50% of their whole portfolio to emerging markets and that should include a mixture of asset classes. But he accepts that this will not happen, since pension fund managers have to follow the herd, even when they accept his arguments that emerging markets are less risky than developed ones.
So where are the opportunities to be found? Chindonesia – China, India, and Indonesia – are attracting attention as the most dynamic areas of growth, according to commentators. These are all countries with a growing population of wealthy consumers which provide a ready market for home-produced goods. This is a turnaround from the past when it was export-led growth, particularly driven by demand from US consumers, that dominated EM economies.
“The core concept of Chind-onesia is it is an earnings growth engine which is secular and largely insulated from the problems we have in the developed world,” says Kunal Ghosh, portfolio manager for international global and emerging markets systematic strategies at Allianz Global Investors Capital. “We like the China consumer, the India consumer and the Indonesia consumer, who make up 50% of the global population. One recurrent them of our global EM portfolio is we are relying on the emerging market consumer to be carrying emerging markets forward.”
Ghosh favours consumer discre-tionary, consumer staple and health-care sectors which should benefit from rising consumer demand. In China wage rises of 30% plus in some industries provide a boost for consumer related sectors.
“Immediate beneficiaries of [wage rises] are the food distributors, supermarkets which will benefit when people start spending beyond the bare minimum on food and clothing,” says Ghosh.
In India he highlights the auto-mobile sector, banks and pharma-ceuticals as ones to watch. But India faces risks in the form of inflationary pressure in the economy, and if the monsoon fails again this year, it will bring problems.
The third arm of Chindonesia, Indonesia, benefits from a strong consumer base, fiscal discipline from its government and reserves of liquid natural gas and coal. Ghosh favours commodities and con-sumer stocks in Indonesia.
Pals at Robeco also highlights the opportunities in China and India. China he sees as a long-term growth story, as the government focusses increasingly on develop-ment of its western regions and central rural areas, and away from the prosperous East coast.
“The next few years will mean high economic growth from central and western China,” he says. “To develop a vast country will take decades. High single digit growth is sustainable.” He predicts GDP growth varying between 7 and 12%.
China has underperformed other emerging markets this year, but earnings growth is starting to come through. “We have seen derating in price/earnings to the global emerging markets average,” he says. “China stocks look attractive from a growth valuation angle.”
India has some way to go to catch up with China in building infrastruc-ture, which will need massive invest-ment. Indian stocks have higher valuations than Chinese, with some justification according to Pals: “Management of companies is stronger and the return on equity is traditionally higher in India than in China. That will remain in the next couple of years, with strong manage-ment teams focussing on returns.”
Robeco decreased its weighting to Brazil earlier this year, taking profits after a 120% rise in share prices last year. Valuations are “no longer super-attractive” says Pals. Also a general election due in October is a source of uncertainty, and oil company Petrobras’ plans to raise a huge amount of equity capital to buy oil assets from the government will dampen down share prices, he says.
Though corporate governance in emerging markets has improved and continues to improve, it is not at the same level everywhere. Matthew Vaight, co-manager of M&G Global Emerging Markets Fund, is a strong believer in the importance of cor-porate governance in investment choices in emerging markets: “Corporate governance really matters in emerging markets because better corporate gover-nance leads to better operating performance, which in turn leads to better share price performance.
“With this in mind, I would caution against EM investors looking
solely at China. The economy has deliv-ered spectacular growth, but standards of corporate governance are often better in other countries. Take Brazil, for example. The equity culture is far more advanced in Brazil and the quality of manage-ment teams is as high as anywhere in the world. We can trust these companies and invest with a strong degree of conviction that these companies will create value for us as shareholders.”
Investors still have a perception of emerging markets as risky, but it was in the US that the sub-prime crisis began, and currency market volatility has centred on Europe with Greece and Spain the source of problems for the single currency.
Booth turns the usual perception on its head, with the US and European economies in serious trouble, while industrial production shifts to emerging markets, which are benefiting from huge currency reserves, and currencies that will appreciate. “The case for emerging markets is now that it is reducing risk not just having a punt, or trying to get better risk adjusted returns. It is actually a risk reduction strategy especially in the very worst case global scenario.”
Important decisions for investors also centre on how to invest in emerging markets – active or passive, global or regional. Emerging markets are usually recognised as an area where active managers can add value. It is argued that these markets are less well researched than developed markets, giving active managers the chance to seek out well managed companies with superior products.
Robert Hayes, managing director, strategic advice and solutions team at BlackRock says though passive management is valid, most of their clients take the active route. A global EM allocation also makes sense for most investors. This allows the manager to add value through cross country asset allocation decisions, he concludes.