Keeping up the impetus

Emerging markets have returned to favour with investors as their economies and stock markets generally have been performing strongly over the past three years. It has been estimated that in 2005 more than half of the world’s increase in economic growth was accounted for by emerging markets. Their share of global exports have more than doubled from 20 per cent in 1970 to 42 per cent, they have two-thirds of the world’s foreign exchange reserves and consume 47 per cent of the world’s oil. Yet their stock markets only account for 14 per cent of the global total. Equity performance has reflected economic growth in general. In 2005, the Russian stock market grew by 66 per cent and Korea returned 53.96 per cent. From the start of 2003 to the end of 2005, eastern European markets returned 226 per cent, Latin American markets grew 265 per cent and Asian markets returned 122 per cent. Of course, within these generalisations not all markets have performed well, with China being one notable example. Flash in the pan? The question confronting investors is whether this economic and stock market performance can be sustained. Dimitri Chatzoudis, manager of the ABN Amro global emerging markets equity fund, says some valuations are high, but many still offer value as they are trading on a discount to the same sectors in developed markets. Furthermore, says Mr Chatzoudis, fundamentals point to continued economic and earnings growth in the future. “Even in a market like India, where valuations have increased significantly, there is strong economic and earnings growth for companies. “We are optimistic about the long-term growth story for commodities although we think there could be a short-term correction as investors take profits. There are still supply constraints on commodities that will keep upward pressure on prices. “High commodity prices have helped emerging markets, such as Brazil, to improve their economies,” says Mr Chatzoudis. Some countries have turned government deficits into surpluses as a result of the commodity bull market. “Emerging markets are also benefiting from the China story.” Two emerging markets favoured by Mr Chatzoudis are Turkey and Brazil. “Turkey is helped by the theme of convergence with the European Union and strong domestic economic growth. Brazil has profited from the high oil price which has increased liquidity.” Mr Chatzoudis took over management of the ABN Amro Global Emerging Markets Equity fund in March 2005 and over the past year has altered the way the fund is managed. He says the investment process now places more emphasis on top-down analysis and is making greater use of its network of analysts around the world. “This helps with evaluating stocks and means the fund takes a more active approach to asset allocation.” The one-year performance figures are encouraging. In the year to 6 February, the fund returned 56.23% against 54.88% by the S&P/Citi BMI Emerging Markets index. Mr Chatzoudis says the fund combines top down and bottom up analysis. “Around 30 to 50 per cent of the risk in the fund comes from the top down analysis with the rest coming from stock picking.

‘Even though average price to earnings ratios have climbed around 20 per cent from nine to 11 or 12 times, this is still not expensive’ - Aquico Wen, CitiEquity Emerging Markets fund

“The top-down analysis selects our favoured countries according to our macro-economic view and then the analysts pick their favoured stocks in each sector.” Stretch marks The strong returns from emerging markets over the past few years has led to many valuations looking a little stretched and some very stretched, says Edward Baker, manager of the ACM Global Investments Emerging Markets Growth fund. He says the stretched valuations are notably in Russia, Brazil and India, three of the so-called BRICs countries (the fourth is China). In contrast, Mr Baker says he believes there are more attractive valuations to be found in other markets that are getting less attention at the moment, such as South Africa and Turkey. He says Turkey has not been subject to the degree of speculation elsewhere and has not been driven upwards by the commodities bull market. While South Africa has a strong commodities sector, Mr Baker says valuations have been restrained by the strength of the rand and domestic companies not being re-rated. Mr Baker also argues that economic growth across emerging markets is sustainable. “There may be lower economic growth going forward but it will still be positive. Economic growth is picking up in Japan and Europe, which will offset any slow down in the US. It will also be helped by domestic demand growing across emerging markets.” Mr Baker, whose fund holds around 120 stocks, says its performance relative to its peers has suffered because the market has favoured value stocks over the past few years. The fund has under-performed the S&P/Citi BMI Emerging Markets index over the past one, three and five years. “We have been able to find plenty of growth stocks we believe are attractive over the past five years,” says Mr Baker. “But the market has rewarded value stocks more than growth companies. The large multiple re-ratings have generally been for value stocks. This has meant the top performers have been value funds.” But Mr Baker believes this has begun to change. “In 2005, value and growth stocks performed roughly in line with each other. We believe the market is now favouring growth stocks to a greater extent.” The fund looks for companies where the team believes earnings growth will be faster than is forecast. Mr Baker says that while mis-pricing in emerging markets is less exaggerated than it used to be, there are still sufficient opportunities because the analysis of emerging markets is less comprehensive than in developed markets. “These opportunities are coming across all sectors and most emerging markets,” says Mr Baker. “For example, we like manufacturers of LCD thin television screens such as LG Philips LCD.” Another important factor considered by ACM before deciding to invest in a company is the level of corporate governance. Mr Baker says there are still challenges in the degree of corporate governance being applied across emerging markets but there has been significant improvement. “We like to invest in companies where the corporate governance is improving. There can be a multiple re-rating when the market recognises that corporate governance is being improved.” On the question of whether valuations are looking stretched in emerging markets, Aquico Wen, manager of the CitiEquity Emerging Markets fund, points to the early 1990s to compare and contrast the current situation. “There was a similar emerging markets rally in the early 1990s that reached its peak in 1994. But valuations are not looking as stretched now as they did in 1994. Even though average price to earnings ratios have climbed around 20 per cent from nine to 11 or 12 times, this is still not expensive.”

‘The average price to earnings ratio looks reasonable at 11 times despite the strong rise in equities over the past few years’- Kerrie McEwen, JPMorgan Emerging Markets Equity fund

When comparing emerging markets stocks with developed markets, however, Mr Wen says valuations are only looking selectively cheap. “The average price to earnings for stocks in developed markets is 15 to 17 times but this does not mean all emerging markets stocks are attractive on a comparative basis.” Lacklustre output The CitiEquity Emerging Markets fund has under-preformed the S&P/Citi BMI Emerging Markets index over the past one and three years but out-performed over five years. Mr Wen says the fund’s recent under-performance is partly a function of its investment approach. The investment approach is influenced by the fact that 90 per cent of the investors in the fund are institutions. It takes a neutral style bias between value and growth. Mr Wen says this is partly because of the difficulty in being able to time strong performing periods for particular styles. In making investment decisions, says Mr Wen, the fund takes a top-down macroeconomic view and stock-picking approach. These two approaches are integrated by using a discounted cash flow analysis of companies and then sets hurdle rates for countries based on their risk premium. Thus, it is harder for a stock in a market that Citigroup views as risky being included in the fund. The fund can take a maximum over or underweight position of 5 per cent in stock markets. Mr Wen says this approach is designed to enable the team to analyse companies from different countries on a like-for-like basis. He admits that if there is a significant re-rating of companies and “poorer quality stocks” do well, then the fund may underperform for a short period. On a relative basis, says Mr Wen, the fund has been impacted by the increase in liquidity in emerging markets. “Investors who dip in and out of the market will tend to buy large-cap stocks. When there are liquidity rallies, the large caps generally out-perform. Our fund has suffered in the past couple of years because of this.” Kerrie McEwen, client portfolio manager of the JPMorgan Emerging Markets Equity fund, says valuations have presented mixed signals over the past six months. “The average price to earnings ratio looks reasonable at 11 times despite the strong rise in equities over the past few years. “The area of caution is the fact the average price-to-book value is two and a half times. But this caution is lessened by the fact the average return on equity has increased from less than 10 to around 15 per cent. As long as emerging markets companies continue to grow their profitability then the valuations will look okay at these levels.” Nevertheless, the fund is under-weight in China. It also only holds a handful of Indian stocks, which is partly because of the substantial rise in the country’s market. Political stability One interesting development this year is the number of elections in Latin America. Ms McEwen describes this as a one in 12-year development. Traditionally this would be expected to create volatility in stock markets but Ms McEwen says economies in South America are generally in a more robust state than in the past, particularly Brazil, which should lessen the volatility. The JPMorgan fund has out performed the index over the past one, three and five years. Its relative performance against its peers was better over three and five years than one. Ms McEwen says the fund has a low turnover of stocks and tends to hold companies for at least three and more usually five years. The fund is driven by a stock selection approach but also uses a macroeconomic analysis to set the stock selections in context. “The level of portfolio turnover is low at less than 20 per cent a year,” says Ms McEwen. “This is both because we take a long-term approach to investing but also because a high turnover adds costs to the portfolio over the longer term and therefore can impact on performance.” The fund has a relatively concentrated portfolio of between 50 and 75 stocks. “We try to invest only in those stocks where we have a high conviction,” says Ms McEwen. “We focus on quality companies where we are confident about future earnings, growth and returns. “In the first nine months of 2005, the fund performed well on a relative basis and held up well in the market fall in October. The fund did less well on a relative basis in the next couple of months during the upside.” Ms McEwen says the fund has an under-weight exposure to materials and energy stocks but has an over-weight position in domestic consumption companies. “The fund avoids focusing on a particular investment theme.”