Solid foundations can withstand rough seas

Emerging markets have attracted investors for both short-term performance and their long-term prospects. The potential economic and stock market growth in India and China has been well documented but fund managers argue that the risk across global emerging markets has reduced and therefore they should be more attractive to investors.

Even though government and corporate finances may be in better health, emerging markets can still be volatile and suffer periods of negative returns. Over the past year, the S&P/Citi BMI index has returned 19.93 per cent.

But over five years, the index is still in negative territory with a return of -11.02 per cent.

The long-term potential of emerging markets was most famously articulated by Goldman Sachs in a report on what it dubbed BRICs. This comprised Brazil, Russia, India and China. Goldman Sachs has predicted that within 40 years BRICs will become four of the six largest economies in the world. It says India’s economy could exceed Japan’s by 2032 while China’s could be larger than the US by 2041 and everyone else’s by 2016. Goldman Sachs adds that stock market capitalisation of BRICs could increase by four times over the next decade to reach $4000bn (?3020bn) and China and India could account for 60 per cent of that total.

Fdi growth

China and to a lesser extent India have received the most publicity of all emerging market countries. It is easy to see why. China, with 1.4bn people, enjoyed 9.5 per cent economic growth in 2004 while India, with 1.1bn people, expanded by 8.2 per cent. They are the two largest locations for offshore services. Furthermore, foreign direct investment has grown rapidly in recent years and exceeded $60bn in 2004.

‘We’re bullish about the growth of a middle class across most emerging markets. It is starting to come through in India and China Brazil and South Africa’ - Wim Hein Pals, Robeco

While economic growth figures have been questioned in the past, the effect of Chinese demand on commodity and energy prices around the world shows its expansion is for real. China in particular is important for other emerging markets because of the raw materials and other goods it imports. Furthermore, Asia accounts for around half the emerging markets index and therefore the region is vital for investors in this sector.

Most fund managers, however, say it is difficult to find stocks they want to buy in China. This is partly a result of stocks becoming so expensive but also because the state still has a large shareholding in many companies, giving rise to issues of corporate governance. Fund managers, therefore, tend to play the China theme through companies based in Hong Kong, Taiwan and Singapore or even further afield.

Chinese hurdles

Emerging markets face numerous economic, political and social challenges to achieve their undoubted potential, which can affect short and long-term returns. Uncertainties include whether China will follow the relatively peaceful path to democracy pursued by Russia and South Korea, will it continue to create the number of jobs required to match its growing population and will the caste system in India restrain economic development.

There are also short-term issues. These include whether the strong returns of the past two years in emerging markets can be sustained and whether this sector still offers attractive valuations. There are questions over whether China can maintain its near double-digit economic growth, the effect of a rise in value of Asian currencies, a sharp slow down in the US and the imposition of protectionist tariffs by developed countries.

Wim Hein Pals, manager of the Robeco Emerging Markets Eq fund, says the asset manager has been positive about this asset class since 2001. Robeco currently has a 15 per cent weighting in its global model portfolio, which Mr Pals says is the maximum overweight it can take.

“We have been positive for several reasons,” says Mr Pals. “We are attracted by the growth potential over the next decade and lower valuations of emerging markets against developed countries. As investors see low returns from mature markets, they will increasingly turn to emerging markets. The average price to earnings ratio (P/E) in emerging markets is 10 times compared with 15 times in mature markets. This discount is too great. Given the greater growth potential but political risk in emerging markets, it could be argued the discount should be around 10 per cent.”

Asia offers the greatest growth potential of emerging markets, says Mr Pals. “We are bullish about the growth of a middle class across most emerging markets. It is not only starting to come through in India and China but also Brazil, South Africa and elsewhere. There are strong dynamics for the sale of goods such as mobile phones. This means emerging markets are far less dependent on selling exports to the US and other developed countries.

“Emerging markets are also benefiting from the continued strong growth in China. At the moment, 12 per cent of the fund is invested in Brazil because of companies such as Cia Vale do Rio Doce, which is the world’s largest iron ore producer and benefits from the strong demand from China.” The biggest overweight in the fund is South Korea. Mr Pals argues it has the cheapest stock market. The South Korean economy is growing 5-6 per cent a year and corporate governance is improving.

The Robeco Emerging Markets Eq fund has a strong record over three to five years but has returned 17.09 per cent compared with 19.93 per cent by the S&P/Citi BMI index over one year. Mr Pals attributes the short-term relative underperformance to an underweight position in emerging Europe. This region performed well in 2004 but Mr Pals argues it now looks fairly priced.

He takes a top-down approach in managing the Robeco Emerging Markets Eq fund, which is the minority investment style. He argues, however, that political and economic factors are more important in determining returns than individual company performance. “The PetroChina share price, for example, is more sensitive to the state of Chinese politics than movements in the oil price. If there is a problem in China, the share price goes down regardless of the oil price.”

Niall Paul, manager of the Aviva Emerging Countries Equity fund, also invests on a top-down basis. He says: “Around 60 per cent of returns come from emerging markets’ stock returns, 30 per cent are attributed to the country choice and the rest to sectors. A big proportion of value from fund managers come through getting market calls right.”

He is optimistic about emerging markets because although their stock markets have performed relatively strongly over the past two years, the P/E multiples have been falling. “This is because earnings have exploded. We are looking at a situation where markets should be choppy but companies have been delivering strong earnings.

“A positive sign is the fact that the good corporate performance has broadened out across sectors in emerging markets. It is not confined to cyclicals and commodities, whose earnings you might expect to slow down over the next year.

“We have overweight positions in the consumers and financials sectors. The internal growth being generated by emerging markets is reflected in the fact that two banks in Brazil have reported an increase in lending of 25 per cent.

‘Brazil has a current account surplus and a trade deficit of only 2 per cent of gross domestic product. Its finances are in a better state than the US’ - Niall Paul, Aviva

“As interest rates fall further, the situation will accelerate as companies and individuals gain access to cheap capital. Another positive indicator is that Brazil now has a current account surplus and a trade deficit of only 2 per cent of gross domestic product. Its finances are in a better state than the US.”

Mr Paul admits, however, that strong inflows into emerging markets funds and stock markets have stretched some valuations, particularly in emerging Europe. “This is the most illiquid part of emerging markets. The converging theme has been going on for some time but many investors have just recognised this. The Hungarian stock market, for example, rose 80 per cent last year.

“Banks in emerging Europe, however, are now priced at four times price to book and these kinds of multiples are hard to justify. Banks in Greece went to 5.5 times price to book when it converged with the European Union. They later fell back to 2.5 to 3 times price to book. I do not see tremendous upside value from here for emerging Europe.”

Most other fund managers argue that a primarily bottom-up approach is more effective. Geoffrey Wong, manager of the UBS EF-Emg Markets fund, says that three-quarters of added value comes from stock selection.

Cheap valuations

Mark Mobius, manager of the Templeton Emg Markets Eq fund, says cheap valuations were the main driver behind the strong recent performance of emerging markets. Over the past three years, the Templeton fund has returned 23.76 per cent compared with 17.86 per cent by the S&P/Citi BMI index.

“The valuations are still compelling as the average P/E is around 10 times and emerging markets are paying dividend yields of 3 to 4 per cent,” says Mr Mobius. “In India and China, there is strong economic growth of 7 to 9 per cent. Populations are growing while per capita income is going up as well. One of the most important indicators of the improvement is the spread between emerging market debt and US Treasuries. It reached 14 per cent after the Asian crisis in 1997 but has now come down to 3 per cent or 4 per cent.”

Among the markets particularly favoured by Mobius are Poland, Russia, Brazil and Mexico. “South Korea is amazingly cheap. Corporate governance is improving and the market is on only five or six times earnings. It could be re-rated as corporate governance continues to improve.” He adds that the tsunami has had no effect on stock markets in the region. This is mainly because it hit coastal areas and in Indonesia was mainly confined to Aceh.

Gary Potter, co-head of the portfolio service at Credit Suisse Asset Management, says he still sees value in emerging markets despite the strong performance of the past two years. “The risk levels of investing in emerging markets have fallen. Painful restructuring means they are less prone to chronic budget deficits. Fewer countries have fixed exchange rates which mean they now have more flexibility. The only emerging markets still to have fixed exchange rates are China, Venezuela, Jordan and Malaysia. Yet 10 years ago, 13 countries had fixed exchange rates.”

He is optimistic about prospects in China. “People were talking about the possibility of a hard landing in China. But China cannot afford to have a hard landing. It needs to create 25m jobs every year to cope with the number of people moving from rural areas to the cities. We expect economic growth of between 8 per cent and 10 per cent a year over the next 10 years.”

Mr Potter is bullish about the three main emerging markets regions – Asia, Latin America and emerging Europe. But Credit Suisse is moving away from investing in global emerging market funds and using more regional funds. “We have found generally that out of every three asset allocation calls, global emerging market fund managers get two correct and one wrong. But the one decision they get wrong tends to cancel out the two they call right.

“Although we use the Thames River Emerging Markets fund, we generally use specialist regional managers who have knowledge of local markets.” Mr Potter adds that he does not invest in individual country funds. This is because of the potentially greater volatility and the difficulty of timing market calls.

‘The valuations are still compelling as the average P/E is around 10 times and emerging markets are paying dividend yields of 3 to 4 per cent,” - Mark Mobius, Templeton