Is long only the best way into emerging markets?

NO

Bart Turtelboom

Co-manager, GLG Emerging Markets

The premise that long only is the best way to invest in China and other emerging markets means taking a rather unsubtle view of these countries.

Given how sophisticated many of these markets have become, we believe that a long short approach is a better one, especially at a time of considerable global economic uncertainty. More importantly, growth in emerging market countries is now entering a different phase; a phase in which, in our view, winners and losers are more likely to differentiate themselves.

While undoubtedly the growth trajectory for emerging markets is stronger than for G10 economies going forward, the crisis in developed economies is clearly still going to affect these countries. Holding a long only portfolio therefore means having to deal with considerable potential volatility. The Hang-Seng was down roughly 50 per cent in 2008 and 20 per cent in 2011 – not the kind of moves that many investors can take without getting nervous. By contrast, a long short approach captures the majority of the excess return emerging markets can provide, but in a risk-controlled manner, allowing investors to be exposed throughout the cycle without having to panic.

If Europe, the US, and Japan were to decelerate, as we expect, if not dive into recession, emerging economies will clearly not be immune. We do expect them, however, to weather the cycle much better. In China for example, a ‘recession’ will look more like a growth rate of 5-7 per cent. Even if the government did spend 30 per cent of GDP over the next few years to bail out non-performing bank loans, clear up shadow banks and deal with real estate bubbles, China’s public debt to GDP ratio would still not touch 50 per cent.

We expect emerging market indices in general to continue to fall until the size of the impending recession becomes more known and more priced-in. Subsequently, we expect passive indices to rally in anticipation of a policy-led recovery. The timing of the inflection point will, as always, be very difficult to forecast. However, it is likely to be a rich environment for absolute return strategies. This will be as true in foreign exchange and interest rates as it will be in equity and credit.

We can already see historical relationships between benchmark stocks and indices severely and unjustifiably dislocated, be they based on a fundamental (multiples, price/earnings, price/book) or a technical perspective (two to three standard deviations in some cases). Over time this dislocation will correct.

It is therefore a great time to deploy our research capabilities to try to identify in which direction they will go. The sectoral concentration of our interest in China and more widely is currently financials, energy and miners. We are biased to be long companies that are direct or indirect beneficiaries of fiscal support because we want to be exposed long to what less indebted governments will spend on – highways, railroads, ports, cement, steel, infrastructure and the champion banks that will intermediate this spending. We are biased to be short exporters to distressed European, US and Japanese economies.

The country biases these views imply are fairly clear, but there are all sorts of exceptions of course. We have a slight preference for Latin American exposure because that economy is comparatively more closed and less exposed to fundamental contagion from Europe. By contrast, pure trading economies in Asia such as Taiwan and Singapore appear more challenged. The Europe, the Middle East and Africa region will have a heavy energy and mining cycle bias and the catastrophic political risk of the Middle East to contend with.

Holding the view that emerging markets will fare better, does not mean every company, and indeed country, within it will do so.

Harald Espedal, Skagen Funds

YES

Harald EspedalInvestment Director, Skagen Funds

There are a number of advantages of long-only equity investment across different regions which are magnified when investing in less developed or emerging markets, particularly when looking for potential triggers in undervalued, under-researched and unpopular companies which could release hidden value and act as a catalyst for increasing the share price. This is important as we believe that emerging markets are a particularly fertile hunting ground for such undervalued companies.

Aside from the widely-held belief that investing in emerging markets provides portfolio diversification benefits and with the current emerging market price/earnings ratio close to historical lows, it makes sense to be long emerging markets from a valuation perspective. Taking a long-only approach provides greater room to build the right investment position and achieve increased scalability in those investments.

Low trading volumes can mean that investors looking to short emerging market stocks may struggle to create a position or acquire enough shares to make the position profitable.

Similarly, a lack of liquidity in emerging market equities can make exiting a loss-making position difficult or costly, a problem which will clearly be exacerbated if leverage is involved.

For these reasons, emerging markets are more suited to investors who take a long position to investment as it is easier to create, build and, if need be, exit a long position. Also, taking a long position within an investment horizon allows positions to be gradually increased over time. This is particularly pertinent if you consider the vast number of small but potentially high growth companies in places such as China and other emerging markets.

We seek to be patient with our own portfolio holdings as we believe that real value is created over the long-term. A good example of this is our investment in Total Access Communication, the second largest GSM mobile phone provider in Thailand – initially a very small position in the portfolio that we increased gradually over several years and which had more than quadrupled in value when we sold it last September.

Another benefit of long-only investing is reduced costs. Shorting strategies or excessive changes to a portfolio can be expensive, particularly in emerging markets where trading costs can be considerably higher than in developed markets (sometimes over 1 per cent) and ultimately detrimental to results.

One way to reduce costs (and risk) is to buy companies listed in developed countries but which generate revenues from emerging markets. One such example would be Standard Chartered, which is listed in London but generates more than four-fifths of its profits from Asia and other emerging economies.

Another opportunity can be seen in Heineken, which although listed in the Netherlands, generates nearly 50 per cent of its revenues from emerging markets. It is also increasingly cost efficient to buy shares in emerging market companies with a developed market listing with the growth of Global Depositary Receipts and American Depositary Receipts.

We remain convinced that taking long-term, long-only positions in good but undervalued companies is the optimum way to tap the opportunities in emerging markets going forward – as our slogan says, it’s the art of common sense!