Address the fundamentals
If you ask the question why invest in emerging market equities, the answer is pretty straightforward: emerging market economies are going to be a much more significant part of the global economy in the future and growth rates are generally higher than developed countries. Jim O’Neil at Goldman Sachs estimates that by 2025, the ‘BRIC’ economies, Brazil, Russia, India and China, will be larger than the G6 on a purchasing power parity basis and on a US dollar basis, will overtake the G6 by 2040, while the new demand from the BRICs could rival that of the G6 by 2010.
All emerging markets do require four fundamental preconditions for them to be able to achieve their potential, according to Goldman Sachs, namely; macro-economic stability, with low inflation, stable exchange rates, etc; stability on the political structure and institutions within a country; openness in trade and investment as economies need free trade to be able to develop rapidly; and finally an educated workforce.
A key factor driving much of the growth is the demographics of emerging markets with a much younger age distribution in general than developed markets, and also an increasing urbanisation. This has also resulted in a rise in per capital incomes increasing consumer demand for all sorts of goods and services. While the BRIC stock markets are currently only 4% of the global equity market capitalisation, they do have 43% of the world’s total population. Their sheer size combined with the adherence to the requirements for rapid development, makes them the most likely countries to become very significant global economies in their own right.
Indeed, by the year 2050, Goldman Sachs estimates that four of the seven largest economies could be the BRICs. Apart form the BRICs, the ‘next eleven’ countries Goldman
Sachs see as having high potential, which also tend to be popular amongst emerging market investors, are Bangladesh, Egypt, Indonesia, Iran, Korea, Mexico, Nigeria, Pakistan,
Philippines, Turkey and Vietnam.
Global equities manager Acadian Asset Management, which runs a top decile performing $7bn (€5.5bn) emerging markets strategy that closed to new investors 18 months ago, recently published a research paper on investing in ‘frontier markets’, ranging from Bulgaria to Botswana and Bangladesh. While these markets are relatively illiquid and small in size, most have reasonable growth foundations and a strong knowledge base, according to the firm. It plans to launch a frontier markets strategy aimed at sophisticated institutional investors which will be capped at $200m.
Churchill Franklin, executive vice president at Acadian, notes that many of these frontier markets are in the same position as emerging markets were 10-15 years ago, following the path of other successful developing countries to develop modern corporations and viable stock exchanges and, as such, represent the beginnings of an opportunity for investors. John Chisholm, Acadian’s co-chief investment officer, considers frontier markets such as Croatia, Namibia and Tunisia to be attractive possibilities
The major attraction of emerging markets is that they have historically had a higher return on equity than developed markets, although this gap is reducing somewhat.
A key characteristic of emerging markets has also been that stocks tend to be much more correlated to local market indices than to global sector indices. Emerging markets have therefore produce useful diversification benefits for global investors.
However, correlations with developed markets are increasing and increasingly, major stocks within emerging markets such as Samsung in Korea, are seen to be global stocks and should be judged against their global peer group.
Risk premiums for emerging markets have seen a long-term reduction and this is seen most clearly in the emerging market debt universe where credit spreads have gone down dramatically. This reflects not only tightening of spreads across all fixed income asset classes, but also a reflection of the movement of a large number of emerging markets towards investment grade credit worthiness, reflected by the fact that around 50% the JP Morgan EMD index is now investment grade.
Emerging markets have been substantially outperforming developed markets since the 1997 Asian crisis. Despite recent market corrections, many emerging markets are close to all time highs. Asia lags somewhat, particularly the China A share market, a market only recently opened up to foreign investors and accessible only through local brokers and as a result, still somewhat neglected by major institutional investors.
In general, emerging market specialists would argue that current valuations are not unreasonable high. Jaap van der Hart at Robeco Asset Management considers emerging markets still cheap with a more than 20% discount versus developed markets based on forward earnings. The strong returns in the last few years have been largely driven by earnings growth, which explains the still attractive valuation levels at around 11 times current year earnings.
Aberdeen’s Devan Kaloo also sees that increasingly “management are focused on profit margins and shareholder value. The balance sheets and cash flows are stronger, so from a fundamental viewpoint, they should be worth more. The key is to buy companies that are focused on shareholders.”
Going on to add that the ongoing convergence of emerging market P/E ratios with developed markets “is dependent on better disclosure, better corporate governance and the selling-off of non-core assets” by emerging market companies.
While the upside potential is strong, the risks inherent in emerging markets also need to be clearly understood. The small size of many of the stock markets means that they are highly susceptible to a reversal of inflows from foreign investors, which accounts for some of the volatility seen recently in them and during any period of global crisis when there is a flight to safety.
Kaloo sees that with too much money flowing onto emerging markets, “the risk is that we see an unjustified lowering in the cost of capital with companies raising money because they can and management as a result getting sloppy, frittering it away on poorly thought out acquisitions or expansion programmes. We are not too far down that road yet; the recent correction is a natural and healthy sense-check.”
The impact of politics can also be dramatic as has been the case of Russia and Yukos Oil, which was effectively taken back from shareholders by the government. The state of China’s economy is also now a risk factor to be taken into account as a large part of global growth has been driven by the impact of China, both in demand for raw material produced by other emerging markets as well as other imports.
Any slowdown will have an effect: higher energy prices introduce an additional element of downside risk as profit margins are squeezed; the impact of the US consumer spending
fuelled by rising house prices means that there is a danger of any setback in the housing market having an impact on confidence and hence spending and finally, inflation may have disappeared over the past few years, but an inflation shock leading to higher interest rates may well be seen in a sharper reaction in emerging markets.
One of the fundamentals issues relating to emerging market investments is that it is not clear what should be included in the universe and what weightings should be applied to individual stocks. Korea and Taiwan are generally regarded as highly developed yet Korea is 18% and Taiwan is 14% of the MSCI index while other index providers have very different weights for them. The MSCI index has 26 countries and over 820 stocks but within it, Korea, Taiwan, Brazil and South Africa account for over 50%.
The weighting applied has been changed dramatically in recent times, to reflect the free float actually available to investors rather than the total market capitalisation. The problem for any investor looking to use an index as a benchmark is does any index actually represent a minimum risk portfolio for an investor? As this is clearly not the case, then what importance should be placed to a tracking error against an index?
The central dilemma for any investment approach to emerging markets is emerging market stocks are highly correlated with local indices and are much less influenced by global sector behaviour. The key decision that any fund manager needs to take is whether the primary emphasis should be placed on country selection, or on stock selection? The answer to this and its incorporation into a coherent investment philosophy underpins radically different approaches to emerging market investment.
Taking country allocations as the primary choice can be done both through passive as well as active approaches. While indexation may appear to be an obvious approach, there are numerous pitfalls within an emerging market context, as it would give rise to costly and pointless rebalancing in illiquid markets especially if undertaken on a sampled basis.
In specific instances however, it may be an interesting option. The China Index Fund, managed by LIM Advisers, for example, fully replicates all 100 or so China B shares listed in Shanghai and Shenzhen. In an illiquid market subject, potentially subject to market manipulation of individual shares by insiders, having broad exposure to the totality of a marketplace, which itself stands at a discount to the domestic A shares, many of which are issued by the same companies or a pari passu basis, is a long term bet on the convergence of the two markets.
Dimensional Fund Advisers get round the issue of expensive rebalancing costs by having a completely passive approach that does not slavishly follow an external index. They construct an internal index based on screening for liquidity etc weighted by the free float to give 450 large cap and 1,500 small cap sticks, excluding countries on the basis of legal risks and a lack of commitment to free markets, while capping exposure to any individual marketplace. As a result, China and Russia are excluded while Taiwan and Korea are capped at 12.5% each.
Many active managers focus on country weightings as the primary source of added value. Country risk, credit risk and interest rate risk are highly correlated in emerging markets.
Country focused approaches invariably rely on developing macro-economic models that seek to identify the relative cheapness of the stock markets and the susceptibility of the economy to an imminent shock, which will invariably have negative repercussions on the domestic stock market.
Given the high correlations of individual stocks to the domestic index, it will invariably lead to a high probability that any stocks held in a portfolio will be adversely effected.
Robeco for example, combines a fundamental assessment with a quantitative model for country selection, seen as the first step in their process. The fundamental research focuses on five key areas: macro-economic and political risk seen in factors like domestic and foreign demand, monetary policy, currency strength and politics; earnings expectations and revisions on an aggregate level; valuations of markets based on price/earnings,
price/cash flow, price/book and dividend yield, and momentum trends and sentiment and demand/supply factors.
The quantitative model looks at a well-diversified set of stock market and macro-economic variables including valuations, balance of payments, reserves and currency returns. Stock selection is then performed on a country neutral basis so for example, “a Brazilian stock is primarily compared with other Brazilian stocks”.
Robeco sees country bets representing 50% of their outperformance against their benchmark according to van der Hart, while for other managers the figure can be much higher. Typically, stock selection requires liquid stocks to be able to take rapid decisions on the market as a whole, with less importance placed on the relative attractiveness.
Ashmore, for example, better known as an emerging market debt specialist, is able to manage emerging market equities with essentially a strong country focus combined with investments in major liquid stocks. GMO also combine a quantitative country model with their quantitative stock selection models applied to the developed markets. Goldman Sachs Asset Management (GSAM) however, “three years ago migrated away from a country specific approach to a stock selection approach with a macro overlay” says Maria Gordon who points out that “if you look at country volatility, it has been in decline since 1998. With increasing globalisation and a wider investor base, investors are keener on franchise value rather than country factors.”
Purely stock focused approaches have to tackle the considerable problems associated with comparing thousands of stocks, (India alone has over 5,000 listed stocks) across multiple jurisdictions with different accounting conventions, tax rates that vary significantly and earnings figures that are effected by different approaches to the amortisation
of goodwill etc.
Moreover, as Kathleen Brown at Axa Rosenberg points out, some countries including Mexico and Chile still have inflation accounting. Axa Rosenberg, as a purely quantitative
manager with a methodology based on breaking down companies into individual sectors and comparing these with each other across the globe to obtain relative valuations, is more dependent than most managers on having access to consistent and reliable accounting data across their global emerging market universe of 4,500 stocks.
Brown sees the task as getting much easier however as “companies are moving to international accounting standards or US GAAP, while those that are not, are trying to align local standards to international. For example, in the MSCI benchmark, only 28% of EMEA countries reported under global standards in 2,000 while the other 72% used local standards. Now, 73% report under US GAAP or international standards and local standards have improved as well.”
While Axa Rosenberg sticks to index country weights very closely, Pictet’s approach is a good example of a pure stock picking philosophy with country and sector weightings arising out of that. Their approach capitalises on the high industrial percentage of emerging market stocks by defining value principally in terms of productive assets, rather than earnings, enabling them to compare similar companies around the globe without the distortions of cash flow based models and based on their own database of over 6,000 stocks.
Given the artificial nature of any global emerging market index, it is not surprising that there are other ways of accessing emerging market listed equities such as regional funds, country funds and thematic funds.
With regional funds, there is a question of what should be included and why – should Asia-Pacific portfolios include Japan and/or Australasia as well as emerging markets? With both regional and country funds, the behaviour of local investors with a sudden influx of wealth through the recent high oil and commodity prices can lead to completely unrealistic
This is arguably the case in the Gulf with 2m of the 16m Saudi population reputed to be playing the market.
Is India overvalued despite the recent corrections? Thirty new private equity firms were reputed to have been set up in India last year, capitalising on the rising stock market potential for IPOs. Despite the concerns, individual Indian companies are increasingly competing on a global basis, which may imply a completely new valuation approach for them.
Dedicated emerging market equity funds are not the only way of accessing those markets and other alternatives are also worth considering: There are hedge funds with local specialist investing across the full capital structure of companies with equity, convertibles and debt within their portfolios. Given the fact that stock markets play only a small part in the economies of emerging markets, the scope for private equity type investment is clearly tremendous, although the key issue is inevitably the protection of minority shareholder
It is also worth realising that managers who run unconstrained global equity mandates are able to take very large overweight positions in emerging markets and much of the recent out performance seen by many global equity mandates can be directly attributed to managers having weightings of 20% or more in emerging markets against an MSCI weighting of 7%.
Finally, for those investors who still see emerging markets as too risky to dive into, there is always the option of focusing on those companies whose operations are heavily geared towards emerging markets such as GE, whose growth is significantly derived from China.