More attractive than ever
According to Jerome Booth at London-based specialist asset manager Ashmore: “In emerging markets, debt outperforms equities except in a rally, so the definition of an emerging market is one where the equity risk premium is negative.”
While you may believe that his view is prejudiced since Ashmore is a leading emerging market debt player, the fact that the firm has also developed a thriving equity business utilising the same macro-focused process illustrates the central dilemma of emerging market investment: should you focus on country bets, or stock and sector bets?
The strong correlation of stocks with local indices rather than global sectors, is a key differentiation with developed markets and the approach that fund managers take to incorporating this into a coherent investment process underpins the radically different approaches to management of emerging markets that can be seen.
The Ashmore approach is at one extreme, taking a completely macro top-down approach to investment with stock selection assuming a very subordinate role. At the other extreme, firms such as Pictet have spent years building up immense databases of detailed emerging market stock information while firms such as T Rowe Price rely on the long-term stability of core teams of regional experts to ensure that detailed stock- specific knowledge is built up and retained within the firm.
Gaining a competitive edge through a local specialisation is seen as the driver for many of the boutiques producing country or regional funds, while others venture into the hedge fund space by adopting a very open-ended approach to investment opportunities within a clearly defined geographic locality.
What is clear is that with the transition of many emerging markets to developed market status and the sheer potential size of the Chinese and Indian economies, investors need to look deeper into the structure of their emerging market exposures than may be justified by current market capitalisations alone.
Todd Henry of T Rowe Price expresses a general view that with emerging markets up 40% per annum over the last three years, now might be a good time to take some profits if you have large exposures to emerging markets. However, “if you have nothing in the asset class then its probably a reasonable time to get in. Markets are down 6% quarter to date (at end October) so it’s not a bad time to be adding incrementally.”
There are a number of very powerful arguments for incorporating emerging markets into a portfolio even to the extent of overweighting their contribution relative to their global market capitalisation.
The demographics of most emerging markets is of a much younger age distribution than the developed countries of western Europe in particular. In the absence of significant immigration compared with the US, Europe is seeing its population age and with it, a lower GDP growth rate than the emerging countries.
Return on equities in emerging markets is much higher than in developed markets. Risk premiums in emerging markets have been declining substantially over the last decade and this is most clearly evidenced in the decline in emerging market debt spreads and the increase in credit ratings of emerging market debt. Finally, emerging markets offer a diversifying asset that is less correlated to developed equity markets.
Stephen Burrows from Pictet argues that while emerging markets are back to all time highs, and in their fifth year of outperformance against developed markets, in the medium term there is “still a significant gap in valuations on P/Es and Price to Book values with developed markets of about 25-30%”. He also points out that “you are paying the same P/E multiple today that you were paying 10 years ago and inflation has fallen dramatically over the period”. As a result “allocations will remain fairly healthy in the asset class over the next five years”.
He echoes Henry’s caution in the near term, arguing that “the extent of the recent rally means that markets are a little overbought, emerging markets were up 18% last quarter. This year energy and materials will represent almost 40% of the earnings growth for emerging markets. For the asset class as a whole that dependence warrants a degree of caution. We find much greater undervaluation in financials and consumer discretionary stocks. Overall we do not think emerging markets will have a significant fall back but just a pause for breath in the short term.”
Henry also points out that “the MSCI World index is on 14.5x average 12-month forward earnings, while emerging markets are on 10x. Earnings have come through in emerging markets so strongly that valuations have been kept reasonable. Before the Mexican crisis, valuations were at 20x; before the Asian crisis they were 17x. “We don’t buy into the argument that emerging markets can trade at or above developed market levels on the basis of their faster growth. In fact we would see valuations at that level as a red flag as their cost of capital and riskiness is higher.”
Any benchmark index constrains investment opportunities if the tracking error targets that managers are given are too low and this is certainly true in emerging markets where there is room for disagreement on which countries should be included. Should emerging markets be regarded as a separate asset class at all is a key question that will become increasingly important going forward. Korea, for example, accounts for almost 18% of MSCI’s emerging market index, while S&P’s regards Korea as a developed country. Similarly, Taiwan accounts for 14% of the MSCI index and would not necessarily be regarded as an emerging country by many investors as is the case with Israel at 3.5% of the index, while Russia, China and India still have weightings of less than 8% each. Geographically, as well, the asset class incorporating three major geographical regions, namely Asia, Latin America and what is often lumped together as Europe, middle East and Africa (EMEA).
Does any index represent the minimum risk exposure for an investor in emerging markets? Since the answer will invariably be no, the issue is how well a manager performs relative to a naïve passive benchmark as represented by an index, rather than looking at deviations against index weightings as shedding any real light on the risks faced by an investor of not meeting performance objectives.
The issues of legal protection for investors, commitment to free market and so on are real risks facing any investor in emerging markets, and managers such as Dimensional Fund Advisors have screened out China and Russia completely from their emerging market funds despite their inclusion in the indices, while capping Taiwan and Korea at 12.5%.
MSCI Emerging Markets index is the dominant benchmark and has 826 stocks from 26 countries. In recent years, the index has been restructured to reflect weightings by free float, rather than total market capitalisation, to better represent the universe of investment opportunities for external investors. Korea, Taiwan, Brazil and South Africa between them account for around 53% of the index. Given this concentration, it is not surprising that many managers choose to run active portfolios with high tracking errors against the benchmark and invest significantly outside the index universe in terms of both companies and countries.
The key issues that managers need to address are: how should macro views on countries be incorporated in a global fund; how to keep track of and analyse a thousand or more companies across the globe; what philosophical approach should you have to consistently generate returns in a very heterogeneous marketplace.
Incorporating macro views of 26 or more heterogeneous markets into a portfolio effectively is, in its most extreme form, seen in the approach taken by Ashmore which uses a completely top-down process to generate absolute returns.
Ashmore’s Booth explains: “It is the macro factors, the politics and the technical factors that drive the markets. In Russia, banks skip around, they move into equities and when they go up, they move out into bonds or cash. If you understand the market behaviour and the technicals, you can do well.” He goes on to point out that “a lot of equity managers completely ignore currency risk or hedge it out. But in emerging markets, currency risk, credit risk and interest rate risk are highly correlated, so you shouldn’t hedge it out but manage it as we do our bond portfolios.”
While “taking a long-term view of value or growth does not make sense. There is value in all these countries but can you extract it?” For Ashmore, stock selection is about getting liquidity into the portfolio and while “we do have sector analysis coming out of the macro views, eg energy/oil, telecoms, credit cycles in Korea etc, the macro views, sector views, market technicals and liquidity essentially means that your choice of stocks has been largely determined”.
In contrast, Pictet’s managers are “first and foremost, bottom-up managers. Our country and sector weightings are driven principally as a result of our stock selection,” according to Burrows. Pictet covers 6,200 stocks using an in-house database and an experienced team of 13 emerging market specialists.
A key contrast emerging markets have with developed markets is that 70% of emerging market stocks are industrial-related, which allows Pictet to define value principally in terms of productive assets, rather than earnings, enabling it to compare similar companies around the globe without the distortions of cash flow-based models. What this entails is that “for each particular sector we choose one benchmark product (such as ethylene) and for each company we visit we look at their different types of capacity and then restate it back into the benchmark product in the same way as you would re-state earnings into a common denominator. We use the replacement cost of each different method of production.”
Such an approach is a variation of the measure introduced by the Nobel laureate James Tobin, generally referred to as ‘Tobin’s Q’ which is the ratio of the market value of a firm to the replacement cost of its assets. If this is higher than 1, a firm is worth more than its value based on what it would cost to rebuild its assets so that excess profits are being earned above and beyond that required to keep the firm in the industry. Company visits are an integral part of the process as the first part of the visit is “checking through capacity and updating replacement costs for that particular industry” and the key point for Pictet is that it can “find that some companies are valued even lower than the replacement costs of their capacity. That’s where you can get a great indication of undervaluation,” according to Burrows.
Such an approach requires a long-term investment horizon because “in the short term there are obviously many other factors which influence how a stock performs” and as a result, “we can hold a stock for two to three years, so turnover is typically low”.
Indexation while an obvious route, has the disadvantage that changes in index weightings will give rise to expensive and unproductive turnover in illiquid markets.
Garrett Quigley argues that Dimensional Fund Advisors’ approach gets round that by constructing its own index based on, first of all, screening countries for basic legal protections for investors, liquidity constraints etc and then screening purely on liquidity for companies, weighting by free float to give 450 large cap and 1,500 smal cap companies.
Unnecessary turnover is eliminated by the simple expedient of not having a rigorous tracking error target, despite having a passive approach to stock selection. They have a strong belief in the academic evidence from Eugene Fama and Kenneth French, indicating that the premium of value over growth applies to emerging markets and as a result, have a large cap, a small cap and a value fund.
Given the complexities and opaqueness of individual local emerging markets, giving individual local experts the opportunity to exercise their judgements is clearly an approach that many firms would suggest is superior – as T Rowe Price’s Todd Henry argues, “sometimes people can overplay the importance of fund manager expertise in their selected markets, but I don’t think that can be overplayed with regard to emerging markets”. The problem lies in combining local views into global portfolios that are not simply a set of stapled together local portfolios.
Henry argues that the manager’s competitive strength is the experience and cohesiveness of its emerging market team with managers incentivised by the performance of the whole portfolio and with a stable process that has been around for more than a decade. The team is split between Latin America, EMEA, North Asia and South Asia, with each of the four regional portfolio managers required to spend 20% of their time outside their region, working closely with the firm’s dedicated research analysts. Countries are continuously evaluated on the basis of four key factors – foreign direct investment flows; corporate governance; health of the financial system; and health of the judicial and legal system. With a definite growth bias, each regional team is looking at its universe for companies with the highest growth potential and attractive valuations.
The development of an integrated global portfolio as against a collection of regional sub-portfolios is ensured “through combining cross-regional travel by the portfolio managers with constant communication amongst the team, led by Chris Alderson from the firm’s London office”.
While macro factors do play a part in overall country weightings, Henry argues that they would not overweight a country if they were not sure about the quality of the companies, with China being a case in point. In Egypt by contrast, “changes in government policy raised attractive opportunities for growth whilst at the same time there were attractive investment opportunities”, which led them to have a 5% weighting against a benchmark 0.8%.
Taking advantage of specialist expertise in individual regions is, at its extreme level, a strategy for investment boutiques focused on particular countries or regions. Atlantis Investment management, for example, although based in London, is a specialist in Asia with capabilities in Japan, Korea and China and expanding to set up a new capability in India. Its Asian recovery fund illustrates the opportunities that unconstrained regional specialists can exploit, focused purely on companies undergoing operational restructuring in the region.
According to Atlantis’ James Alexander, “this could be a high quality company undertaking new activities eg, outsourcing, but more than likely this could also be a troubled company restructuring after a period of distress”. Unlike a private equity investment they would have no management interest and what they are seeking to do is take advantage of an earnings surprise by investing early with a typical holding period of 18 months.
Clearly, emerging market equities can be highly volatile and country specific factors have often overwhelmed stock selection. What is also clear, however, is that the longer-term structural developments in key emerging markets will make them more important going forward and the issue for investors will be how to choose and combine managers to best exploit the opportunities.