On the far side of crisis
The word ‘crisis’ in Chinese is composed of two characters. The first is a symbol of danger. The second is a symbol of opportunity. Emerging market equities share the same duality. They promise greater opportunities for extracting value than developed market equities, but at greater risk.
However, emerging market equities have not always kept their promise. Their potential dangers have been underlined by the Asian crisis and the Russian debt default, and their performance over the short to medium term has been disappointing.
Over the past 15 years emerging markets have returned an annual 10.05%. However, this performance is spread over two distinct periods. In the first six years they performed exceptionally well with an annualised return of over 36% , but over the past nine years they have performed poorly with an annualised return of minus 0.46%.
Chris Alderson, head of emerging markets at T Rowe Price International in London says that the conventional case for investing in emerging market equities has looked shaky. “The traditional view was that emerging markets provided higher returns and diversification. The reality has been some risk diversification but lower returns.”
In spite of this, he believes the present opportunities of the asset class outweigh the dangers. Among the factors that are providing a tailwind for emerging market equities are record low interest rates in developed economies, and structural improvements in emerging market companies.
These structural improvements are a consequence of the freeing up of emerging market currencies, says Alderson. “The major reason is that there’s been a lot of structural change in the emerging markets is the de-pegging of a lot of currencies which have moved to a free float basis. The Argentinean peso had a fixed peg until 18 months ago and the Brazilian real had a crawling peg. Now these and nearly all the Asian countries that were pegged have de-pegged.”
He suggests that the move to a free exchange rate in emerging markets has produced three benefits for the investor: first, undervalued currencies; second, lower correlation with developed market equities (because the currency acts as a ‘safety valve’); and third, through the combination of undervalued currencies and the attractive return characteristics of emerging markets, the prospect of higher returns.
The traditional case for investing in emerging markets – diversification – also appears to be strong, according to two studies carried out by Standard Life Investments (SLI). In the first study, using the MSCI indices for the period for which there is data – that is, from 1987 to date – SLI investigated the correlation between emerging markets and those in the developed world. The findings suggest that there is more diversification available among emerging markets than among developed markets.
The second study calculated the correlation between the Emerging Markets Index and the world index and looked at the effect on volatility of combining emerging markets exposure with developed markets exposure. This showed that investors could achieve lower volatility of their equity holdings more effectively by adding emerging markets exposure rather than by increasing the number of developed markets in which they hold equities.
However, the strongest case for investing in emerging markets are the current low valuations, says Alderson. “In the golden days of emerging markets investing, before 1995, emerging markets used to sell sometimes at or at premia to developed market peers.
“Since then it has traded at large discounts to the world index. In fact the current discount on price earnings is about 40%, despite the fact that at the moment the emerging markets free index has a 20% higher return on equity than the global index. So you’re paying a discount multiple for a premium in terms of return, which we think makes no sense.
“The average P/E, using consensus earnings forecasts for the next 12 months, is currently around 9 compared with a historical average of 12.5 for the period since the beginning of 1996.”
Tom Rodwell, investment manager in the emerging market equities team at Pictet Asset Management, says: “The main attraction of emerging markets to the equity investor in particular is the opportunity to be able to buy stocks at much more attractive valuations both individually and in aggregate to developed markets.
“At a price to book value, emerging markets trade at 1.4 times in aggregate, while developed markets are about 1.7 and the US still about 2.2. So there is a clear valuation gap, although it’s not as wide as is was perhaps 18 months ago.”
Emerging markets have been showing much stronger earnings flows than their developed counterparts, he points out. This is chiefly because emerging market companies did not over-invest during the past three to five years and consequently carry less debt than developed market corporates.
The Asian crisis and the Russian default also acted as a wake-up call for emerging market companies, he suggests. “They realised that they couldn’t be running massively leveraged balance sheets at a time when their access to capital markets was intermittent at best. So you didn’t see the excesses of capital expenditure that you saw in the US and Europe.
“As a result emerging market companies have been generating much stronger free cash flow. The aggregate return on equity for emerging markets is now about 14%, marginally above developed market return on equities. So you’re getting better earnings streams at a much lower price to book value. That is really the case for emerging market equities going forward.”
Emerging market companies also have the edge over their developed country competitors in reducing costs, says Arjun Divecha, head of emerging market equities at GMO. “Cost reduction will become more important,” he says: “New valuation metrics will emphasise cost savings over revenue, and markets will reward companies that cut costs.”
Divecha says the case for emerging market equities is unanswerable: “Changes in technology and a new economic landscape have given certain emerging markets better opportunities for growth in the next five years than they have had in a long time.”
If a pension fund accepts the case for investing in emerging markets, the next question is how large a part of the portfolio should it represent? “Nobody would advocate having a large part of your pension fund invested in it because it’s clearly more volatile,” says Alderson of T Rowe Price. “Some studies suggest you should have 20% in emerging market equities because the demographics and growth prospects are so much more attractive than developed market equities, but I think you would be taking a very extreme position were you to go out to that sort of level. I think it would be imprudent to have more than 10% of your plan in emerging market equity, and most of our clients would hold 2% to 3%.”
One possible benchmark for allocation is the MSCI ACWI (All Country World Index) Free index, a free float-adjusted market cap index that covers 49 developed and emerging market country indices.
Aquico Wen, managing director and head of emerging market equities at Citigroup Asset Management, says: “We believe an allocation of about 8% to 10% in emerging markets equity out of the overall allocation to total equities would be reasonable. This would represent an overweight relative to the 4.2% weight of emerging market in the MSCI ACWIF Index.”
Another consideration is whether allocation should be to global or regional emerging markets. Mahendran Nathan, managing director and regional head of business at SGYAM in Singapore, suggests that an allocation to global emerging market equities reduces the opportunities for returns. “The key question is whether Asia should be a part of the emerging markets allocation or is the allocation better to global emerging markets, where Asia represents about 50%.
“Obviously this will depend on an institution’s internal asset liability structure and their funding and return requirements. However, we strongly feel that global emerging markets dilutes a lot of the potential of Asia-Pacific. We think that Asia Pacific excluding Japan today still offers strong emerging market returns on a stand-alone basis.”
Nathan suggests that allocation to Asia typically should not be more than 1% or 2% of a pension fund’s asset base, within the emerging market allocation. One way of increasing the allocation, he says, would be to include investment in developed Asia – notably Hong Kong, Taiwan, Singapore and Korea.
The choice of an appropriate benchmark will depend to some extent on the definition of an emerging market. The World Bank provides the classic definition, by dividing the world into high and low income countries, along a line between $9,000 - $10,000 gross national income (GNI) per capita. This creates a universe of 114 developing countries. However, the bank revises its classification every year so some countries will move up to more developed status.
Not all these countries will be investable. Some will have no have stock markets. Others that do have stock markets may not allow foreigners to invest in them. MSCI will only include developing countries in its emerging markets indices if foreigners are allowed to own stock.
The most broadly based emerging market indices currently are the IFC Investable Composite or the MSCI EMF (Emerging Markets Free). Some managers, such as Pictet, swapped from the IFC to the MSCI index when the MSCI switched to allocating country weights on a free float basis.
An asset manager’s use of a benchmark will largely dictated by the client base, says Citigroup’s Wen. “About 95% of or client base is institutional so our strategy is benchmark-orientated. Our benchmark is the industry standard, MSCI, probably the best and most representative benchmark available. So in terms of starting off on out portfolio construction process, we start with the universe provided by MSCI.”
However, some asset managers feel that emerging market indices are of limited use. Genesis, which manages only emerging market portfolios for institutional investors, suggests that indices do not fully capture the opportunities of emerging market investment. “Attempting to replicate an index will not necessarily expose an investor in the emerging markets to the highest returns,” it warns. “We believe the companies included in emerging markets indices tend to be those which have already attained a certain level of recognition, given the concentration of the indices in large capitalisation stocks.”
Alderson agrees that indices have their limitations: “The MSCI is not a perfect index. But then the day it’s a completely efficient index is the day I’d like to move off to another asset class, because I think a lot of the fun will have gone.
“We have to be conscious of where the benchmark is, because most of our money is institutional money and that’s what they measure us against. But there are always plenty of opportunities to buy something that’s truly emerging and coming into the asset class, and could be a big part of the benchmark in a couple of years time.
Asset managers with global emerging markets mandates will use the MSCI EMF as the starting point of their portfolio construction. Some have developed a systematic construction process that seeks to identify investment opportunities among emerging market companies.
Citigroup Asset Management, for example, uses what it calls a country -sector cell, or critical cell concept. “This involves dividing the constituents of the MSCI EMF benchmark into a matrix of sector and country cells, with countries along the rows and sectors along the columns.
It then populates each of the cells with the most attractive stocks in that cell. Whether a stock is attractive is determined by a combination of analysts’ ratings and valuation assessments. It assesses the risks of individual companies risks using a “dividend discount model”, an enhanced version of the discount cash flow (DCF) concept.
Wen says : “We find this concept to be particularly helpful because we are investing in emerging markets from a global perspective and can reflect the different risk levels of the different markets that we are seeking to invest in. So a company in Indonesia would have a different discount rate than a company in Hungary, since both are at the extremes of risk level in emerging markets.”
As well as bottom-up analysis, two country strategists provide top-down views. The strategists are responsible for setting the country risk premium across all the markets that Citigroup wants to invest in.
Pension funds have a choice of investing in emerging market equities either through a dedicated emerging markets manager, or through their existing global equities manager. Larger pension funds are more likely to choose a specialist, says Jonathan Hayes, head of business development for northern Europe at Pictet Asset Management. “What smaller or medium-sized pension funds would tend to do is ask their global equity manager to put 5% into emerging markets.
“That situation could change because a lot of consultants are now putting forward the case that maybe funds should increase their exposure to emerging markets. In this case it might become more attractive to separate that out from their global equity manager to an emerging market specialist.”
Funds can choose broadly two types of portfolio management for their emerging market equities mandates – diversified or concentrated. A well-diversified portfolio at the company and the country level would include some 140 different stocks and two dozen markets. The advantage of this approach is that diversification will smooth the peaks and troughs of performance. A portfolio that concentrates on a smaller number of stocks and countries will inevitably perform far better in some years than in others.
Another key decision for a pension fund is whether to choose a regional or global strategy. “The big debate normally is whether they are going to go down the regional or global approach to emerging markets,” says Hayes. “Generally it tends to be the more sophisticated investors that feel that they can do the asset allocation themselves and decide whether or not they want us to invest only in Europe, for example, and ignore Latin America.”
The choice of whether to invest through pooled or segregated accounts will be largely determined by the size of their mandates, he says. “The smallest clients will go into our pooled funds, the larger ones will have segregated accounts. For us, in terms of cost, a minimum portfolio size would be somewhere between $30m and $50m for a segmented account. Less than that and the trading and administrative costs and the fund manager’s time mean that it’s more efficient to put it into our pooled products.”
Larger pension funds that are able to invest in particular emerging markets can choose from a range of what might be called safe bets and big bets. One of the safer bets is reckoned to be Central Europe, says Plamen Monovski, co-head of Merrill Lynch Investment Management’s emerging Europe fund.
“The convergence process has been going on there for around 10 years now and it’s close to its completion. In May 2004 these countries will be part of the EU so all political and most economic risks would be similar to the risk that they invest in their core markets. That is why we think that a western portfolio manager could benefit from exposure to this convergence process.”
“The other reason that we are quite positive is the currency reason. Quite a lot of the return of this market so far has been by currency, because productivity growth in these countries still continues to be much higher than western Europe.
“Over the last seven or eight years productivity has been consistently higher than western Europe by about 3% to 4% higher every single year. Because of this these countries have become a prime destination for foreign direct investment and outsourcing. The Czech Republic, Hungary and Poland have been the backyard of German manufacturing.
The big bets are Russia and China. In Russia, Prosperity Capital Management in Moscow, which specialises in Russian companies has been banging the drum for investment in Russia. Scandinavian insurers Skandia and Sampo and the pension funds of the SEB group make up a third of Prosperity’s investors.
Mattias Westman, chief investment officer and managing director of Prosperity Capital Management in Moscow, says that investment in Russian companies would suit the long-term objectives of pension funds: “Obviously there’s been lot of volatility over these years but the what should matter is long term annualised return that you can get.
“You need to look at evolution of Russian companies to understand why the returns can be quite good over a long period of time. Ten years ago these were not companies at all. They were Soviet production units and not intended to generate shareholder value in any way. Now they are moving towards becoming real corporations. This process of turning factory processes into corporations is immensely value-generating.
“If you overlay that with a pretty strong GDP development – GDP is expected to double between 2002 and 2006 – then you have a good foundation for good returns over the medium to long term.
“Clearly volatility and liquidity are going to make some companies worse and some better . But if you’re a pension fund your main interest would be where you want to be in 10, 15 even 30 years time. And there I think a Russian investment makes a lot of sense.”
In China, too, the earnings growth of Chinese companies is the main attraction for investors, says Winson Fong, SGYAM’s deputy chief investment officer. “Being the world’s most populous nation is important but it’s not the key reason why you should invest in China. It’s really because of companies that generate earnings.”
Fong says that Chinese companies will avoid the mistakes made by other Asian bubble economies such as Hong Kong. “Hong Kong had the biggest collapse in Asia in the property market. That’s why China will continue to keep a very tight control on property prices. They will let property prices go up in accordance with economic growth but never excessively. It is not like Hong Kong where property developers earned 50% margins and the government did nothing about it.
“That is why one of our investment strategies is that we will avoid totally buying Chinese property development shares. These companies are not able to get double digit margins. The government will not allow them to build excessive profits.”
Could emerging markets have become less risky? Ken Forman, global investment strategist at SLI thinks thy have: “It is our contention that some of the riskiness in emerging markets has been purged by the reactions to the various crises in the past 25 years and that the environment is likely to be more stable for the foreseeable future.”
If that is so investing in emerging market equities promises greater opportunities than dangers.