The importance of emerging markets to global investors was illustrated on Tuesday 27 February, when shares in Chinese domestic stock markets fell by 8.8 per cent. This had a knock-on effect on stock markets around the world. The Dow Jones Industrial Average fell by 3.29 per cent, the S&P 500 index slumed 3.47 per cent and the FTSE 100 was down 2.31 per cent.
These falls in stock markets were the largest one-day declines since the terrorist attacks on 11 September 2001.
Interestingly, concerns about taxing capital gains from shares and the future pace of economic growth in China and not the US acted as the trigger to spark the falls in equities. This is not to deny, however, that there are concerns about the housing market and economic growth in the US.
With the exception of May and June 2006, emerging markets had enjoyed strong returns over the past four years until the end of February. Over the three years to 12 February 2007, for example, the MSCI Emerging Markets index returned 113.97 per cent. Given this four-year bull market, investors have been asking for how long equities can continue to rise.
Robert von Rekowsky, manager of the Fidelity Funds Emerging Markets fund, says it is not possible to generalize about the valuations in emerging markets, however. “Not all emerging markets have performed strongly.
Taiwan, for example, has under-performed other emerging markets over the past four or five years.
“We are optimistic about the medium to long-term growth prospects for emerging markets, however. This is reflected by the fact that when you attend presentations by developed market companies, they say their best growth prospects are in emerging markets.”
Traditionally, the outlook for emerging markets equities has partly depended on your view of the US economy. But one school of thought argues that the rest of the world is now better able to withstand an economic slow down in the US. This rests on continued strong growth in Asia, led by China and India.
While Mr von Rekowsky says emerging markets are more self-sustaining than in the past, he adds that the US economy is still important for the rest of the world.
“Nevertheless, there has been a growth in intra-emerging markets trade,” says Mr von Rekowsky. “The intra-emerging markets trade has risen from 37 per cent in 2000 to 44 per cent. In the late-1990s, 27 or 28 per cent of exports went to the US but now it is 21 per cent.”
Stephen Burrows, investment manager at Pictet Funds, says he is currently finding more value in Asia than Latin America and EMEA (Europe, Middle East and Africa). “We are over-weight in Asia, such as Taiwan. The region has delivered good absolute returns but under-performed global emerging markets over the past three years.”
Mr Burrows is optimistic about certain sectors including financials and telecoms. This is partly because of the low penetration of such sectors in emerging markets and the potential growth in demand.
Reasons to be careful
Nevertheless, Mr Burrows admits there are reasons to be cautious about shortterm valuations. “Three or four years ago, emerging markets were on a discount to developed markets of around 35 to 40 per cent. But these discounts have now been closed.
“We expect positive returns this year but there is likely to be greater volatility. There are investment opportunities but investors have to work harder to find them.”
Mark Mobius, the legendary veteran manager of the Templeton Emerging Markets fund, says South Africa and Latin America continue to offer interesting investment opportunities. Mr Mobius agrees the fund invested early in South Africa but believes it is set to reap rewards.
“South Africa is a classic example of our value approach,” says Mr Mobius. “We saw that South Africa was a cheap market and invested. It has taken a while for the rest of the market to realise this. Sometimes we have to be patient.
“The potential of South African equities is shown by Bain and Company bidding for Edgars Consolidated Stores, which is the country’s largest retailer.
We have opposed the bid because we believe it undervalues Bain and Company.
“Private equity managers have woken up to the fact that South Africa is a cheaper market than elsewhere and offers attractive value. Emerging markets are the natural playing field for private equity managers because this is where the fastest growth is.”
Mr Mobius admits individual stock markets are looking stretched. “Interestingly, it is domestic markets where foreigners cannot invest that are looking most stretched, such as China and Vietnam.”
He says the biggest risk for emerging markets is of too much enthusiasm among investors and asset prices rising too strongly. “We would be cautious in such an environment as it would mean things were getting out of control. At the moment, we continue to find attractive valuations.”
Claire Simmonds, client portfolio manager of the JPMorgan Emerging Markets Equity fund, says emerging markets have returned just under 100 per cent over the past three years but adds that JPMorgan still believes the secular trend is upwards. “The fact that emerging markets under-performed the global index in the first two months of the year is too short a period too draw any conclusions, especially as emerging markets are volatile.
“The sovereign and corporate bond risk has reduced in emerging markets and the return on equity has improved. If you look at the asset class as a whole, equities are still on an attractive valuation given the improvement in fundamentals. This is through such factors as cost control, profits and earnings. There is lower inflation and higher GDP growth.”
While valuations are higher in India and China, Ms Simmonds says that in some cases they are justified by the growth prospects of these stocks. One of the key investment themes in the fund is domestic consumption. These include infrastructure companies.
“We expect emerging markets to spend $1,000bn ( �� 758.1bn) on infrastructure over the next three years, particularly in China, Russia and Latin America,” says Ms Simmonds.
“There are industries with a low penetration in emerging markets. Mobile technology penetration in developed markets is more than 100 per cent but is below 10 per cent in India. Lending is 10 times higher in Taiwan than Russia. But Taiwan is not 10 times as rich as Russia. We do not know by how much it will grow in Russia but it will increase.”
Ms Simmonds says JPMorgan Emerging Markets Equity is a best ideas fund. It has out-performed the MSCI Emerging Markets index over one, three and five years to 12 February 2007.
Sustainability
The fund holds between 60 and 75 stocks and they remain in the portfolio for an average of three to five years. Analysts for the fund are divided on a country basis.
In selecting stocks, Ms Simmonds says the fund looks at the sustainability of companies. A prime consideration, says Ms Simmonds, is the quality of a company’s management. “We conducted 3,000 company visits last year and this can counter-balance a lack of transparency and corporate governance in some markets.
Aligning interests
“We are also looking for companies in which management has aligned its interests with ours. This is demonstrated by such factors as the dividend policy. One company in Brazil pays all its employees on the basis of the return on equity, for example.”
 | ‘We saw that South Africa was a cheap market and invested. It has taken a while for the rest of the market to realize this. Sometimes we have to be patient’ - Marc Mobius, Templeton Emerging Markets fund |
Mr Mobius says he has a value investment approach and this means the Templeton Emerging Markets fund under-performs in certain periods. We tend to be more cautious when investing compared to some other funds in the sector,” says Mr Mobius. “This helps to protect the fund’s performance in down periods, however.
We are looking for cheap markets, sectors and stocks. This means we have to be patient to see our valuation potential being met.”
Mr von Rekowsky says he changed the investment approach of the Fidelity Funds Emerging Markets fund when he took over management at the start of 2004. Previously, there were three regional sub-fund managers as well as a lead manager. Now the fund has five dedicated analysts who focus on sectors.
Differing viewpoints
Mr von Rekowsky adds that he can leverage off analysts in Fidelity offices around the world. “For example, I can gain three views on Samsung. One is from the fund analyst, one from a South Korean-based analyst and one from our global technology analyst.”
The fund takes a bottom up stock picking investment approach, says Mr von Rekowsky. A macroeconomic team at Fidelity provides a top down overlay.
When selecting stocks, says Mr von Rekowsky, the team seeks companies “with unique situations such as in terms of pricing power. We look for companies in emerging markets with business models that have worked in developed markets and with a strong market share. This has included banks in emerging markets where consumers are seeking loans for homes and cars for the first time.
“I ask analysts to take a 12 to 18 month view of the outlook for companies. I take the best ideas from each of the analysts and hold them in the fund.”
While he says the fund enjoyed strong positive performance in 2005 and the first half of 2006, Mr von Rekowsky says the stock market environment did not favour the fund’s investment approach in the second half of last year. The Fidelity Funds Emerging Markets fund has returned 11.96 per cent over one year to 12 February 2007 compared to 12.60 per cent by the MSCI Emerging Markets index. But, over three years, the Fidelity fund returned 120.53 per cent against 113.97 per cent by the index.
“After the sell off in May and June 2006, there was a feeding frenzy,” says Mr von Rekowsky. “We avoided stocks that we felt did not offer much value over a 12 to 18 month view. But some of these stocks performed strongly in the last few months of 2006. China, for example, was looking frothy.”
Mr Burrows says the Pictet F (Lux) Emerging Markets fund takes a bottom up investment process with a value bias. “The starting point is that we do a screen to identify cheap stocks across emerging markets.
“The main focus of the screening process is on industrial stocks. This is around 70 per cent of our investment universe. We analyse how companies’ valuations compare against their industrial capacity.
“Once the database produces potentially cheap companies, we do not automatically invest in them. We carry out a fundamental analysis. Among the factors we look at are the strength of the balance sheet, management and use of capacity. Corporate governance is also important. This analysis is partly designed to see why stocks are cheap and if they offer attractive valuations.”
Mr Burrows says a similar process is used for banks with capacity measured relating to deposits. He adds that around 10 per cent of companies are intellectual property stocks. These include pharmaceutical and media companies.
Final check
The final part of the stock selection process is to review the macro economic environment in countries. “This acts as a final risk management check on our stock selection. It is rare that we do not invest in a stock because of this final analysis but it can influence our allocations.”
Mr Burrows points to the fact that while the fund is currently over-weight Turkey, the allocation would have been larger had it not been for some macro economic concerns that are not fully priced into stocks.
The value bias of the fund, which holds 120 to 160 stocks, means it may under-perform other funds in the sector over the short-term, says Mr Burrows. The Pictet fund under-performed the MSCI Emerging Markets index over one year to 12 February 2007 but out-performed over five years.
“We do not chase momentum in this fund or do short-term trading. The turnover of the portfolio is low at 40 to 50 per cent a year,” says Mr Burrows.
“We have suffered on a relative basis over the past year because of the momentum in emerging markets. We look to out-perform over a full business cycle, which is typically three to five years.”
