Low interest rates and an oil-sensitive economy mean Canada shouldn’t be the only place where clients invest. Here are five other markets to consider.
1. Mexican fixed income and equities
Jean Charbonneau calls Mexico a model market. “It’s one of the most stable emerging market economies,” says the Toronto-based portfolio manager with AGF Investments. The country’s rated at BBB+.
Gustavo Galindo, a senior portfolio manager with Russell Investments in New York, adds Mexico has a wage advantage. Chinese workers, traditionally global manufacturing’s backbone, are demanding higher wages than Mexican workers, so “the labour cost disparity will continue to provide incentive to shift production to Mexico.” Car companies, in particular, are diving in; data service fDi Markets found that, in 2013, Mexico’s auto industry received more foreign direct investment than China’s for the first time.
These changes bolster firms serving the middle class. “Cement company Cemex will benefit because there will be demand for housing,” says Galindo. And, he likes telecom América Móvil, since “more middle-class people means more cell phones.”
He warns, “Valuations are high because the market’s aware of these trends, but the growth opportunity is large enough that there will be a chance to find attractively priced stocks.”
Mexico only has 60 equity names, and a few dominate the benchmark, including América Móvil. “If you don’t like them, you don’t like a big portion of the index,” he says, making the market ripe for stock pickers.
The government’s reliance on oil revenues means low oil prices are challenging the country. Fortunately, “the Mexican government has hedged the price for 2015, but not 2016,” Galindo says. “At least this year, they should be fine; next year, they’ll know what they’re getting into when they write the budget.”
Charbonneau’s emerging markets bond fund owns both dollar- and peso-denominated government bonds, and he’s overweight Mbonos (the peso version) by 2%. “The fundamentals are the same,” he says. “But, the 10-year Mbonos are yielding 5.8%,” while the Mexican USD 10-year bond yields 3.2%. “There’s an additional 2.6% in going locally, [because] the USD-denominated bond is driven by the U.S. yield curve.” He adds that Mexican bonds are on the cheap side.
As for corporate bonds, he likes América Móvil. It issues A+ bonds in USD, and its 7-year bond yield is 2.7%—almost 100 bps more than the comparable U.S. Treasury.
2. European equities
The low-vol approach
Jean Masson, managing director of TD Asset Management in Montreal, is “a little underweight Europe, and a little overweight the U.K.” That’s because volatility’s lower in Britain.
“Given today’s high government and household debt, investing in less-volatile equities makes sense.” To that end, Masson avoids extremely expensive companies, saying many tend to exhibit higher volatility.
Thanks to these principles, “We tend to have underexposure to the financial sectors of [continental] Europe,” he says, since a possible Greek default is creating uncertainty. Instead, he’s exposed to British banks and insurers. He also likes water and power utilities for their low volatility.
He does like strong European brands. One is William Demant Holding Group, a Denmark-based hearing aid manufacturer with global reach. “It’s not sensitive to market ups and downs. People replace hearing aids when they don’t work, or [get one] when they start having hearing problems. Anybody who can afford top quality would consider their products.”
Masson also holds Porsche. “The cars are exciting, but the stock is boring, and we go for boring,” he says. “Porsche is close to 1% in our portfolio.” He likes it because “in good times, they don’t triple their production,” meaning consistent demand.
The value approach
Portfolio manager James Harper, who’s based in Nassau, Bahamas with Templeton Global Advisors, is overweight Europe by 15% to 20%. Low crude prices have depressed valuations in the region, “so we looked at the most price-sensitive names: oil services, engineering and construction companies.”
He realized the market was discounting sub-$50 oil prices “almost into perpetuity. We thought that was incorrect, certainly in a five-year view.” That’s created opportunities, albeit with higher volatility. “These companies are trading at 0.6x, 0.7x book value; below 10x P/E.”
Over the last three months, Harper has purchased Petrofac, an onshore engineering and construction company. “We bought that between £6 and £7, or 8x P/E,” he says. It’s trading at about £9 as of June 9. He also bought Subsea 7, a Norwegian deep-water engineering company, at 0.6x book value, “and we’ve made about 20% to 25%.”
Harper also likes European financials, which stand to benefit when the economy rebounds. “Some companies are discounted 70% to their long-term average multiples. The ones we’re looking at are reducing risk-weighted assets, cutting costs and driving returns up organically.”
For instance, Barclays is trading at 0.8x tangible book value. The firm “has a strong franchise in terms of its personal banking and credit card businesses.” He says the credit card business makes a 23% return on tangible equity, while personal banking makes 17%.
Its investment banking business, however, is struggling due to increased regulation; its overseas businesses are also making low returns. “The market is focused on those short-term issues, but on a five-year view, this could be a much stronger business.”
Harper has been underweight utilities in Europe and globally “for a while. We’re not finding value. Dividend yields have been growing in other sectors, and it seems irrational to pay up in a highly regulated industry.”
3. Russia and frontier market equities
Unloved markets create opportunities for value investors, says Louis Lau, director of investments at Brandes Investment Partners in San Diego, Calif.
He says FactSet data pegs the MSCI Frontier Index’s forward P/E ratio at 10.8x, compared to 16.6x for the MSCI World. Russia’s ratio is 5.8x (Canada’s is 17.7x).
Lau is overweight Russia by 8%. The country, which has a benchmark weight of 4%, has suffered due to a weak currency, conflict with the Ukraine and low oil prices. “The bulk of our allocation is oil companies that are dollar revenue-generators. [Yet] the market treated all [oil] companies as ruble-denominated, and sold them as the ruble depreciated.” He says these companies “can preserve cash flow by reducing capital expenditures.”
He also owns shares in the country’s biggest bank and a commercial railway. “Most positions are large companies that we believe can outlast the downturn.”
Low oil prices have also hurt Nigeria’s and Oman’s oil producers, which have higher costs than extractors in other countries. So Lau says it’s a good time to buy in those frontier markets. And, both countries have experienced political upheaval, creating further uncertainty (and opportunity).
He looks for a significant discount to present value for most companies, but, “if it’s a high-quality company, trading in a good [region] with few political issues, we could make do with a lower discount.” Equity costs in emerging markets average 12%, so he picks discount rates “that mean you can outperform that cost of equity in the next year. And if you need to revise down company value, you have a cushion.”
Lau says these riskier investments can be worthwhile. The MSCI Frontier Index returned 30% for the year ended Sept. 30, 2014, compared to 12.2% for the MSCI World. And, he says, “You have [GDP] growth simply from catching up to developed markets, or even to emerging markets. For example, only 35% of households in Kenya have a colour TV.”
Frontier names are volatile, “so you need to hold these companies for [at least] three to five years.” The benchmark weight for frontier markets in a global equities portfolio is 0.3%, and Lau recommends going up to 1%.
4. Japanese equities
For more than two decades, equity investors shunned Japan. But the country’s stock market has boomed since late 2012, says Eileen Dibb, portfolio manager at Pyramis Global Advisors, a Fidelity Investments company, in Smithfield, R.I.
“Japan is a lot more business-friendly than it was before the Abe administration,” she says. New policies encourage more dividend payments, broader dialogue between shareholders and management, and better corporate governance.
The country also has a labour shortage, thanks to flat population growth. “That’s important, because one key thing to getting Japan going is wage hikes. We’ve seen deflation for many years.” She adds firms will look for workers domestically, since “a lot of what could have moved overseas [to lower-cost locations] already has been.” Against this backdrop, Dibb likes pharmaceuticals and automakers. Pharmas lagged for many years as their patents expired, she says, “but we now like the sector because there are several companies with strong [drug] pipelines.” Her second-largest holding, as of Dec. 31, 2014, is Astellas Pharma, which makes popular cancer and overactive bladder drugs.
For instance, “XTANDI, which treats prostate cancer, is a drug with a global franchise.” Another pro: “Astellas is improving margins faster than expected, and has excellent free cash flow.” As of Dec. 31, Dibb’s Japan-Canada fund is 3% to 4% overweight pharmaceuticals.
Toyota was her top holding at year-end, and 14.6% of the fund is in auto components and automobiles as of March 31, 2015. The TOPIX Index allocation was 12.7%. Autos “are relatively inexpensive; they have good product cycles and they’re weak-yen beneficiaries.” (Dibb notes the overall market tends to do well when the yen’s weak.)
Dibb encourages being at least neutral on Japan, saying, “The risk is being underweight.” The country’s benchmark weight in a global portfolio is 10%, and 20% in an EAFE portfolio.
Jérôme Teïletche, head of Cross Asset Solutions at Unigestion in Geneva, is overweight the country by 3% to 6%, depending on the portfolio. “Japan is one of the last markets that is not expensive,” he says. “There has been structural improvement, and we’ve been adding to our [equities] position” through futures and ETFs.
How Politics impact markets
Chief investment officer at BMO Private Bank in Chicago
Issue 1: U.S. presidential election
Ablin: Hillary Clinton will likely win the Democratic nomination; it’s not clear who’ll be on the Republican ticket. “I would say the election is a non-event for the markets.”
Dalpé: “Whoever gets elected, Republican or Democrat, I don’t think it’ll have a lasting impact on markets.” A key reason is the executive branch has limited powers, except under extreme circumstances like war or financial crises. “It’s not like Canada, where if there’s a majority, the prime minister can do pretty much whatever he wants.”
Issue 2: Russia-Ukraine
Ablin: The situation affects European access to natural gas. And, “initially, we saw corn prices rise dramatically. Ukraine is one of the biggest producers of corn, so there was fear [it] would be taken out of the market in some way. But that has since abated.” He adds investors often react to headlines, “but if a headline doesn’t stay in the news, it tends to be forgotten.”
Dalpé: It’s less volatile than earlier in the year. Some argue the turmoil presents an opportunity to invest in Russia: its market “got clobbered in the last 12 months” because of the Ukraine situation, combined with halved oil prices and a falling ruble. While Dalpé says this analysis is probably correct, he’s staying away. “We touch pretty much everything, but we don’t touch Russia.”
Issue 3: If Iran gets the bomb
Ablin: “It changes the calculus on geopolitics, but I’m not sure how it would translate into an actionable investment thesis.”
Dalpé: If Iran gets the bomb, the country will be constrained by the same logic that kept the U.S. and Soviet Union from firing nukes: mutually assured destruction. That said, the bomb would enhance Iran’s power and status in the Middle East, which would mean more leverage and bargaining power.
Issue 4: ISIS
Ablin: “I don’t think it’s impacting investment strategies yet. It’s a geopolitical uncertainty, so you’ll see knee-jerk reactions.”
Dalpé: Many argue ISIS is attempting to establish a state on defined territory. “That’s why there seems to be more of a concerted effort to attack the situation. Arab countries are getting publicly involved to limit the growth of this organization, perhaps because they feel it has more traction than others.” He says it’s likely impacting markets, but the effect is hard to quantify.
Interviewed by Dean DiSpalatro, senior editor of Advisor Group
5. Brazilian equities
Galindo is overweight Brazil. “It’s been painful while the real is stabilizing, but the opportunity for strong franchises to recover is massive.” Lau agrees, citing the country’s forward P/E ratio of 12.2x, according to FactSet data. “This is toward the low end of the emerging markets,” he says, adding Brazil’s been at 14x or 15x, historically. His fund has a 19% allocation to Brazil, compared to the 8% benchmark.
Political gridlock, along with a recent corruption scandal involving oil giant Petrobras, doesn’t worry Lau. “People are concerned [president] Dilma [Rousseff] doesn’t have the support to pass fiscal tightening measures,” he says. “But the measures, including increasing taxation, trying to move from a budget deficit of 4% to a surplus of 1.2%—those are driven by the capable finance minister, Joaquim Levy.”
As for the scandal, Galindo says, “Petrobras will eventually emerge. It’s already been beaten down significantly, so it looks really cheap.” The company has also benefited from low oil prices, since it subsidizes the fuel for Brazilians. “When oil was expensive, Petrobras was losing money. Now, it’s not politically painful to remove that subsidy.”
Lau adds Brazil is experiencing its worst drought in more than 80 years. “The reserve levels are about 20% of what they used to be, which is why we own a water utility,” he says. “There are pockets of value in Brazil, simply because the sentiment is so bad.”
Galindo warns the country’s disparity between rich and poor is concerning. “The only way to close that gap is with economic growth, [so] the poorest have more opportunities,” he says. “That’s how it’s happening in Mexico and China.”
When to account for geopolitics
Louis Lau of Brandes Investment Partners invested in a steeply discounted tobacco company when Egypt was on the brink of a military takeover. “[We] buy stable companies like consumer staples and telecoms where demand is relatively inelastic, and ride through instability.” Once the situation’s resolved, the price often moves back to intrinsic value. Lau avoids investing where company value is highly likely to be impaired.
Melissa Shin is deputy editor of Advisor Group.
Originally published in Advisor's Edge Report
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