After a punishing financial crisis in the developed world, some wonder if emerging markets are still good investments.
Ashish Swarup, portfolio manager of the Fidelity Emerging Markets Discovery fund in London, says core emerging markets—Brazil, Russia, India, China and Indonesia—are still emerging. But the factors driving their growth today are different than they were 10 or 15 years ago.
“Today,” he says, “countries like India and Indonesia are driven by domestic consumption growth; China is driven by high fixed-asset investment growth, while Russia and Brazil benefit from higher resource prices.”
Swarup diversifies across countries at different stages of development. His biggest country weightings (as of September 30, 2012) are:
- South Korea (20.9%)
- Brazil (11%)
- Indonesia (8.4%)
- Russia (7.7%)
- Hong Kong (7.1%)
- China (6.2%)
- India (5.8%)
His largest sector concentration is financials (22.9%), followed by information technology (13.6%), materials (11.4%) and consumer discretionary (11%).
Diversification mitigates political and economic policy risk in any market. Some countries such as Argentina and Pakistan, he says, have stalled “because they failed to enforce property rights, educate their population, invest heavily in fixed capital formation and implement a favourable legal and macro-policy environment.”
Gauging risk at the company level is tricky. Many companies in emerging markets have short operating histories and less-evolved corporate governance and disclosure standards. Also, legal protections for minority shareholders’ rights are not as robust.
Swarup says it’s important to talk with management and board members, and to conduct background checks on them. He avoids companies whose founders or principal shareholders got rich illicitly or have political connections, or those conducting inappropriate transactions with related private companies.
He likes to see quality, independent directors and auditors, as well as management compensation structures aligned with minority shareholders and a history of fair capital allocations and M&A activity.
His firm has a dedicated team in India for forensic accounting and background checks, and 30 emerging markets analysts in Boston, London and Hong Kong. They’ll spend around six months doing due diligence on a company.
A new consumer class
Bhim Asdhir, founder and CEO of Excel Funds in Mississauga, believes emerging markets are quickly transforming into consumption stories.
Asdhir, who was born in India, says India and China have reached a point on the Global S-Curve, where domestic consumption starts growing exponentially. He adds his former neighbourhood in New Delhi had only two TVs 10 years ago, but now has two in each home.
“At about US$1,000 GDP per capita, people start having disposable income,” he says. “Increased spending provides governments with more money to invest in infrastructure development, and this improves efficiencies; companies employ more people and wages increase, and this has a multiplier effect on consumption.”
He’s focusing on domestic consumption: As these markets move up the value chain, consumer-oriented companies become more attractive than industrial-oriented companies.
“Sometimes those companies are just outside the index, so you need portfolio managers on the ground in these markets to find them.”
Both fund managers search for valuations that leave a wide safety margin to account for risk. “If you look at Chinese companies,” Asdhir says, “their average 12-month forward P/E ratio is 9x, while the historic average is about 13-14x, which means they’re trading at a 30-40% discount. Yet their earnings are growing at 13-15%.”
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The same is true in India, he says. He considers Indian consumer-oriented companies especially compelling because India’s global share of middle-class consumption is only 5%, but the United Nations expects it to rise to 50% by 2050. The $10 Trillion Prize, a new book from Harvard Business Review Press, predicts consumer spending in India and China will triple by 2020.
“When you see equity valuations in these markets this attractive,” he says, “you should jump in.”
Excel’s flagship India fund, which aims to capture alpha through an active, bottom-up management style, has returned 287% (in CAD) since its inception in 1998. Its benchmark Sensex index has returned 142% over the same period.
Asdhir has other reasons to be excited about India and China, too: GDP growth three times higher than in developed countries; rising employment; and young demographics.
Plus, their currencies are stable or appreciating, and their debt is relatively low and under control compared with Western countries because their banks are mostly traditional banks. This is reflected in their strengthening credit quality.
Other emerging countries are enjoying debt-rating upgrades also, including Russia, Brazil and Mexico. Today, Asdhir notes, “debt in emerging markets is 60% investment grade, but in 1993 that number was about 2%.”
Their resilience since the global financial crisis is in sharp contrast to bonds in developed countries like Greece, Spain, Portugal and the United States, which have experienced credit-rating downgrades.
Excel expects emerging-market debt ratings to improve over the next decade, driven by domestic growth, strong foreign-exchange reserves and low sovereign debt levels.
Recent upgrades—Fitch just deemed Turkey’s sovereign debt investment quality—together with low nominal and real rates in developed countries means emerging markets will see lower borrowing costs and continued inflows to both credit and equities.
“When you look at emerging markets right now,” he says, “you find they are high-return, low-risk propositions, which is quite different than 15 years ago.”