Sector Watch: Emerging markets poised for growth?

For example, he notes, markets in Indonesia and India have been buoyed by the election of reform-minded leaders. In addition, some central banks were hawkish at the end of 2013 and began to raise interest rates.

“There were policy adjustments that coincided with the so-called ‘tapering’ scare around the U.S. Federal Reserve [Board],” says Nemmoe, who shares portfolio-management duties with Irina Hunter, senior portfolio manager at LGM. “So the backdrop was probably better coming into 2014.

“But the most important argument is the realization that the world was not coming to an end,” he says, referring to fears last year that the end of quantitative easing in the U.S. would be bad for emerging markets.

Although Nemmoe argues that it’s important not to regard emerging markets as a monolithic block, he also believes that markets, in general, are looking through the risk factors, such as rising interest rates in the U.S. and economic weakness in Europe.

“For more domestically driven economies, such as India and Indonesia, that have already pre-emptively tightened monetary policies, a hike in U.S. interest rates and a weak Europe should not be too much of a headache,” Nemmoe says. “But the elephant in the room is the U.S. dollar [US$]. Emerging markets historically have traded inversely against the US$. When you see a stronger US$, that means there is less liquidity flowing into the sector and, historically, they tend to correct – and vice versa.”

From a company-specific perspective, Nemmoe argues that many emerging-markets players are holding their own: “We have had a little bit of multiple expansion this year. But the bulk of the performance has been driven by earnings and cash flow growth.”

Nemmoe is a bottom-up investor. About 34% of the BMO fund’s assets under management (AUM) has been allocated to consumer staples, 28% to financials and 14.4% to consumer discretionary, with smaller amounts in sectors such as technology. From a geographical perspective, India accounts for the largest holding in the BMO fund at 21% of AUM, followed by the Philippines (11%), Indonesia (10%) and Mexico (10%). There are smaller holdings in countries such as South Africa.

A top name in the BMO fund’s 46-holding portfolio is Commercial International Bank (CIB), Egypt’s largest private-sector bank.

“Its return on assets has been above 1.8% every year since 2005, which is extremely high in the emerging markets context,” says Nemmoe. “Despite the Arab Spring, asset quality has been relatively stable. And [CIB has] a very strong focus on costs.”

CIB’s global depositary receipts, listed on the London Stock Exchange, trade at about US$6.40 ($7.40) and pay a 2.3% dividend.

Philippe Langham, head of emerging-markets equities with London-based RBC Global Asset Management (U.K.) Ltd. (RBCGAM/UK) and lead portfolio manager of RBC Emerging Markets Equity Fund, is equally bullish. He also points to the election of reform-minded governments in India and Indonesia as a positive sign.

“As these more investment-friendly governments start to implement policies, we can expect to see reforms,” says Langham. “These improvements are likely to feed through to better economic growth and, by extension, better earnings growth.”

Langham prefers to look at least three to five years out rather than making dicey, near-term forecasts. On that basis, he is optimistic. “The reforms by investment-friendly governments will have a major impact over the medium term,” says Langham, who works with Zeena Dahdaleh, associate portfolio manager, and Laurence Bensafi, portfolio manager, with RBCGAM/UK.

For example, Langham points to China’s move away from state-owned enterprises and its greater emphasis on the private sector. “That is likely to lead to improvement in returns on capital,” Langham says. “There has been overinvestment for several years. It’s clear to policy-makers that they need to move toward consumption, although these policies need to be implemented gradually.”

Langham believes that today’s low valuations could remain that way for a while. “[The] price to book [ratio] has been around 1.5 times, which is lower than the historical average,” he says, adding that there is a discount of 25% or more in emerging markets compared with developed markets. “But valuations can stay low for some time. It needs an improvement in fundamentals to drive them higher – although I believe we are likely to get that improvement over the coming years.”

A bottom-up investor, Langham has allocated about 29% of the RBC fund’s AUM to financials, 16.7% to information technology, 16.1% to consumer discretionary and 12.4% to consumer staples, with smaller weightings in sectors such as industrials. Geographically, India accounts for 12.7% of AUM; China, 11.9%; South Korea, 9.6%; and Taiwan, 9.2%. There are smaller holdings in countries such as South Africa.

A top holding in the 63-name RBC fund is Credicorp Ltd., Peru’s largest bank with 35% of deposits in that country. “Having such a large market share gives it a very sustainable funding advantage,” says Langham, adding that the bank should benefit from low levels of credit in Peru.

Listed as an American depositary receipt on the New York Stock Exchange, Credicorp stock is trading at about US$148.90 ($172.45) a share or 16 times trailing earnings, and pays a 1.2% dividend. There is no stated target.

Another favourite name is SABMiller PLC, the world’s second-largest brewer, which is based in South Africa and poised to capture fast-growing markets. “The majority of its revenue come from emerging markets and it has industry-leading positions,” says Langham, noting that the firm also has exposure to early-stage growth markets such as India. “Forty-four percent of its earnings come from areas [in which] beer per capita consumption is 60 litres per annum, which is relatively low compared with developed markets.”

SABMiller stock is trading at about ZAR 57,856 ($5,872) a share.

But slowing economic growth may be cause for caution, argues Alpha Ba, vice president at Toronto-based AGF Investments Inc. and portfolio co-manager of AGF Emerging Markets Fund. Ba works with Stephen Way, senior vice president of AGF.

“The U.S. has been growing slowly, and Japan and Europe have been slowing to almost recession levels. Meanwhile, we’ve had consistently negative revisions in growth expectations for emerging markets,” Ba says. “Last year, [emerging markets’] gross domestic product [GDP] grew by 4.8%, but this year we’re looking at 4.4%. Global GDP growth is expected to be static this year at about 3.3%. But we’re expecting some downward revisions because, going into the year, we had hoped for an acceleration of growth.”

With equities markets in a volatile state this autumn, Ba describes the asset class as “muddy.” Moreover, there are worries about rising interest rates in the U.S., which would make financing more costly in emerging markets. Also, there are concerns that countries such as Turkey and South Africa have been slow to implement structural reforms.

Still, Ba believes there are positive signs, such as India reducing its current account deficit to 1% of GDP from 5%. “On top of that, we had a good prime ministerial election result this year,” he says. “[Indians] have elected a reformist whose initiatives include lowering food and fuel subsidies and opening up to foreign investment. “

In the same vein, Ba points to reforms in Mexico – particularly, in the oil industry – which now is open to foreign investment, and to China’s efforts to shift the focus away from infrastructure and exports and toward domestic consumption. “That entails a slowdown. But it’s a healthier, more balanced way to grow in the future,” says Ba.

A “growth at a reasonable price,” bottom-up stock-picker, Ba has allocated about 30% of the AGF fund’s AUM to consumer cyclicals and consumer staples, 25% to financials, 12% to energy and 11% to technology, with smaller weightings to health care and industrials. From a geographical perspective, China and Hong Kong account for 17.6% of the AGF fund’s AUM; South Korea, 13%; India, 12.7%; and Brazil 10.4%. There are smaller weightings in countries such as Thailand.

One top name in the 67-holding AGF fund is Lupin Ltd., an India-based pharmaceuticals firm that is evolving from a generics producer to a global speciality drug-maker.

“That growth into attractive niches is margin-accretive, because those niches have higher margins,” says Ba, adding that the firm is producing anti-tuberculosis and cardiovascular drugs.

Lupin stock is trading at 1,340 Indian rupees ($24.50) a share, or about 24 times forward earnings. Ba believes the stock has 15%-20% upside over the next 12 to 18 months.

Another favourite name is Localiza Rent-a-Car SA, Latin America’s largest car rental and fleet-management firm, which is based in Brazil. Besides having a dominant position in the region, Localiza excels at making profits from selling its fleet every year. “[Localiza] has a 13% cash flow return on investment and generates 28% return on equity,” says Ba.

Localiza stock is trading at about 36.20 Brazilian reals (BRL) ($16.50) a share, or at 4.4 times book value. The 12- to 18-month target is about BRL 44 ($20) a share.

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