It has been a difficult year for emerging markets, as China’s once torrid economy has been slowing, Brazil’s inflation is on the rise and worries of the European contagion spreading has sent stocks plummeting. Yet, fund portfolio managers maintain that despite the intense market volatility, valuations are very attractive and the fundamentals will reassert themselves.
“Investors are trying to get a comfort level on the outcome of the drivers in the market,” says Robert von Rekowsky, vice president with Boston-based FMR LLC, a.k.a. Fidelity Investments, and manager of Fidelity Emerging Markets Fund. “Markets have been trying to digest concerns about emerging markets’ inflation. And, starting in September 2010, we became more cautious on emerging markets. We thought they were getting extended in their valuations vs developed markets. People were a little complacent about how much you should pay for emerging-markets equities.”
The lingering European malaise is making investors think twice about emerging markets. “Just as the stock markets thought they were comfortable on [slowing European growth],” says von Rekowsky, “we’ve come back to the issue of whether China is really slowing. There is very little conviction on where the bottom is for expectations for growth. There has been a wave of concern that China was the last ‘growth cylinder,’ and it might be slowing. Stocks with high valuations, which were dependent on China’s growth continuing forever, have come down a notch.”
But, von Rekowsky believes, markets have been subject to indiscriminate selling: “When we see high-quality companies hitting their earnings estimates, and stocks are falling on prospects, we know the baby is being tossed out with the bathwater. We are positioning the [Fidelity fund’s] portfolio with high-quality names at decent valuations.”
Backed by a global team of analysts, von Rekowsky is a bottom-up investor. Although country weightings are a secondary consideration, the largest weighting is in South Korea, comprising 20.6% of the Fidelity fund’s assets under management, followed by China at 15.8%, Russia at 6%, Brazil at 4.1% and smaller positions in markets such as Hong Kong, at 5.6%.
Running a fund with about 200 names, von Rekowsky likes South Korea-based Samsung Electronics Co. Ltd. “[It tries] to be No. 1 in whatever business [it is] in, although sometimes [it] suffers because of that,” says von Rekowsky, noting that the firm’s return on equity is in the mid-teens. “But for the first time, prospects are looking good for Samsung’s three main businesses: the memory space, handsets and tablets, and panel TVs.”
Samsung’s stock is trading at around 945,000 won ($849) a share, or 10 to 11 times earnings and less than two times book value.
Another favourite in South Korea is Hyundai Motor Co. The automobile firm has grown rapidly in the U.S. and Europe, and has taken market share from domestic and other foreign players. Hyundai’s stock is trading at about 228,000 won ($205) a share.
Emerging-Markets Stocks have been unfairly punished, says Alice Popescu, an associate portfolio manager with Toronto-based AGF Management Ltd. and a member of the team that oversees AGF Emerging Markets Fund: “Since last August, when risky assets came off and the crisis in Europe really started to unfold, we’ve seen a sharp fall in earnings-per-share estimates revisions [for emerging-markets stocks]. And it happened at a much more rapid pace than in developed markets. Typically, this happens when we see a liquidity crunch and uncertain times. The valuations do not reflect the strong fundamentals for these countries.”
Popescu argues that emerging markets were oversold in 2008 on fears of collapsing trade links with the developed world. “This time around,” she says, “unless there is a complete systemic European collapse, the emerging markets will be able to weather the situation well. There would be different forces for growth, particularly on the internal side.”
Popescu, who shares portfolio-management duties with AGF senior vice president Patricia Perez-Coutts, maintains that China is close to ending its monetary tightening process and other countries, such as Indonesia and Turkey, have already started to ease interest rates. “China has a lot of fiscal power, should it choose to stimulate the economy,” adds Popescu. “Fiscal revenue is up 30% year-to-date. [China has] the firepower to protect [itself] against external shocks.”
Meanwhile, Popescu says, valuations are very attractive. Emerging-markets stocks are trading at around 1.4 times book value vs 1.6 times for the developed world. But emerging-markets companies boast an average 16% ROE vs 13% for those in the mature markets. “We believe,” she adds, “that emerging markets are much more sustainable [than those in the developed world].”
Growth-at-a-reasonable-price investors, Popescu and Perez-Coutts do not follow the benchmark MSCI emerging markets index; rather, they focus on firms with consistent ROE. Currently, about 20% of the AGF fund’s AUM is in Greater China (including Hong Kong), 11% in Brazil, 10.6% in India, 10% in South Africa, 6% in South Korea, with smaller weightings in markets such as Mexico.
One of the top holdings in the 80-name AGF fund is Daphne International Holdings Ltd. A leading women’s shoe retailer in China, it boasts 5,100 stores under the Daphne and Shoe Box brands. “[Daphne and Shoe Box] have a national presence, which is unique in the retail space in China,” says Popescu, noting that the firm is a beneficiary of rapidly rising consumer income. “In the first half of this year, [both brands] exhibited 17% same-store sales growth. They have had superior profitability growth, putting them in the top quartile of their peers.”
A long-term holding, Daphne International’s stock is trading at about HK$8 ($1.02) a share. Popescu has no stated target.
Another favourite long-term holding is Brazil’s Lojas Renner SA, a large retailer of apparel and furniture. “In this [uncertain economic] environment,” says Popescu, “same-store sales have grown 10% in the first half of the year.”
Lojas Renner stock is trading at around 16.8 times 2012 earnings, at about 54.75 real ($31.50) per share.
Although Valuations have become more attractive, the uncertainty surrounding the European sovereign-debt crisis is creating a significant headwind, says Jai Jacob, director with New York-based Lazard Asset Management LLC and a portfolio manager on the team that oversees BMO Emerging Markets Fund.
“Valuations need traction in order to deliver asset price returns,” says Jacob, noting that the benchmark MSCI emerging markets free index is trading at around 10 times earnings. “But with this degree of uncertainty, valuations often are ignored. Even a certain outcome that is known to be bad is preferable, from a valuation standpoint, to an uncertain outcome. Once the ability to measure risk and reward becomes clearer at the company level, the relevance of valuation metrics should increase.”
From a security-selection viewpoint, the Lazard team is seeing attractive entry points in the markets. “But the risk is not specific to companies, but [to] the global environment,” Jacob adds. “Once we have some certainty, good or bad — coming out of Europe, among other things — valuations are likely to gain traction. To use an analogy, it’s like a wheel spinning a few inches above the ground: when the wheel hits the ground, we will have some progress.”
The Lazard team has not been so bullish since March 2009. Says James Donald, managing director of Lazard and co-manager for the BMO fund: “But if we have a major shock, such as a European debacle, or another surprise, we could easily have another leg down in markets. On the whole, barring that, the risks are very much to the upside.”
From a strategic perspective, the Lazard team uses a balanced approach and splits the BMO fund’s portfolio-management methodologies in the belief that different methods work better at different times. The style mix typically follows a 60% value/40% GARP pattern; but lately, the fund has shifted away from value, which now represents 55% of its AUM, and toward growth, which accounts for 45% of AUM. Although Jacob and his team determine the allocations to each strategy, Donald runs the value team and portfolio manager Kevin O’Hare manages the growth side of the 138-name BMO fund’s portfolio.
On a geographical basis, about 18.8% of the BMO fund’s AUM is in Brazil, followed by 11.4% in Russia, 9.8% in China, 9.2% in South Africa and 9% in South Korea, with smaller holdings in markets such as Taiwan.
One representative value name is Philippine Long Distance Telephone Co. The largest cellphone provider in that country, it has boasted ROE greater than 30% for the past four years. “It’s very stable, which is one of the things we really look for,” says Donald, adding that the long-term holding has a 5% dividend yield.
PLDT’s American depository receipts, which are listed on the New York Stock Exchange, are trading at about US$56.40 ($56). Donald has no stated target.
On the growth side, the Lazard team likes Cie Lojas Hering SA, a leading department-store chain in Brazil. Its same-store sales are growing by more than 20% a year and the firm boasts 30% return on invested capital.
The shares are trading at about 36.9 real ($21.40) apiece. IE