Emerging markets have been delivering strong performances year-to-date, with the benchmark MSCI emerging markets index up by about 25%, which is double the rise in the MSCI world index. These results for emerging markets are driven by a confluence of factors, according to some fund portfolio managers, many of whom remain bullish about prospects for these markets.
“Number 1: the U.S. dollar has been weakening, and that’s positive for emerging markets because local currencies have more breathing room and countries can cut interest rates,” says Sammy Simnegar, portfolio manager with Boston-based FMR LLC (a.k.a. Fidelity Investments), who oversees Fidelity Emerging Markets Fund. “Number 2: commodities prices have been relatively stable. Number 3: because of the first two factors, earnings [of emerging markets stocks] have been very good in the first half of the year, meeting or beating expectations for the first time in several years. Valuations also have been relatively attractive, while the rest of the world has seen considerable [financial] multiples’ expansion.”
For the next 12 months, Simnegar notes, the MSCI benchmark for emerging markets will be trading at 12.5 times earnings. In contrast, the MSCI world index will be trading in the mid-teens, which amounts to an approximate 25% discount for the former.
But, Simnegar argues, emerging markets’ fundamentals offer a very mixed picture.
“Look at Brazil, where, because of the corruption scandals, [the government] is passing meaningful reform, interest rates are coming down and we’re seeing real structural improvements. Brazil, coming out of the crisis, will be much better than going in,” he says. “On the other hand, Turkey is the opposite. It used to have a disciplined central bank, a pro-market government and so forth. Today, [the government] has been destroying institutions rather than building them. I’ve given two examples at the extremes. But in the next three to five years, the outlook for Brazil is much better than for Turkey.”
Simnegar also lauds structural reforms in India, where the government has cleansed the economy of ill-gotten money by forcing people to deposit large rupee notes, which ultimately ended up in financial services products, and is streamlining the tax system by introducing a general sales tax.
As for China, Simnegar argues, investors shouldn’t bet against China’s authorities: “Are there large imbalances in the economy? Yes. Will [the government] have to deal with [those imbalances] at some point in a meaningful way? Maybe. But with time, if the economy continues to grow, it will gradually ‘de-lever.’ And state-owned enterprises are in better shape than they have been in the past. China’s government has shown an uncanny ability to manage the economy.”
Simnegar, largely a bottom-up investor, admits he prefers countries’ domestic-oriented businesses that have stable growth qualities, good balance sheets and shareholder-oriented management teams: “I’m looking to compound alpha over time, without taking on too much risk.”
From a geographical perspective, about 25% of the Fidelity fund’s assets under management (AUM) are held in Greater China, which includes stocks listed on the Stock Exchange of Hong Kong and American depositary receipts listed on the New York Stock Exchange (NYSE). There also is 13% held in India, 7.5% held in Brazil and 6% held in South Africa, with smaller holdings in countries such as Mexico.
A favourite holding in the 145-name Fidelity fund is Tencent Holdings Ltd., a Hong Kong-listed Internet firm that has emerged as a leader in gaming, e-commerce and payment services in China.
“In 2010, Tencent earned 0.89 renminbi a share. The consensus number for 2018 is 8.5 renminbi a share, which means a tenfold increase,” says Simnegar. “The numbers speak for themselves. That’s what I look for.”
Tencent’s shares are trading at 344.20 Hong Kong dollars ($52.65), or 33 times forward earnings. There’s no stated target.
Another top holding is Housing Development Finance Corp., a leading mortgage and consumer lender in India. “It’s been compounding its earnings at 20% for the past 20 years,” says Simnegar. Shares are trading at 1,750 rupees ($33.40), or 22 times forward earnings. There’s no stated target.
Much of the recent strong performance in emerging markets can be attributed to a so-called “catchup” phase, argues Rishikesh Patel, portfolio manager, India and emerging markets, with London,U.K.-based LGM Investments Ltd., BMO Global Asset Management Corp.’s specialist boutique investment manager covering Asian, global emerging and frontier markets.
“But from a longer-term perspective – five to seven years – developed markets have done better than emerging markets. Maybe [the improving fundamentals in emerging markets] is just a case of reversion to the mean,” says Patel, who co-manages BMO Emerging Markets Fund with Irina Hunter and Damian Bird, senior portfolio manager and portfolio manager, respectively, with LGM.
Although some of the emerging markets have shown robust economic momentum, Patel says, he prefers to focus on structural trends, as he disagrees with Simnegar regarding improving fundamentals: “The fundamental case for emerging markets has not changed. It was the same five years ago and 10 years ago. And it will remain the same for the next five or 10 years. If you look at the world’s population, about 80% is in emerging markets. Yet, emerging markets contribute only 60% of the world’s GDP [i.e., gross domestic product] and only about 10% to 15% of the world’s market cap. That’s where the opportunity of emerging markets lies.”
GDP per capita in developed markets is about US$30,000-US$40,000, but it’s only US$4,000-$5,000 in emerging markets.
“As per capita income rises, it leads to higher consumption. In looking at long-term structural trends, we see several categories in which demand begins to take off when per capita GDP exceeds US$4,000,” says Patel, adding that GDP growth rates in much of Asia are more than double those in developed markets. “We look to exploit those trends and the growing profit pools in emerging markets. There are strong growth trends owing to the larger populations, younger demographics and rising per capita GDP, which will give rise to exponential growth in goods and services.”
Patel, like Simnegar, is a bottom-up stock picker and prefers to invest in domestic-oriented, quality companies that can grow their cash flow over the long term and the stock can be bought at reasonable prices.
“Every now and then, there are opportunities. For example, late last year, we saw opportunities in Mexico, because of the so-called ‘Trump tantrum.’ You could buy great [stocks] at wonderful prices,” he says. “But you have to be brave when everyone is fearful. For us, risk is seen only in the fundamentals and valuations. How well do you know a company and how cheaply can you buy it? Those are the key risks.”
By way of example, Patel points to a company that makes hair oil in India. “Are Indians going to change their patterns of using hair oil because the European or U.S. central banks are going to tighten monetary conditions? Probably not.” Or take a snack-food processor in the Philippines: “Will Filipinos change their diets because the U.S. may tighten? Probably not. So, we ask ourselves: ‘Will the cash-flow patterns of these companies change because of the impact of macro factors?’ Probably, the answer is no. Will markets react? Of course, they will. Understanding the fundamentals of a company is more important than the macro risks.”
From a geographical perspective, India represents the largest weighting in the BMO fund, at 22.8% of AUM, followed by: Indonesia, at 12.9%; Mexico, 12.4%; emerging markets stocks listed in the U.S., 7.9%; and South Africa, 6.6%; with smaller weightings in countries such as Malaysia.
One of the top holdings in the 44-name BMO fund is Yum China Holdings Inc. An NYSE-listed firm with a market cap of US$15 billion, Yum China receives 100% of its revenue from a network of 7,500 fast-food outlets in China that operate under the Pizza Hut, KFC and Taco Bell brands.
Yum China’s shares are trading at US$39.80, or 26.2 times trailing earnings. There’s no stated target.
“Most of Asia is all about rice and noodles. Bread is a very small part of the food plate. But here’s a company that is the most dominant brand of Western-style, quick-service food,” says Patel, noting that the firm was spun off from parent firm Yum Holdings Inc. in 2016. “Bread consumption is a small portion of diets, but it will grow. This is a structural trend that will unfold over a long period.”
Another favourite is Wal-Mart de Mexico SAB de CV, which serves Mexico and much of Central America. “The company is fairly dominant because it has a 25% share of the total retail market,” says Patel. “But, most important, the firm has about 70% of the profits of Mexico’s total retail industry, benefits from Western-style management and corporate governance, but operates in the emerging markets.” The shares are trading at 42.25 Mexican pesos (C$2.92), or 21 times forward earnings. There is no stated target.
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