While developed markets are plagued with uncertainty as a result of this past summer’s credit crunch and concerns about a U.S. economic slowdown, emerging markets are pulling ahead. Indeed, some fund managers maintain, compared with past years, the roles are reversed; the prospects for emerging markets are the more robust.

“In many ways, it is a reversal of the 1997-’98 situation,” says James Upton, senior portfolio specialist for the emerging markets group at New York-based Morgan Stanley Investment Management Inc. and a member of the team that oversees TD Emerging Markets Fund, offered by TD Asset Management Inc. of Toronto. “Then, the trouble began in Asia, spilled over into Russia and spread to the U.S. with the Long-Term Capital Management LP crisis.

“Back then, the troubles in emerging markets negatively affected developed markets,” he adds. “This time, the U.S. subprime mortgage meltdown and credit crunch have negatively affected emerging markets, but not for any fundamental reasons.”

The earnings power of many companies in emerging markets is in good shape, he adds: “While we have had the occasional day when emerging markets responded to events in the U.S., investors have gained perspective and are looking at the underlying health of these markets. The re-rating of emerging markets is back on track.

“They deserve to have higher multiples and higher values,” he says. “For several years, we have had steady economic growth, current account surpluses and currencies have been appreciating over the past few years, while the U.S. dollar has been weakening.”

The bull market rally is five years old, he admits, but it has been driven by earnings growth. “The part that has not yet occurred is the multiple expansion phase,” he observes, adding that the MSCI Emerging Markets index is trading on a forward price/earnings ratio of 12 times, roughly in line with developed markets.

“If you look at other long-run rallies, such as the Nikkei 225 index, multiples only expanded in the second phase. We haven’t seen that in emerging markets,” he says. “In our view, trading should be at a premium, when you consider that earnings overall are strong and healthier than in much of the developed world. Until they are trading at a very sharp premium, this rally is not over. When they are trading at 30%-40% over developed markets, that’s when stocks will be expensive.”

Using a blend of top-down and bottom-up investment styles, Upton and lead manager Ruchir Sharma, managing director at Morgan Stanley, tend to overweight stocks in countries with superior macro-economic conditions.

“Taiwan, South Korea and Malaysia don’t have the dynamic level of growth they had in the past,” Upton says.

Conversely, the team is overweighting China at 19% of the fund vs 15.5% in the MSCI Emerging Markets index, Russia at 9.5% vs 9% in the index, India at 9.9% vs 6.9%, Turkey at 3.7% vs 1.7%, Mexico at 6.1% vs 4.9% and Poland at 4.2% vs 1.7%.

One of the top holdings in a 150-name fund is Sberbank, a leading retail and commercial bank in Russia. “It combines our view on the catalysts that are driving the Russian market, where we have seen growth in the access to credit and a dramatic rise in consumption in the past seven years,” says Upton. “GDP per capita has nearly quadrupled, to about US$10,000 a person. That has brought a dramatic increase in consumption, lending and borrowing. All these things are at their beginning stages.”

The Frankfurt-listed stock recently traded around 366 euros a share, compared with 270 euros a share at the beginning of the year. Upton has no stated target.

Another large holding is China Construction Bank. “For us, it is a good example of a company that benefits from all the positive macro-economic developments taking place in China,” says Upton. “It’s attractively valued relative to the rest of the market.”

Although the financial services sector has been hurt because rising inflation has caused the Chinese central bank to raise interest rates, Upton expects inflation to subside from its current 6% and financial stocks to rebound. The Hong Kong-listed stock recently traded around HK$7.70 a share, vs HK$5 a share at the beginning of the year.



Equally upbeat is Pablo Salas, manager of CI Emerging Markets Fund, offered by CI Investments Inc. , and managing director of Trilogy Global Advisors LLC in Orlando, Fla.

@page_break@“From the macro perspective, the asset class is in much better shape than in the 1990s,” he says. “When you look at the large countries in the MSCI index, their macro-economic conditions are better than in developed countries, whether these are the U.S. or Japan.”

He notes that debt/GDP ratios for many emerging markets are less than 60%, vs Japan with a ratio of more than 100%.

As well, government bond yields are close to what Canada and the U.S. pay on their long-term debt. “This reflects strong financial conditions,” says Salas, adding that most leading emerging markets firms can borrow at the same low rates as those in developed markets, which reflects their strong balance sheets.

One of the big challenges facing emerging markets, however, is that their strength has largely been on the commodity side. They have benefited from high oil, steel and energy prices that have been driven by the China growth story.

“The challenge to this solid environment is if there is any slowdown in the Chinese economy, it could result in not as strong a demand for oil or materials,” says Salas. “This is a risk.”

For now, however, there are no obvious indicators that a slowdown is imminent. “The big picture still looks OK,” he adds.

From a stock perspective, Salas argues that most sectors trade in line with their global peers: “There is no longer a discount. A lot of the fundamentals are priced into the stocks. The question is: what happens from here? The issue of sustaining the growth rate is becoming more critical.”

Indeed, to outperform global stocks, emerging markets have to be re-rated upward or generate higher earnings growth. Salas notes that if emerging markets meet expectations for stronger growth, investors could see attractive returns. “But, if for some reason they don’t, I expect emerging markets stocks will perform in line with global markets,” he says.

Salas does not think there is much downside risk, as emerging markets are trading at P/E multiples of 13-14 times and earnings continue to come through. “It’s not like the technology bubble days,” he says. “There are reasonable multiples.”

Still, he notes one major exception: Chinese stocks are trading on average at 28 times earnings, which makes them the riskiest. “That is the one main market in which we are cautious,” he says. The fund’s exposure to China is about 6%.

Meanwhile, the fund has an overweighted 13% of assets in South Africa, 6% in Turkey and 11% in Russia. There are index-neutral holdings in Taiwan at 12%, South Korea at 16% and slightly underweighted positions in Brazil at 10% and Mexico at 3.5% (and smaller weightings in countries such as the Czech Republic).

A bottom-up investor, Salas is running an 88-name fund. One of the larger holdings is South Africa’s Standard Bank. “It operates in a near-oligopoly, and GDP growth has been healthy for the past few years,” he says. “You have an environment with strong credit growth. Rates have been going up but, in absolute terms, they are much lower than in the past.” The bank has a return on equity in excess of 20%.

Bought about two years ago, the stock recently traded around 104 rand a share. Salas’s 12-month target is 127.50 a share.

Another favourite is Turkcell Iletisim SA. The firm is the leading wireless network operator in Turkey and its earnings have been growing at about 15% a year. “There is a lot of room for growth,” says Salas, noting that Turkey’s wireless penetration is less than 60%. Purchased a couple of years ago, the stock trades as an American depository receipt on the New York Stock Exchange. Its recent share price was US$21.85; his 12-month target is US$25 a share.



Asia remains the place to allocate money, but there are growing concerns about the red-hot Chinese market, according to Patricia Perez-Coutts, manager of AGF Emerging Markets Fund and vice president at AGF Funds Inc. in Toronto. About 55% of the fund is in Asia — including 15% in China and 7% in India — and 28% in Latin America, 10% in a mix of European and South African names and the balance in cash.

“Since the beginning of the year, we have been increasingly favouring companies in countries such as Thailand, where our weighting is close to 7%,” says Perez-Coutts, a value-oriented investor.

“We’ve moved up our South Korean holdings to 12% from 9% — at the expense of some Chinese companies,” she adds.

The most prominent divestiture was China Mobile Ltd., the largest wireless operator in China. Perez-Coutts bought the Hong Kong-listed stock more than four years ago at around HK$5 a share and sold out last spring at HK$80 a share, only to see it rise to HK$154 a share.

“There is a massive liquidity binge in the Chinese market,” she says, noting that as Chinese nationals have been permitted to invest in Hong Kong it has unleashed a huge buying spree.

“We are not unhappy, because we have done well elsewhere,” she says. “But we feel more comfortable with companies that have better growth profiles, better fundamentals and more reasonable valuations.

“Some natural resources stocks are trading at 40 or 50 times earnings, which we cannot justify,” Perez-Coutts adds. “Just because valuations are where they are because of excessive liquidity and not the fundamentals does not mean exposure should go up. We are seeing bubble-like characteristics in the Chinese market.”

Running an 83-name fund, she favours China Overseas Land & Investment Ltd. A real estate developer and home builder, it is capitalizing on China’s plan to move about 200 million people from the countryside into urban centres.

The company is also a turnaround story, Perez-Coutts says, as it has transformed itself from a Hong Kong developer to one that operates mainly in China. “We’ve met with management and feel comfortable with the sustainability of its operating margins, which are around 30%,” she says.

Bought more than five years ago at around HK$2 a share, it was recently trading around HK$17 a share. Perez-Coutts believes its net asset value is HK$20 a share and, therefore, foresees an additional 17% upside in about 12 months. IE