Emerging-markets stocks have demonstrated considerable resilience since this past spring, outpacing the rebound in the developed world by a two-to-one ratio. Indeed, fund managers argue there is more upside, given that the fundamentals are superior to those in mature markets.

“We’ve had a pretty good bounce,” says Pablo Salas, manager of CI Emerging Markets Corporate Class fund and managing director of Orlando, Fla.-based Trilogy Global Advisors LLC. The benchmark MSCI emerging-markets index peaked at 1300 in October 2007, dropped to 468 in November 2008 and is now at around 960. “We’re up 100% from the lows,” he adds, “but still around 26% below the peak in 2007.”

There were significant factors behind the market decline, says Salas: “It was one of the worst financial crises that the world has seen in [the past] 30 years. You had a combination of two factors: expectations that emerging-markets earnings would collapse and risk premiums shot up. That meant valuations for many stocks got severely depressed. When the average decline was 70%, a lot of stocks were down even more.”

As events turned out, however, the fears were unfounded. “With the benefit of earnings results from the past two or three quarters,” Salas says, “those fears were exaggerated.”

The fact that earnings have fallen less than expected in some cases, and have continued to go up in other cases, he adds, has meant that some of the rebound has reflected the relative strength of earnings.

On a valuation basis, emerging-markets stocks are trading at 19 times trailing earnings, and at 13 times 2010 earnings. Since 1990, the average price/earnings ratio has been around 17, says Salas, adding that current valuations are fair.

“They’re not as cheap as a year ago, when they hit seven to eight times earnings,” he says. “Given how severe the global downdraft was, there could be some confidence that 2010 could see a strong recovery in earnings.”

A bottom-up investor, Salas runs a portfolio of about 90 stocks. Lately, he has favoured the financial services sector, which accounts for 26% of the CI fund’s assets under management, compared with 23% in the index. One recent acquisition is Power Finance Corp. The India-based firm is a state-controlled lender to the power-generation industry and is a beneficiary of an industry whose capacity is insufficient to meet growing demand.

“It can borrow at a cost of funds that is similar to the sovereign rate,” says Salas. “[And] because it has low funding costs, it generates attractive margins and benefits from a growing pipeline of projects.

“We see loan growth close to 20% over the medium term. On forward earnings, it’s trading at 11 times. It’s fairly attractive in India, and [in] the finance and electricity sectors in the emerging markets,” says Salas, who has no stated share-price target. The stock is trading at around 228 rupees a share.

Another favourite is Desarro-lladora Homex SA (a.k.a. Homex), one of Mexico’s largest home builders. “We see an interesting secular growth [trend] in middle-income and lower-income housing,” says Salas. “Because of the 1990s financial crisis, and lack of financing, the housing supply has not been adequate, and there is a shortfall of over four million homes.”

Thanks to a housing finance program for lower-income earners, low interest rates and growing affordability, the domestic market has boosted sales for Homex, which sells about 60,000 units a year. Salas added to an existing position this past April, when the New York Stock Exchange-listed American depository receipt dipped to US$18 — an all-time low. Currently, the ADR is US$42. “Given the deficit on the supply side,” Salas says, “the company can continue to deliver 15-20% earnings growth for the medium term.”



The robust equities recovery is justified, given the superior fundamentals in emerging markets, argues Tom Leventhorpe, vice president of J.P. Morgan Invest-ment Management Inc. in New York, a client portfolio manager and a member of the team that manages Mackenzie Universal Emerging Markets Class fund.

“Historically, when these crises happen, it has been the fault of emerging markets. Last year, it was the darned Americans, and British, and so on, who took on massive risk and lack appreciation for that risk,” says Leventhorpe, who works closely with lead manager Austin Forey, managing director, global emerging markets, in J.P. Morgan’s London, England, office.

@page_break@“Emerging markets are the ultimate risk assets,” Leventhorpe adds. “Because of an aversion to risk assets, emerging markets were very heavily hit — despite the fact the underlying economic fundamentals have rarely been better. That’s why we have bounced back so well.”

Take, for example, fiscal balances. Leventhorpe points out that the developed markets will have an 8%-10% fiscal deficit in 2009-10 — twice as high as the 4% level in the emerging markets. From the perspective of public debt as a percentage of gross domestic product, the developed markets’ ratios are expected to climb to more than 100% in the next five years from 70% .

“In the developing markets, [the debt/GDP ratio] is around 40% and forecast to remain reasonably stable. And most of the emerging markets don’t have to bear the bur-den of bank recapitalizations. Financially and fiscally, the developing markets are in much better shape,” says Leventhorpe, adding that emerging markets have captured a rising share of global profits, which now stands at about 10% compared with 2% two decades ago.

Bottom-up stock-pickers, Forey and his team seek companies that can incrementally increase their rates of return. Moreover, the J.P. Morgan team is focusing on companies that will benefit, directly or indirectly, from the massive infrastructure spending in countries such as China.

“A lot of the policies undertaken by government are designed to stimulate more rapid growth in their domestic economies,” Leventhorpe says, “given they cannot expect high rates of growth in the global economy to support an export-led model.”

One of the top holdings in the 60-name Mackenzie fund is Housing Deve-lopment Finance Co. A home-mortgage lender in India, the firm is noted for its efficiency and has an ultra-low cost/income ratio of 13%.

“It’s a growing player, given that the mortgage penetration rate in India is about 8%,” says Leventhorpe, noting that only 28% of the Indian population lives in cities and towns. “If you think that mortgage penetration in the U.S. is about 73%, then there is still a substantial opportunity for this company, which is more efficient than most of its state-lending peers.”

A longtime holding, the stock trades at 2,700 rupees, compared with 1,275 rupees this past February. “The size of the opportunity is substantial. It’s a business that still has good long-term potential,” says Leventhorpe, adding that there is no stated stock-price target.

Another top holding is China Merchants Bank Co. Ltd. A relatively smaller player in China, it benefits from the low penetration rate for retail products and mortgage lending, and has acquired a fair amount of Western expertise from stakeholder, HSBC Holdings PLC.

“It’s an area that will be exciting because of the growing urbanization of China, and rising incomes,” says Leventhorpe. “We don’t want to get involved in corporate lending, since a lot of it is state-directed, and very mature. This is a business we’d rather own, in terms of upside potential and growth opportunities.”

Acquired in late 2008, when the Hong Kong Stock Exchange-listed stock was around HK$10 a share, it is now HK$18.50. Noting that the J.P. Morgan team takes a long-term view, Leventhorpe adds: “We are looking at an annual 21% earnings growth over the next five years.”



Despite the benchmark’s 70% year-to-date rebound, emerging markets are not overheated, says Michael Quigley, who provides oversight on Omega Emerging Markets Fund and is senior vice president, distribution, with Nat-can Investment Management Inc. in Montreal: “Some individual countries and companies are at high levels. But, overall, the asset class remains quite attractive. It’s a healthier environment today than it was back in the peak in 2007.”

Emerging markets were in decent shape when the financial crisis hit, observes Quigley, who works closely with a 13-person team at subadvi-sors Baillie Gifford Overseas Ltd. in Edinburgh, Scotland. “Although [emerging markets] got hit by the fall in exports, they did not have the fundamental balance-sheet problems that the developed countries had,” says Quigley. “They were in a healthier state, so it’s normal, in our view, that they would emerge stronger — and faster.”

There is a possibility of a short-term correction, however. One possible trigger, he notes, is if China decides to tighten its lending standards and choke off growth. “But from the perspective of our investment committee, China will not tighten lending before the winter of 2010. Our view is that a pullback is not likely for the next few months,” says Quigley. “There is more room to run.”

Bottom-up investors, the team at Baillie Gifford favours firms whose distinct advantages are underappreciated by stock markets. One top holding in the 67-name Omega portfolio is OAO Gazprom, a leading oil and gas producer in Russia.

“It’s a company with huge reserves that are underestimated by the market,” says Quigley, noting that the firm has about 17% of the world’s natural gas reserves. “It’s an export-oriented name, since it supplies gas to Western Europe. But it’s also a play on Russia’s growth.

“And it trades at an attractive valuation,” he adds. “On a reserves basis, it’s one of the cheapest oil and gas companies in the world.”

A core holding over the past four years, the NYSE-listed Gazprom ADR peaked at US$15.40 in May 2008, bottomed at US$3.35 this past March and now trades at US$6.70. There is no stated price target.

“The reserves are there. The issue is how quickly they will get sent to market, and at what price,” says Quigley. “As demand picks up, along with growth, it will sell more products. There will be growth in earnings, and the stock price will follow.”

Another favourite name is Samsung Electronics Co. Ltd. The South Korean firm is a global leader in liquid crystal displays, flat-panel TVs, cellphone handsets and so-called “D-RAM” (dynamic random access memory) semiconductor chips. “In this cycle, in which so many companies in the chip industry have been savaged by high debt and poor cash flows, Samsung is the opposite,” says Quigley. “It has no debt, strong cash flow and has invested heavily [during] the down cycle. Samsung will probably come out a leader on the other side.”

D-RAM production accounts for 40% of revenue, he adds: “[Samsung] will be in a position to take share in the D-RAM market, and will also be very competitive in LCD televisions. That’s what we like about growth companies; you want them to get stronger when times are tough.”

Acquired about three years ago at around 550,000 South Korean won a share, the stock dipped to 450,000 this past February, and is now trading at 760,000 won a share. IE