Emerging markets have been volatile in the past year, driven by fears of a sharp economic slowdown in China and continuing worries regarding Europe. Although fund portfolio managers maintain that shares are attractively valued, they also are cautious about prospects into next year.
“Stocks are cheaper now, but there is a lot of uncertainty out there,” says Stephen Way, senior vice president with Toronto-based AGF Investments Inc., and lead manager of AGF Emerging Markets Fund. “For the next couple of years, the deleveraging we’re seeing in the developed world will create a ‘muddle-through’ type of economic environment, and the developing world is impacted by that. At the same time, [emerging markets’] domestic economies are slowing, which causes a certain degree of volatility.”
Meanwhile, central bank policies, such as the U.S. Federal Reserve Board’s Quantitative Easing III, are adding fuel to the fire by fostering the so-called “risk on/risk off” environment.
“It doesn’t mean you can’t make money,” Way says. “But the volatility will be there.”
He argues that valuations are “fair” as emerging-markets stocks are trading at about 1.7 times book value, compared with two times in 2010 and 1.1 times when markets bottomed in March 2009.
But he remains cautious on 2013. “There’s an expectation that things will improve, in part because of the stimulus in place. But the risk is that there is a lot of optimism. I’m not an optimist,” says Way, who shares portfolio management duties with AGF portfolio manager Alpha Ba. “The forecast for a second-half recovery in 2012 didn’t seem to happen, so some people are pushing that forecast into 2013. We will see some improvement – but it will be a modest one and we will muddle through. We’ll have periods when things look better, followed by periods that look worse. But you can use that volatility to your advantage because there is a lot of liquidity in the world.”
A bottom-up stock-picker, Way did not make any extensive changes to the portfolio when he assumed management duties this past spring from former portfolio manager Patricia Perez-Coutts.
From a sectoral standpoint, financial services account for 20% of the AGF fund’s assets under management (AUM), compared with 25% for the benchmark MSCI emerging markets index. As well, 16.7% of the fund’s AUM is in consumer discretionary (8.1% for the benchmark), 11.3% is in consumer staples (8.6%) and 12.6% is in materials (11.6%), with smaller holdings in sectors such as telecommunications services.
From a geographical viewpoint, 19.6% of the AGF fund’s AUM is in China and Hong Kong combined, 12.4% is in Brazil, 9.2% is in South Africa, 8% is in India and smaller weightings are in countries such as Mexico.
One of the top holdings in the 73-name AGF fund is Tingyi (Cayman Islands) Holding Corp., a Hong Kong-listed manufacturer of noodles and beverages. “There is an opportunity for margin expansion in the ready-to-drink tea business,” says Way. Tingyi is trading about at HK$23.65 ($2.95) a share. Way expects about 15% upside in the next 12 to 18 months.
Another is Wharf (Holdings) Ltd., a Hong Kong-listed, mixed-use property developer in China and shopping mall owner in Hong Kong. Although Wharf is trading at HK$51.45 ($6.40) a share, Way believes that the net asset value is HK$70 ($8.70): “The stock is heavily discounted.”
volatility may persist for a while, agrees Irina Hunter, senior portfolio manager with London-based Lloyd George Management (Europe) Ltd. and co-manager of BMO Emerging Markets Fund.
“Emerging markets will be influenced by events in the developed world, specifically Europe,” she says. “The sensitivity may be higher for the BRIC [Brazil, Russia, India and China] markets, where global events could be exacerbated by challenges in their domestic economies.”
However, she adds, there may be lower volatility for countries with stronger current accounts and fiscal discipline, such as the Philippines, which belongs to the Association of Southeast Asian Nations (ASEAN).
For the medium term, Hunter is optimistic about emerging markets because of their strong balance sheets, consumption-driven economies and attractive valuations. “But, shorter term,” she says, “the outlook depends partially on the progress of reforms in the BRIC countries, the continuous impact of trade with developed countries and what’s discounted in the prices of individual companies versus a prospect of their slower growth.”
As a bottom-up investor, Hunter (who shares portfolio-management duties with Rasmus Nemmoe, senior portfolio manager with Lloyd George) is more optimistic about companies with strong domestic growth drivers: “We find more of those companies in ASEAN countries; Andean countries, such as Chile and Mexico; and South Africa. We’re looking for strong business models that are resilient, regardless of market conditions. We’re looking for sustainable and visible earnings growth and cash flows. “
Hunter focuses on individual companies rather than markets. But the largest weighting in the BMO fund is in China/Hong Kong, which account for a combined 15.4% of the BMO fund’s AUM. Brazil accounts for 11.6% of AUM; South Africa, 9%; South Korea, 7.9%; and Russia, 4.6%. There are smaller weightings in markets, such as the Philippines. There is also about 6% cash.
One top holding in the 60-name BMO fund is Giordano International Ltd., a Hong Kong-listed clothing retailer that generates 40% of its revenue in China, 30% in ASEAN markets and the remainder in Hong Kong and Taiwan.
“Unlike other retailers chasing volume growth and fast fashion,” says Hunter, “Giordano focuses on margin and inventory management first, which are the two contributors to cash flow.” Giordano is trading at about HK$6.30 (80¢) a share and pays a 5.9% dividend. Hunter’s target is HK$7.35 (90¢) within 12 to 18 months.
Another favourite is Life Healthcare Group Holdings Ltd. “It is the most efficient hospital operator in South Africa,” says Hunter. “[Its] secret to high profitability is the focus on simple procedures. That keeps costs down and margins up.” Life Healthcare is trading at about ZAR3,064 ($344.40) a share and pays a 2.1% dividend. The target is about ZAR3,650 ($410.25) in 12 to 18 months.
Although it would be preferable if markets responded to the fundamentals, says Gustavo Galindo, portfolio manager in a New York with Seattle-based Russell Investments Group, who oversees Russell Emerging Markets Equity Pool, “The reality is that they react too much to the news – and result in the risk on/risk off environment we have seen. Today, the risk has been coming back on. There are two fundamental reasons for that.”
First, argues Galindo, many of the threats that plagued stock markets during this past summer appear to be subsiding. “The U.S. is starting to recover; there seems to be a rebound in the housing market. Then, you have the European Union taking a more organized approach to its crisis,” says Galindo. “Yes, there continue to be troubles in Spain. Yet, even with that, there is more of a desire from core countries such as Germany to contain the crisis. The tail risk in Europe is reduced.”
Second, as the yields in so-called “safe” asset classes keep dropping, investors have to find alternative assets that will meet their targets, adds Galindo: “The risk is coming back on. It’s likely to be a volatile environment going forward. But that doesn’t mean that emerging markets will underperform.”
From a valuation perspective, Galindo says, emerging-markets stocks are more or less in line with historical ranges. “But they are cheaper than other alternatives, such as U.S. equities, for instance,” he says, adding that emerging markets are trading at around 12 times earnings and have, on average, 9%-12% upside, while Russell’s internal research indicates that U.S. stocks are fairly valued, if not slightly overpriced.
“There is an argument that says emerging markets will become more expensive, relative to historical valuations, and will catch up to other asset classes,” Galindo says. “That’s primarily because the growth continues to be there and the quality of the companies has continued to improve and opportunities expand. As more investors discover them, the discount will be closed.”
From a management perspective, the Russell fund’s portfolio is divided among three subadvisors: AllianceBernstein LP, a New York-based value manager, oversees 30% of AUM; Harding Loevner LP, a Bridgewater, N.J.-based quality-growth investor, manages 45%; and Boston-based Delaware Management Holdings Inc., a so-called “value core” investor, oversees the remaining 25%.
From a geographical viewpoint, the largest weighting in the Russell fund is in China/Hong Kong, with a combined 14.3% of AUM, followed by 13.7% in Brazil, 13% in South Korea, 6.4% in Russia and smaller exposures to countries such as Mexico.
One representative name in the 240-name Russell fund is Samsung Electronics Co. Ltd. “It is a difficult stock to hold,” says Galindo, referring to the US$1-billion legal settlement with Apple Inc. “Yet, all our managers like it; Samsung has good long-term prospects. We believe we will see more Android-based devices, and Samsung has a very good foothold in that market.” Samsung is trading at about KRW1.325 million ($1,165.50) a share, or 11 times trailing earnings. There is no stated target.
Another favourite is Petroleo Brasileiro Petrobras SA, Brazil’s state-controlled oil company. Although this stock was out of favour in 2010-11 because of the perception of government interference, Delaware Management began buying, says Galindo: “The stock was showing some value, and that’s an important consideration.” Petrobras is trading at about BRL22.12 ($10.65) a share, about 15 times trailing earnings. There is no stated target. IE
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