The surface of the Earth moves on tectonic plates. So, too, it seems, do the emerging markets—where economic opportunities (“There’s a growing taste for whisky in Brazil”) often get swept under deeper, more profound realities (“Who cares? The country’s oil is too cheap and its president is about to be impeached.”)
That leaves everyone watching the big waves either for signs of tsunamis or for surfing conditions, and the markets earlier this year provided the latter. The MSCI Emerging Markets Index rallied 24% between January 21 and April 19, 2016.
The beginning of a bigger rally? The end of a trough? Not so fast. A team at Goldman Sachs said that, despite whatever happens inside these very dissimilar, variegated countries, their performance is right now being distorted by macroeconomic trends. The team, led by Caesar Maasry, wrote on March 8 that the rally was getting an artificial high from a softening dollar (which makes emerging assets and currencies more attractive), firming oil prices and a surprisingly mild tone from the U.S. Federal Reserve about future interest rate hikes.
“Specifically, the commodity-heavy EMs (Brazil, Russia, Chile, South Africa) have been the best performers amid the rally in commodity prices,” wrote Maasry and his team.
According to Goldman Sachs, the last 15 years (covering the most recent bull and bear cycles) have seen a close correlation between EM equity and commodity prices (especially oil). Those macroeconomic distortions cover up familiar problems: China’s growth is softening and it’s the biggest, fattest elephant in the index. Many countries also have to clean their credit houses, and there’s wan demand from slowing developing markets.
Worse yet, the team wrote in early May, emerging market earnings per share, after China and commodities are taken out of the picture, were “flat from end-2011 through mid-2014 ($56 to $57) and has since declined by 13% to $50. In short, [earnings per share] weakness appears not to be simply a commodity or China issue.”
But active managers make the case that after the index’s decline last year (a drop of almost 15%) there are bargains here—oversold companies unfairly abandoned and neglected after the market decline. There are, the managers say, companies that are really cheap, if only you know where to look for them.
“Countries like Brazil and Russia have had very bad years for the past few years, so in some sense [the rally was] a correction,” says Patricia Oey, an analyst at Morningstar. “The macro environment has been getting better and these markets were super-cheap. Russia was trading at low mid-single-digit P-Es. So there can be a balance when sentiment improves.”
The rally, thus, has favored value plays, she says, companies that had previously been deadweights in the index. And so Morningstar’s top funds for the year as of April 26, 2016, had a value tilt (and for that saw double-digit returns). The top five, Oey says, were the PIMCO RAE Fundamental PLUS EMG fund, the Invesco Developing Markets fund, the WisdomTree Emerging Markets High Dividend ETF, the PIMCO RAE Low Volatility Emerging Market Fund and the Lazard Emerging Markets Equity fund. A brief scan of their tickers indicates these funds were pulling 15% to 19% returns for the first four months of the year. And Brazil represented 16% of the Invesco fund, she says, while WisdomTree and Lazard had almost 10% Brazil (it’s closer to 6.5% in the MSCI index). South Africa, a battered commodity play, also had higher-than-average allocations in a couple of funds, Oey says.
It’s very telling, however, that the better long-term performance plays—those that outperformed over the past five years (not three months) are not only completely different, but have swept the bottom in 2016. That includes the five- and four-star Morningstar names such Virtus Emerging Markets Opportunities fund (HIEMX), American Funds New World (NEWFX), the EGShares Emerging Markets Consumer fund (ECON) and the Thornburg Developing World Fund (THDAX). “All these guys are kind of at the bottom of the list year to date,” Oey says.
How To Play?
Charlie Wilson, co-portfolio manager of the Thornburg fund, says that volatility in this space, always the thing that makes investors queasy about it, has not offered the rewards it should. The excess capacity created by the commodity boom in the last decade is now stuck in a world of less global demand, thus we’re in an age where domestic consumer demand within the countries become more important. He says that with risk not being properly rewarded, investors should favor companies with better cash flow and less leverage.
He sees countries like Peru and Indonesia trying to make that transition to internal consumption. India, too. “There’s a company that we own in Indonesia,” he says, “It’s called Matahari Malls.
… They have a little over 100 stores. They are a consignment model where about 70% of their inventory is on consignment from local merchants and the other 30% is … their own brand. They’re adding stores at a pace of about eight to 10 per year. And they think their total store opportunity across Indonesia is about 400. The way they look at their opportunity is they think for every 150,000 to 200,000 people in the middle income portion of the Indonesian economy they can have a new store. That part of the market is actually growing 3 to 4 million per year. So the market itself is growing faster than they can add new stores every year.” Thornburg thinks the company can add 10 stores per year for the next decade without reaching market saturation. Better yet, the company’s same store sales growth is rising.
“So the company is growing 20% per year but they are still paying a 3% dividend because their returns are so high and cash flow is so good out of these stores,” Wilson says. “And interestingly enough, those are the kinds of names that got left behind in this recent rally.”
Jonas Krumplys, portfolio manager, with the $600 million Ivy Emerging Markets Equity fund (a Waddell & Reed affiliate whose ticker symbol is IPOAX), agrees that the emerging markets are attractively priced and the softening dollar and strengthening oil market have made Russia and Brazil bargain buys. Russia has gotten on top of its problems with inflation and the nonperforming loans at its banks after the ruble plummeted in 2013. That’s left a lot of room for the surviving banks to thrive.
“We have been overweight in Russia and Brazil and very much underweight in China, and we also have the flexibility to buy currencies, so we have bought a basket of the commodity currencies above and beyond being exposed to commodity countries,” Krumplys says. That can give the firm access to local currency improvements when the country might otherwise have problems (he mentions the Malaysian ringgit, which is strengthening even though the stock market there is hurting over a political scandal involving the country’s prime minister).
“One of our biggest holdings is Sberbank; it’s the largest bank in Russia,” Krumplys says. “The central bank, basically the financial authorities, own just over 50% of it, and they have absolutely fantastic positions. They have … payroll customers that have their paychecks automatically deposited into the bank and so they can issue credit cards, mortgages, car loans with a very long history of what’s been going on with that particular client. So it’s a name that can win on many fronts. The central banks could be cutting rates; it looks like inflation is getting better and there should be more demand for loans as the economy gets better.”
Some argue that no matter how good emerging markets might be as a long-term holding, the volatility is just too much for most investors, and 2015 was another horribly volatile year in this space (in which it teetered between a 13% gain and a 27% loss).
One portfolio manager has come up with an answer to that. Swan Global Investments is an asset manager that wraps core holdings in an options strategy. Randy Swan, who conceived the strategy, says it’s agnostic to the underlying holdings (he’s applied it to the S&P 500, gold and real estate, for example). “To manage market risk, instead of using diversification as the solution we use options to hedge out most of the downside risk.”
The firm opened an emerging market version of this strategy at the end of 2014, feeling it was appropriate to this space. The firm invests in BlackRock’s EEM then uses hedging techniques, directly buying options on the strategies. At the end of the year, the firm re-hedges the portfolio, selling the original put option, buying a longer duration option, say two years, and using the excess cash from the sale of the original put option to generate cash, which it can use to add to the exposure. That allows the firm to reinvest in a market low, says Swan.
“I think the premise to me on emerging markets is very simple,” he says. “This is where a lot of growth is going to occur in the future, but of course the volatility is just ridiculous.”
Another argument is that the indexes themselves offer no real diversification, since they overwhelmingly represent China (almost a quarter of the MSCI EEM index) and commodities. Morningstar’s Oey says her firm doesn’t advocate huge weights to one country, and that means the main MSCI index, with a high weighting in China, ironically doesn’t offer as much diversification as what an active manager might bring to the table.
Not everyone agrees active management is the solution, however. Jeff Davis, the CIO at LMCG Investments, says his firm’s Global Multi Cap Strategy mutual fund with an allocation to emerging markets. Mostly the fund uses ETFs (and some individual company names to tweak the weightings, which it doesn’t do in its separate accounts).
He eschews the notion that active management is necessary in this space in the long term, saying that “the laws of nature show that the indexes will simply deliver you over time the average return and people forget that. … After 20 years of observing, the indexes themselves will gravitate toward the median.”
He does think it’s important to watch concentrations, but says you can do that with indexes. He notes that the MSCI Emerging Markets Small Cap Index is dramatically different from its large-cap cousin. “That index when you look at it actually changes the weighting of the regions and countries that you’re in fairly dramatically.” Better yet, “it just lopped off the commodity issue altogether. Petrobras, Gazprom, Lukoil, and so on … those dominant commodity oil companies are really not in that index. So what you get is something very different.”
For the past three years, the small-cap index fell only -2.7% while the main MSCI emerging markets index fell -4.5%, he says.
“That’s a big differential particularly exaggerated by the commodity cycle. So you can get to those good ideas passively.”