Short-term pain leads to long-term gains in emerging markets, or so argue fund managers who focus on them. Does that mean explosive conflicts between Ukraine and Russian separatists and between Israel and Hamas in Gaza present buying opportunities?
At the end of July, the MSCI Emerging Market Equities Index companies were trading at just 1.3 times book value and at a discount of price-to-book value. Stocks were trading at about 10 times earnings—less than the P/E ratio of stocks in the United States, Japan, Europe and the United Kingdom. In addition, the per capita income, productivity and economies of these countries exhibited faster growth rates than those of developed countries.
“We don’t run a lot of cash,” says David Ruff, manager of the Forward Emerging Markets Fund. “We are a bottom-up investor. Asia offers the best perspective for growth, value and yield. Eastern Europe is better from a value and yield standpoint, but growth is a question mark at this time.”
Ruff isn’t fazed by territorial turmoil in the South China Sea. He says China is evolving from an export economy to a consumer-driven economy. He likes small companies, such as China Yuchai International Limited, which transports domestic goods in China.
He increased his exposure to Russia. He is investing in MMC Norilsk Nickel, a nickel and palladium mining and smelting company. Both companies have strong balance sheets, low dividend payout ratios and free cash flow. The stocks were yielding more than 7%.
Meanwhile, Heidi Heikenfeld, manager of the Oppenheimer Emerging Markets Innovators Fund, is finding good deals in companies with high profit margins and market capitalizations of up to $10 billion.
She says the emerging markets are holding up well despite the turmoil. The average diversified emerging market fund is up 8% for the year ended in July, according to Morningstar in Chicago.
“I’ve been surprised,” she says. “Russia and Taiwan [stocks] are beaten up.” Nevertheless, she is standing pat in Russia and buying mid-cap and small-cap growth stocks worldwide.
Heikenfeld invests in companies with high margins and projected strong sales and earnings growth potential. Her holdings sell unique products, like dental insurance in Latin America, funeral insurance in Africa and innovative drug delivery systems that help cancer treatment. Over the long term, she believes these companies could return 15% annually, though it will be a bumpy ride.
“The fund invests in companies with innovative products, brands, business models and other strategic differentiators that establish an entirely new market or result in rapid share gains,” she adds. “We believe certain companies will be responsible for the next wave of growth in emerging markets.”
Meanwhile, the large-cap companies in the Oppenheimer Developing Markets Fund are good buys in the midst of geopolitical crises. Valuations tend to rebound after bad news abates. Companies in Asia, Europe and the Americas make up 80% of the fund’s holdings. The largest holdings include Tencent Holdings Limited, a Chinese social networking company; Housing Development Finance Corp., a major India housing lender; and Yandex, Russia’s No. 1 search engine.
Historically, hot money moves in and out of the emerging markets. But research shows clients should accept the short-term losses in return for longer-term gains. A 2003 study by Yale professor Lingfeng Li reveals that investors enjoy substantial diversification benefits by adding emerging market securities to a portfolio of stocks and bonds from the United States, the United Kingdom, France, Germany, Japan, Canada and Italy.
Over the short term, however, the emerging market volatility and correlations with the major markets, like the United States and euro zone, can reduce the benefits of diversification just when investors need the protection. This has happened several times over the last 10 years, according to a study by MSCI Barra.
With emerging markets, accounting problems lurk under the surface. Portfolio managers tend to stick with companies that adhere to the International Accounting Standards Board rules, Hong Kong reporting rules or U.S. rules that cover dollar-denominated securities. Chinese companies, however, have a reputation for cooking their books. Chinese banks underreport nonperforming loans. Heikenfeld, of Oppenheimer, is suspicious of companies that project high earnings growth but don’t have the infrastructure or margins to back up their estimates. And Ruff, of Forward Emerging Markets, backs away from companies that only adhere to a country’s generally accepted accounting standards.
Meanwhile, a study by Aswath Damodaran, a professor at NYU Stern School of Business, says emerging market valuations fail to sufficiently consider country risk, a lack of transparency in these companies or their corporate governance.
Investment-grade emerging market bonds are issued without covenants or collateral, despite the fact that their cash flow to meet annual interest and principal payments typically exceeds the cash flow of their U.S. counterparts. Also, emerging market bankruptcy laws are weak, says Fitch Ratings. This doesn’t bode well for either stock or bond investors.
“Emerging markets continue to present incremental risk to fixed-income investors,” says Daniel Kastholm, a managing director at Fitch based in Chicago. “There is still a limited track record [of improved bankruptcy laws] and the results are not good.”
Unfortunately, a vast number of emerging market stock and bond funds hedge against currency risk, according to Morningstar. That may be a mistake. By hedging the currency risk in emerging markets, managers inhibit the excess return over the risk-free rate on a portfolio with a mix of asset classes, according to a 2013 study by Rutgers University economics professor Uzi Yaari.
Despite the instability, emerging market fund managers stress that the risk is worth it. “Emerging market equities have very favorable valuations and better growth metrics versus developed markets,” says Ruff of Forward. “With prospects for more favorable politics in much of the [emerging market] world, including Indonesia, Asia, Brazil and Turkey, we believe these markets can show much stronger relative performance going forward.” But he adds that emerging market labor productivity may decline as wages rapidly rise (the wage growth in the developed world is slower).
Investing in emerging market bonds isn’t a cakewalk either. Emerging market countries borrowed record amounts of money in the first half of 2014. Typically, investment-grade bonds are rated just “BBB,” the lowest level of investment grade, by Standard & Poor’s. Central banks have warned that record debt issuance could lead to trouble in a few years.
That said, fund managers are cherry-picking investment-grade-rated companies with solid cash flows, high debt coverage and low debt-to-equity ratios. “Opportunities have arisen as a consequence of geopolitical tension in Eastern Europe and the Middle East,” says Mike Conelius, manager of the T. Rowe Price Emerging Markets Bond Fund. “We are finding attractive yields in corporate credits with strong capacity to service their external obligations.”
He says valuations remain relatively attractive, particularly for investment-grade-rated issues. On the plus side, the Ukraine government is taking positive steps with help from the West, especially the International Monetary Fund. He has reduced his Russia exposure, but is taking small positions in domestic-oriented companies where the threat of new sanctions is diminished. Conelius says India’s recent election could be a “game changer” for reigniting growth potential. “India could be the next Mexico in terms of policies and growth,” he says. “We could see a whole second wave of companies coming out of India. Mexico is still a tremendous opportunity on the energy reform front.”
Conelius stresses, however, that there is political turmoil in Turkey, Indonesia, Brazil, the Middle East and Ukraine. Another risk is the likely rise in U.S. interest rates and volatility in currency values.
His fund is about 60% invested in dollar-denominated foreign government bonds and the rest in corporate bonds. The fund sports a duration of six years. And 58% of the portfolio is invested in Brazil, Mexico, Venezuela, Turkey, Indonesia and Russia.
Michael Gomez, manager of the PIMCO Emerging Markets Bond Fund, also keeps the duration of the fund’s holdings at just six years because of the market volatility. He is overweighted in Mexico, Luxembourg, Indonesia, Venezuela and Ireland. About 35% of the holdings are in corporate bonds. The largest holdings include bonds from Russia, Mexico and the Philippines.
Meanwhile, currency diversification is the focus of the Lazard Emerging Income Fund. Manager Ardra Belitz invests in short duration corporate and sovereign bonds in local currencies in countries such as Africa, Latin American, Asia, Eastern Europe and the Middle East. The correlations among local debt markets and developed countries are low, she says.
“The portfolio has the potential to benefit in a period of rising interest rates as global demand conditions improve,” Belitz says. The reason: the sizable depreciation in local currency valuations in recent years.