There’s an old Saturday Night Live sketch in which Will Ferrell plays a German intellectual talking to a baby. After facing frustration that the baby does not appreciate his insights, the intellectual demands, “Grow up now!”

Emerging market investors seem to have the same problem. They know that emerging economies will one day be developed middle-class consumer giants. They boast booming populations of potential young consumers who will buy phones, open bank accounts, buy fast food, date online and get home loans. But investors often don’t want to wait through developing countries’ gawky growth phases. They want the baby to grow up now.

Still, there were few better places to be in 2017 than in emerging market stocks, which easily outpaced developed market names. After years in the doldrums, the MSCI Emerging Markets Index shot up 37% for the year, finally rewarding patient investors, while the S&P 500 had a return of less than 21% and developed world markets returned 23%. The reasons for the outperformance were fairly straightforward, say portfolio managers.

“In the end, it comes down to earnings,” says Deborah Vélez Medenica, portfolio manager of the Alger Emerging Markets Strategy. “I think there was perhaps a recognition that overall aggregate earnings in emerging markets was probably better than that of the developed world and there was probably acceleration in those earnings.”

Katie Koch, the global head of client portfolio management and business strategy for Goldman Sachs Asset Management, says 2017 was an outstanding year for EM stocks because you got two times the earnings growth at a 25% to 30% discount to what you could get in the U.S. and many developed markets.

A lot of managers had been optimistic about 2018 for the same reasons (at least they had been until a recent market selloff began). But the asset class had also been the beneficiary of a lot of good cyclical macroeconomic trends: The dollar had finally started to deflate. China initiated reforms, opening up its capital markets to more foreign ownership and reining in its material-making capacity to allow the price of commodities to strengthen.

There’s also a richer set of public company names in EM than there used to be. While the maturing U.S. economy today has half the number of publicly listed companies it did 20 years ago, Koch says, many of the EM countries GSAM invests in have seen a 50% increase in public listings, she says.

The composition of the markets has changed, too. Ten years ago, the combined weight of energy and materials, (i.e., commodities) in the MSCI index was close to 40%. Today it’s about 14%. “Consumer, health care and technology have all taken share,” Koch says. Indeed, information technology, which was only 13.2% of the index in 2007, was 27.6% at the beginning of 2018. Some argue that the MSCI index is starting to look more like the S&P 500, top heavy with tech companies like Tencent, Alibaba, Samsung and Baidu. But more names makes for a richer universe of diverse and idiosyncratic opportunities. “We own an online Indian dating company,” says Koch. “We own a Polish discount food retailer. We own a Brazilian e-commerce company. These are the types of businesses that we think are going to thrive.”

Warning Signs

But try as you might, you can’t disentangle EM stocks totally from what’s going on in global equity markets. And many areas correlate more highly with what’s going on in the U.S. That became painfully obvious in early February when all the world markets caught the flu. The MSCI Emerging Markets Index fell about 10% from January 26 to February 9, in what some have seen as a long overdue correction.

Given worries about a new inflationary regime in the U.S., world stocks collapsed, and emerging markets were not spared. This seemed to vindicate critics like Jeffrey Gundlach of DoubleLine Capital and Jonathan Garner of Morgan Stanley who said emerging market prices had gotten too overheated. 

Still, Richard Thies, a portfolio manager at Driehaus Capital Management, which runs a suite of emerging market funds representing some $4 billion in assets, says that his firm was impressed with the resilience of emerging markets during the selloff. The fundamentals of these stocks helped, he says. Investors will now wait in suspense to see whether those fundamentals will prop up the asset class. The P/E ratio for the MSCI index was 16.03 at the end of January.

The most important thing to remember is that few emerging market funds are interchangeable. Not many of them track to the MSCI index, which is full of state-owned enterprises and overladen with financials, and not all of them play these consumer themes. That’s why there’s a great dispersion in emerging market opportunities.

The long bet for investors in this space is still on the middle-class consumers in these markets, but Thies says the space will always be doing a tango with global economic forces—like commodity prices and dollar strength. He sees the sector’s outperformance in 2017 as part of an overdue cycle, and says these stocks are still in the growth phase of that cycle.

“Emerging markets are in general a much more cyclical asset class than something like investing in the S&P would be,” Thies says. “Emerging markets, at the end of the day, are capital importers and require capital to grow faster, so you need capital markets to be providing [it].” If the U.S. is in a classic late cycle with little excess supply of labor or manufacturing, EM countries are now in the opposite place.

“You are going from having a lot of excess supply in labor markets and in capacity just on the supply side in general, and really it’s a story about that leverage being put to use.” That’s one of the more obvious times to make money, he says.

For these macroeconomic reasons, he says, his team has been increasing its exposure to more cyclical industries. “We’ve still been increasing exposure in Brazil in a number of different names over the last several months,” he says. “The market is sort of underestimating how strong the cyclical recovery is going to be there.” Loan growth has recovered there, and there’s a lot of pent up demand in various sectors, he says.

In China, the firm has been reducing long-term winners like Alibaba and adding exposure in old economy companies like coal producer China Shenhua Energy. “Things like China tech generally trade similarly to the way companies like Facebook and Amazon trade,” Thies says.

Robert Marshall-Lee, manager of the Dreyfus Global Emerging Markets Fund, says that part of what’s changing emerging markets is the Chinese economy, which has moved from infrastructure development to a reliance more on domestic consumption.

In China, he says, the middle class was something like 100 million people seven or eight years ago and that number has gone up four- or fivefold. “Just the number of people who are suddenly earning $30,000, $50,000 a year to have a Westernized lifestyle … that’s come quite quickly. … So [there’s] been huge growth in outbound tourism and health care, insurance, use of internet, private education, all these kinds of things.”

India is set to benefit from great demographics as well, he says. “If you look at something like India you’ve got very, very strong population growth over the next 20 years or so on the U.N. estimates from 2015 to 2035. It’s just under 25% working age population growth. You contrast that with most of Western Europe and Japan and even the Eastern European countries, you have something like a 15% contraction.”

Marshall-Lee says a big trend for his firm has been electric vehicles. Worldwide regulations are going to force automakers to update their fleets, he says, and over the long term, lithium battery hybrid cars are going to make up bigger parts of those fleets. For that reason, his fund has bought in this space since 2011, investing in lithium producers in Latin America and battery makers in Korea, for instance.

Nick Niziolek, the co-CIO, and head of international and global strategies at Calamos Investments, points to secular growth opportunities in the internet, fintech and consumer themes. Calamos is very overweight in China and India, he says. In the firm’s Evolving World Growth Strategy, the India allocation rose close to 20% toward the end of 2017, which he said is more than two times the benchmark.

He says that emerging markets have leapfrogged developed markets when it comes to some things like digital currencies. When he was in China last year, he saw a street musician take donations not with a bucket but with a QR code.

He points to idiosyncratic small- and mid-cap investments that helped his funds last year. One big winner was Vakrangee, a banking, insurance and e-commerce company that operates a kiosk system throughout India. “It’s a kiosk that you can open up basically in any storefront and it allows mom-and-pop business to allow for government services to be completed there, do some banking functions. And they have a partnership with Amazon, so you can have your package picked up there. And given the infrastructure in India, that’s actually pretty important.” The company reportedly saw 40% earnings growth in 2017.

He also points to Asian fintech holding Ping An, an insurance company that’s overweight in the Calamos fund. The company is using mobile technology data about its users to price risk for things like the underwriting of insurance policies. “They’ve been able to utilize your smartphone device to help track driving habits and how often you speed, how often you start and stop.”

Calamos is also exposed to burgeoning financial services in India. It’s overweight in housing finance in India and has some consumer and corporate banks, mutual funds and brokerages, Niziolek says.

Charlie Wilson, a co-portfolio manager on the Thornburg Developing World Fund, says that his fund is still concentrated in China, where it has a third of its holdings, and India, where it has a one-tenth. He mentions China Unicom, a state-owned enterprise that the government is now allowing to be infused with private capital as part of its reforms for mixed ownership. The new co-owners include Tencent, Alibaba and Baidu, which will reportedly help China Unicom build out data, cloud and 5G developments.

Rishikesh Patel, the co-portfolio manager of the BMO LGM Emerging Markets Equity Fund, says that his team doesn’t pay much attention to macroeconomic factors. Instead, they pick stocks from the bottom up and, for them, the structural themes for emerging markets aren’t changing.

“Emerging markets is almost two-thirds of the world’s population,” Patel says. “It’s about half of the world’s GDP. And yet it’s only about one-sixth of the market cap of the world. And that really is the opportunity to invest.” These economies are growing at a faster pace, have younger populations and rising per capita GDPs. “And that is going to give rise to large, growing profit pools for our companies to benefit from. Essentially selling production services to this growing middle class.” The BMO fund is overweight in India and Mexico. “We don’t look at the index at all.” Most investors chase companies based in the emerging markets, rather than companies that sell to the emerging markets, he says.

“In sharp, rising markets … typically our strategy tends to lag. But having said that this year we have been able to keep pace with the index, and this despite the fact that we do not own any of the Asian IT or technology stocks which have gone up substantially in 2017.”

The firm did find itself taking money out of certain investments in 2017, he says, because the rally caused many of those companies to hit their valuation goalposts sooner than expected. He points to the advantages he sees in countries like Mexico. Some investors thought it might be a victim of Donald Trump’s protectionist talk, but that fear has made it a buying opportunity, says Patel.

He points to Walmart in Mexico, which is called Walmex. “Walmex is almost 25% of the total retail sales in Mexico. And in terms of profit and cash flows they are almost 70% of the market. So it’s a dominant company in an emerging market which is right next door to the largest market in the world. … You have a Western brand, Western management, Western corporate governance, operating in an emerging market.” The fund bought the company around the time of the U.S. presidential election when share prices dropped on fears of protectionist talk. Patel says the opportunity was “like a Black Friday sale.”

He has also liked Yum China, an offshoot of Yum! Brands. The theme is similar: a Western brand with Western corporate governance selling mainly to an emerging middle class in China. “This is the largest fast-food chain company in China. They [have] about seven and a half thousand stores. They have been operating in China for 20 years.”

At the end of the day, says Robert Marshall-Lee, the case for emerging markets is obvious. “The demographics are as clear as day,” he says. “It’s the most predictable economics you can get.” When you look at the U.N. website, what’s happening in the population of these countries stands in stark contrast to what’s going on in the developed world. “Over the very long term, that is one of the key GDP drivers.”  

(Clarification: the print version of this article stated that Robert Marshall-Lee was the manager of the Newton Global Emerging Markets Fund. He is the manager of both that fund and the Dreyfus Global Emerging Markets Fund. The Newton fund is a U.K.-domiciled UCIT fund available only to European Union-based investors. The Dreyfus Global Emerging Markets Fund is the mutual fund available for U.S. advisors and investors.)

 

Newton Investment Management is the subadvisor for the Dreyfus Corporation, a subsidiary of BNY Mellon Investment Management.