FUNDS

Port­fo­lio man­agers of emerg­ing mar­kets funds are bullish on that sec­tor.

Investment Executive - - FRONT PAGE - BY MICHAEL RY VAL

emerg­ing mar­kets have been de­liv­er­ing strong per­for­mances year-to-date, with the bench­mark MSCI emerg­ing mar­kets in­dex up by about 25%, which is dou­ble the rise in the MSCI world in­dex. Th­ese re­sults for emerg­ing mar­kets are driven by a con­flu­ence of fac­tors, ac­cord­ing to some fund port­fo­lio man­agers, many of whom re­main bullish about prospects for th­ese mar­kets.

“Num­ber 1: the U.S. dol­lar has been weak­en­ing, and that’s pos­i­tive for emerg­ing mar­kets be­cause lo­cal cur­ren­cies have more breath­ing room and coun­tries can cut in­ter­est rates,” says Sammy Sim­ne­gar, port­fo­lio man­ager with Bos­ton-based FMR LLC (a.k.a. Fidelity In­vest­ments), who over­sees Fidelity Emerg­ing Mar­kets Fund. “Num­ber 2: com­modi­ties prices have been rel­a­tively sta­ble. Num­ber 3: be­cause of the first two fac­tors, earn­ings [of emerg­ing mar­kets stocks] have been very good in the first half of the year, meet­ing or beat­ing ex­pec­ta­tions for the first time in sev­eral years. Val­u­a­tions also have been rel­a­tively at­trac­tive, while the rest of the world has seen con­sid­er­able [fi­nan­cial] mul­ti­ples’ ex­pan­sion.”

For the next 12 months, Sim­ne­gar notes, the MSCI bench­mark for emerg­ing mar­kets will be trad­ing at 12.5 times earn­ings. In con­trast, the MSCI world in­dex will be trad­ing in the mid-teens, which amounts to an ap­prox­i­mate 25% dis­count for the former.

But, Sim­ne­gar ar­gues, emerg­ing mar­kets’ fun­da­men­tals of­fer a very mixed pic­ture.

“Look at Brazil, where, be­cause of the cor­rup­tion scan­dals, [the govern­ment] is pass­ing mean­ing­ful re­form, in­ter­est rates are com­ing down and we’re see­ing real struc­tural im­prove­ments. Brazil, com­ing out of the cri­sis, will be much bet­ter than go­ing in,” he says. “On the other hand, Turkey is the op­po­site. It used to have a dis­ci­plined cen­tral bank, a pro-mar­ket govern­ment and so forth. To­day, [the govern­ment] has been de­stroy­ing in­sti­tu­tions rather than build­ing them. I’ve given two ex­am­ples at the ex­tremes. But in the next three to five years, the out­look for Brazil is much bet­ter than for Turkey.”

Sim­ne­gar also lauds struc­tural re­forms in In­dia, where the govern­ment has cleansed the econ­omy of ill-got­ten money by forc­ing peo­ple to de­posit large ru­pee notes, which ul­ti­mately ended up in fi­nan­cial ser­vices prod­ucts, and is stream­lin­ing the tax sys­tem by in­tro­duc­ing a gen­eral sales tax.

As for China, Sim­ne­gar ar­gues, in­vestors shouldn’t bet against China’s au­thor­i­ties: “Are there large im­bal­ances in the econ­omy? Yes. Will [the govern­ment] have to deal with [those im­bal­ances] at some point in a mean­ing­ful way? Maybe. But with time, if the econ­omy con­tin­ues to grow, it will grad­u­ally ‘delever.’ And sta­te­owned en­ter­prises are in bet­ter shape than they have been in the past. China’s govern­ment has shown an un­canny abil­ity to man­age the econ­omy.”

Sim­ne­gar, largely a bot­tom-up in­vestor, ad­mits he prefers coun­tries’ do­mes­tic-ori­ented busi­nesses that have sta­ble growth qual­i­ties, good bal­ance sheets and share­holder-ori­ented man­age­ment teams: “I’m look­ing to com­pound al­pha over time, with­out tak­ing on too much risk.”

From a ge­o­graph­i­cal per­spec­tive, about 25% of the Fidelity fund’s assets un­der man­age­ment (AUM) are held in Greater China, which in­cludes stocks listed on the Stock Ex­change of Hong Kong and Amer­i­can de­posi­tary re­ceipts listed on the New York Stock Ex­change (NYSE). There also is 13% held in In­dia, 7.5% held in Brazil and 6% held in South Africa, with smaller hold­ings in coun­tries such as Mex­ico.

A favourite hold­ing in the 145name Fidelity fund is Ten­cent Hold­ings Ltd., a Hong Kong-listed In­ter­net firm that has emerged as a leader in gam­ing, e-com­merce and pay­ment ser­vices in China.

“In 2010, Ten­cent earned 0.89 ren­minbi a share. The con­sen­sus num­ber for 2018 is 8.5 ren­minbi a share, which means a ten­fold in­crease,” says Sim­ne­gar. “The num­bers speak for them­selves. That’s what I look for.”

Ten­cent’s shares are trad­ing at 344.20 Hong Kong dol­lars ($52.65), or 33 times for­ward earn­ings. There’s no stated tar­get.

An­other top hold­ing is Hous­ing De­vel­op­ment Fi­nance Corp., a lead­ing mort­gage and con­sumer lender in In­dia. “It’s been com­pound­ing its earn­ings at 20% for the past 20 years,” says Sim­ne­gar. Shares are trad­ing at 1,750 ru­pees ($33.40), or 22 times for­ward earn­ings. There’s no stated tar­get.

much ofthe re­centstrong per­for­mance in emerg­ing mar­kets can be at­trib­uted to a so­called “catchup” phase, ar­gues Rishikesh Pa­tel, port­fo­lio man­ager, In­dia and emerg­ing mar­kets, with Lon­don,U.K.-based LGM In­vest­ments Ltd., BMO Global As­set Man­age­ment Corp.’s specialist bou­tique in­vest­ment man­ager cov­er­ing Asian, global emerg­ing and fron­tier mar­kets.

“But from a longer-term per­spec­tive — five to seven years — de­vel­oped mar­kets have done bet­ter than emerg­ing mar­kets. Maybe [the im­prov­ing fun­da­men­tals in emerg­ing mar­kets] is just a case of re­ver­sion to the mean,” says Pa­tel, who co-man­ages BMO Emerg­ing Mar­kets Fund with Irina Hunter and Damian Bird, senior port­fo­lio man­ager and port­fo­lio man­ager, re­spec­tively, with LGM.

Al­though some of the emerg­ing mar­kets have shown ro­bust eco­nomic mo­men­tum, Pa­tel says, he prefers to fo­cus on struc­tural trends, as he dis­agrees with Sim­ne­gar re­gard­ing im­prov­ing fun­da­men­tals: “The fun­da­men­tal case for emerg­ing mar­kets has not changed. It was the same five years ago and 10 years ago. And it will re­main the same for the next five or 10 years. If you look at the world’s pop­u­la­tion, about 80% is in emerg­ing mar­kets. Yet, emerg­ing mar­kets con­trib­ute only 60% of the world’s GDP [i.e., gross do­mes­tic prod­uct] and only about 10% to 15% of the world’s mar­ket cap. That’s where the op­por­tu­nity of emerg­ing mar­kets lies.”

GDP per capita in de­vel­oped mar­kets is about US$30,000US$40,000, but it’s only US$4,000$5,000 in emerg­ing mar­kets.

“As per capita in­come rises, it leads to higher con­sump­tion. In

Emerg­ing mar­kets’ in­vest­ment fun­da­men­tals of­fer a very mixed pic­ture

look­ing at long-term struc­tural trends, we see sev­eral cat­e­gories in which de­mand be­gins to take off when per capita GDP ex­ceeds US$4,000,” says Pa­tel, adding that GDP growth rates in much of Asia are more than dou­ble those in de­vel­oped mar­kets. “We look to ex­ploit those trends and the grow­ing profit pools in emerg­ing mar­kets. There are strong growth trends ow­ing to the larger pop­u­la­tions, younger de­mo­graph­ics and ris­ing per capita GDP, which will give rise to ex­po­nen­tial growth in goods and ser­vices.”

Pa­tel, like Sim­ne­gar, is a bot­tom-up stock picker and prefers to in­vest in do­mes­tic-ori­ented, qual­ity com­pa­nies that can grow their cash flow over the long term and the stock can be bought at rea­son­able prices.

“Ev­ery now and then, there are op­por­tu­ni­ties. For ex­am­ple, late last year, we saw op­por­tu­ni­ties in Mex­ico, be­cause of the so-called ‘Trump tantrum.’ You could buy great [stocks] at won­der­ful prices,” he says. “But you have to be brave when ev­ery­one is fear­ful. For us, risk is seen only in the fun­da­men­tals and val­u­a­tions. How well do you know a com- pany and how cheaply can you buy it? Those are the key risks.”

By way of ex­am­ple, Pa­tel points to a com­pany that makes hair oil in In­dia. “Are In­di­ans go­ing to change their pat­terns of us­ing hair oil be­cause the Euro­pean or U.S. cen­tral banks are go­ing to tighten mon­e­tary con­di­tions? Prob­a­bly not.” Or take a snack­food pro­ces­sor in the Philip­pines: “Will Filipinos change their di­ets be­cause the U.S. may tighten? Prob­a­bly not. So, we ask our­selves: ‘Will the cash-flow pat­terns of th­ese com­pa­nies change be­cause of the im­pact of macro fac­tors?’ Prob­a­bly, the an­swer is no. Will mar­kets re­act? Of course, they will. Un­der­stand­ing the fun­da­men­tals of a com­pany is more im­por­tant than the macro risks.”

From a ge­o­graph­i­cal per­spec­tive, In­dia rep­re­sents the largest weight­ing in the BMO fund, at 22.8% of AUM, fol­lowed by: In­done­sia, at 12.9%; Mex­ico, 12.4%; emerg­ing mar­kets stocks listed i n the U.S., 7.9%; and South Africa, 6.6%; with smaller weight­ings in coun­tries such as Malaysia.

One of the top hold­ings in the 44-name BMO fund is Yum China Hold­ings Inc. An NYSE-listed firm with a mar­ket cap of US$15 bil- lion, Yum China re­ceives 100% of its rev­enue from a net­work of 7,500 fast-food out­lets in China that op­er­ate un­der the Pizza Hut, KFC and Taco Bell brands.

Yum China’s shares are trad­ing at US$39.80, or 26.2 times trail­ing earn­ings. There’s no stated tar­get.

“Most of Asia is all about rice and noo­dles. Bread is a very small part of the food plate. But here’s a com­pany that is the most dom­i­nant brand of Western-style, quick­ser­vice food,” says Pa­tel, not­ing that the firm was spun off from par­ent firm Yum Hold­ings Inc. in 2016. “Bread con­sump­tion is a small por­tion of di­ets, but it will grow. This is a struc­tural trend that will un­fold over a long pe­riod.”

An­other favourite is Wal-Mart de Mex­ico SAB de CV, which serves Mex­ico and much of Cen­tral Amer­ica. “The com­pany is fairly dom­i­nant be­cause it has a 25% share of the to­tal re­tail mar­ket,” says Pa­tel. “But, most im­por­tant, the firm has about 70% of the prof­its of Mex­ico’s to­tal re­tail in­dus­try, ben­e­fits from Western-style man­age­ment and cor­po­rate gov­er­nance, but op­er­ates in the emerg­ing mar­kets.” The shares are trad­ing at 42.25 Mex­i­can pe­sos (C$2.92), or 21 times for­ward earn­ings. There is no stated tar­get.

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