By Simon Edelsten
The developed world is in decline and young, thrusting emerging economies will overtake the developed economies. This is now received wisdom and it is based on reliable demographic data. Applying this to an investment approach is, however, far from simple.
Firstly, the ‘official’ definition of emerging markets is laid down by the folk who design stock market indices and they can’t even agree amongst themselves: the MSCI index includes South Korea while the FTA index does not. Certainly a few decades ago Korea would have been regarded as emerging, but Japan would have been seen that way in the 1960s. Unfortunately, when fairly large, fairly developed economies are still classified as ‘emerging’, they end up becoming the largest part of the index. Investors who buy emerging market index funds or ETFs may be surprised to find a quarter of their money invested in fairly wealthy countries such as South Korea and Taiwan.
Furthermore, the next three large countries in the emerging market indices are dominated by oil and mining: Brazil (12%), South Africa (7%) and Russia (5.5%). Commodities have performed rather poorly over the last few years and investors may have been doubly hit by the high weighting to these industries in both their emerging market funds and in the UK index where BP, Royal Dutch Shell, BHP Billiton, Rio and now Glencore Xstrata all have heavy index weightings. Until you look under the bonnet it would not be obvious that UK and emerging market funds might expose you to very similar investment risks and offer little diversification.
As global equity fund managers, our interest in emerging markets is founded on the belief that six billion of the world’s population aspire to the lifestyle currently enjoyed by only one billion. This theme is well rehearsed, but it is more difficult to put into practice in an investment portfolio. Indeed at various times, valuations in emerging markets have run far ahead of reality: in the bear market of 2008, the Shanghai market fell over 60% – as far as any other stock market. China was little affected by the world banking crisis; the fall seemed to simply come down to a valuation correction.
So what valuations are ‘too much to pay’ for the growth of emerging markets? One approach is to benchmark companies against developed world listed stocks with significant emerging market exposures. Unilever Indonesia last year declared earnings of 628 rupiahs, putting it on 36 times today’s price of Rp31,000. Hindustan Unilever trades on over 30 times historic earnings. The Unilever parent company quoted in London trades on 17.4 times 2012 earnings and has a yield of 3.5%.
Perhaps the higher rating of the emerging market stocks will be justified by higher growth, but growth in emerging markets is seldom a smooth path. The one emerging market where valuations appear currently modest is China – a reflection of the level of concern about that economy. Over the last decade – that is since the listings of many large Chinese state companies in Hong Kong – disaster scenarios for China have appeared almost every year. It is a shame that the professional disaster theorists chose the one economy which has proven stable during a decade where most other economies have crashed. This week’s Chinese GDP data suggests the economy may grow at only 7.5% this year. We regard this as a perfectly healthy growth rate for a maturing economy where valuations are modest.
For fund managers like us with a global equity mandate, the best value for money seems currently to be in developed market quoted companies with strong positions in emerging markets. Longer term investors currently face very low returns on cash and bonds. With developed economies ageing and their governments struggling with debt, developed market stocks often offer more yield than growth. The improving lives of the world’s less advantaged is an astounding human story before it is an investment theme, but, like any investment theme, valuations can become stretched. Selling emerging market stocks to buy Unilever may not be very glamorous, but as cautious long term investors, that’s where we currently find the value.”
Simon Edelsten is manager of the Artemis Global Select fund
Comments