Investing in BRICs

BT Financial Group coined 2005 the “year of the disconnect”, because of the various anomalies occurring in the developed versus underdeveloped share markets and economies.

For example, given the sustained bull run in the Asian markets, investors would normally find these high returning markets becoming more expensive as valuations rise. However, this has not happened.

Favourable valuations, favourable cyclical factors, structural improvements and good diversification continue to add up to the classic textbook reasons for investing in global emerging markets (GEMs) and, in particular, the Brazilian, Russian, Indian and Chinese (BRIC) markets.

As BT points out, good performing funds are all about the ‘stock story’ and, mostly, the GEMs have been able to deliver — and not just for one or two years.

While institutions and superannuation funds are the most active investors to date, there are many reasons why more individual investors with an increased appetite for risk may want to partake in future.

The Asian success story

Perennial’s Asian portfolio specialist Diane Lim says the success of the Asian region prevailed, in spite of specific market contrasts over the past year.

Despite great expectations, Lim says China and some of the ASEAN markets, such as Thailand, Malaysia and Indonesia, disappointed investors while Korea and India led the returns.

Lim forecasts a stronger performance this year from China, with growth at 8 per cent, which she says is “a good number”, and a better investment case than, say, India, which is pricey and already discounted for future earnings growth.

ING director and head of emerging markets, equities Jan-Wim Derks sees the “rosy” performance of the BRIC markets as equally segmented, preferring Brazil for outperformance to, say, China and India.

He says Brazil is also a window into China because of its commodity exports.

Performance ahead of schedule

Certainly, when the Goldman Sachs emerging markets group highlighted the special importance of the BRIC markets over the next 50 years in an article in 2003, little did it foresee the amazing trajectory of growth for these non-G6 countries.

Dreaming with BRICs: the path to 2050 modelled the 50-year growth projections for each of these key emerging markets, mapping out gross domestic product (GDP) growth, income per capita and currency movements.

What is remarkable is that countries like China, with its manufacturing powerhouse, and India, with its booming information technology sector, stable government and middle class, seem well ahead of this schedule.

Speaking from ING’s Frankfurt office, Derks says: “The amazing conclusion is that in less than 40 years, the BRIC economies together could be larger than the current G6 [the six richest countries in the world: US, Japan, Germany, UK, Italy and France] in US dollar terms.”

He adds: “In other words, over the next couple of decades these countries will gain substantially in relative importance in the world. This goes for BRICs as well as for a lot of other emerging economies, like South Korea, Taiwan, Turkey, South Africa and Mexico.

“For investors, an important implication is that over time their relative importance in equity markets will grow substantially.”

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<[Australian investors also face fewer options for GEM investments outside of Asia.

Sure, there are the investment bank products, but pure country plays beyond that are limited. They are also prohibitively expensive for the individual if they are wholesale, but those on platforms may be possible.

In the Asian space there’s increasing choice, with active specialist funds offered by Perennial, Platinum, HSBC (Challenger recently took over its funds) and Aberdeen, as well as BT’s Asian Fund, managed by Putnam Investments.

Indexed funds include AMP Capital Investor’s China funds one and two.

Fund of funds include one by Macquarie in Asian hedge funds and also Asia Pacific Asset Management.

Fidelity has Chinese and Indian funds with ING’s Optimix (fund of funds) and is likely to launch more specialist funds later this year.

Further afield, global offers include ING’s Emerging Global Fund, Goldman Sachs, ABN Amro and Fidelity.

Vanguard offers an indexed fund for longer-term investors.

Llegg Mason, which recently acquired Citigroup’s Asset Management globally, has an emerging market trust that is on the Navigator platform along with ING.

A Llegg Mason spokesperson said that while $800 million in funds comes from Australian sources, almost 98 per cent is institutional money, mainly from super funds.

India and China build their profile

While cherry picking of stocks is important, investor perceptions of these funds tend to be governed by themes, says one analyst.

For example, ex-Credit Suisse Asset Management head Peter Sartori runs boutique Treasury Asia Asset Management with funds in Asia. His bottom-up style is also high conviction, with a maximum of 50 stocks in the fund.

Sartori also uses adviser Dr Marc Faber, who is reportedly extremely bullish about Asia, recently telling Australian investors that maybe they should jump on this wagon for opportunities and growth in property in ASEAN countries (not just Hong Kong) and shares.

“International investors have been getting back into Asia over the past three years and the appetite is re-emerging locally too as the equity market wanes.

“We think the fact that Asian markets have had a three-year run, and there’s still strong fundamentals underpinning [them], means it’s only natural to see the interest continue, especially in high profile places like India and China,” he adds.

Earnings growth remains strong

Brad Aham, head of the emerging markets equity team at State Street Global Advisors in the US, is another who believes that, despite the massive jump in the MSCI index of 162 per cent over the past three years, the valuations are still good.

He says this is because earnings growth has stayed strong.

“Three years ago, emerging markets were trading at 1.4 x book, 14 x earnings, 8 x cash flow, and had a 2.4 per cent dividend yield.

“Today, markets are at 2.4 x book, 15 x earnings, 9 x cash flow, and have a 2.5 per cent yield.

“So we’ve seen a meaningful increase in asset valuation multiples, but cash flow and earnings are still strong and companies have increased their payout ratio. Compared to developed markets, valuations have compressed as EAFE now trades at 2.4 x book, 17 x earnings, 10 x cash flow, and has a 2.3 per cent yield.”

According to Aham, valuations make it more difficult to argue for dramatic outperformance of emerging markets, but otherwise the fundamentals still look reasonably good.

“Macro risks to look out for in 2006 include elections throughout Latin America, as well as any shocks to the global economy from energy prices, avian flu or other unanticipated events,” he says.

“With good global growth and continued low interest rates, there appears to be little to derail emerging markets other than the psychological burden of three good years of performance.”

Not for the faint-hearted

While this still sounds like a strong signal for entry by the savvy investor, there are obvious risks like increasing interest rates, liquidity crises, oil price hikes (which aren’t negative for the producer countries), and most of all, currency devaluations.

Penelope Joye, managing director of new boutique financial advice firm Superwoman, has firsthand experience of the risks of emerging markets, particularly in South America, having worked in the area with Morgan Stanley in the 1990s.

She says that while the asset class was considered “hot” back then, many remembered the Latin American debt crisis sparked off by Mexico’s default on loans in the 1980s.

“If the reserve banks start defaulting, it’s not the place you want to be and these markets aren’t for the faint-hearted. They should only be part of an aggressively diversified portfolio.

“Your client must be able to understand this risk before an adviser even considers recommending this type of fund to them.”

The Asian crisis in 1997, the Mexican crisis in 1994, and the South American crisis in the 1980s, have all tipped out major returns on these markets in the aftermath.

Can it happen again? Asian players say no, but it’s also fair to say that with movers like George Soros warning of a “significant chance” of a US hard landing in 2007, this could result in negative flow onto European and, to a much larger extent, Asian markets.

Predictions for the near future

However, not everyone sees the world in the same way and in a recent update respected local AMP economist Shane Oliver suggested that a hard landing in the US was less likely.

ING’s Derks says: “For 2006, we think the BRIC economies will continue to grow their economies much faster than the main developed markets: Brazil plus 3.5 per cent, Russia plus 6 per cent, India plus 7 per cent, China plus 8.5 per cent, versus US plus 3.5 per cent, Japan plus 2.6 per cent, and Europe plus 2.1 per cent.

“The macro economic fundamentals of the BRIC economies will continue to improve.”

Of the four BRIC markets, ING sees the Brazilian stock market as having the highest upside potential in 2006.

“Real interest rates, currently around 13 per cent, may drop to single digit levels. This should propel the equity market,” Derks explains.

“Also, we think the outlook for the Russian, Indian and Chinese stock markets is relatively rosy. Russia will continue to benefit from the current high oil prices, India from the outsourcing trend in software services, and China from becoming the manufacturer for the rest of the world.”

According to Sandeep Kothari, portfolio manager for the Fidelity India Fund, there are various so-called emerging markets and the characteristics of these markets vary in terms of risk profile, stability of growth and long-term growth potential.

“Selecting which emerging markets are the most appropriate depends on an investor’s objectives,” he says.

“If an investor wishes to accumulate assets in the long-term with some stability, India is one of the suitable candidates due to its strong fundamentals.

“It is similar to investing in the big and developed economies of the future or investing in Japan in the 1970s. India may have some short-term volatility. However, it is an excellent long-term investment opportunity,” Kothari adds.