Point of View: June 3, 2004: Finding value in emerging markets

John Gall (‘Opportunity in emerging markets’, MM, May 13, 2004, p18) was correct to criticise Australian investment managers for ignoring the opportunities available in emerging markets, but he stopped short of suggesting an appropriate allocation.

Given the relative long-term economic prospects for emerging markets (Asia in particular), we believe an allocation to emerging markets of 10-15 per cent is not unreasonable.

Why are we so bullish? While we agree with Mr Gall that macro-economic conditions make investment in emerging markets attractive, it is the opportunities that exist at a corporate level that make it so compelling.

The three global emerging market regions — Latin America, Eastern Europe and Asia — are growing at significant rates. But you cannot look at the nominal GDP growth rates in isolation. Venezuela is a case in point.

For the year to December 2003, Venezuela’s economy grew at a nominal rate of 9 per cent. However, with an inflation rate of 26.6 per cent, the economy shrank in real terms by 13.9 per cent. This example highlights a simple but important theme — when investing in emerging markets it is extremely important to do the necessary research first.

When looking at the various regions, we find Latin American economies tend to be very cyclical, with growth predominantly fuelled by export-led factors, so they tend to be more susceptible to global shocks and hence more volatile. However, it is still possible to identify good quality companies that rely more on domestic demand. This reduces the volatility of corporate earnings.

We look for companies with quality management and strong fundamentals, which will outperform across the full economic cycle, not just when the macro picture is rosy.

Since joining the European Union, Eastern European economies have had fiscal discipline imposed on them. This has resulted in a convergence of inflation and interest rates that has led to improved corporate earnings. However, this is old news and valuations are now not as cheap as they once were.

And then there’s Asia, which represents 55 per cent of the MSCI Emerging Markets Free Index. Asian GDP growth is strong, inflation and interest rates are at record lows, governments are committed to liberalising their economies and inter-regional trade is booming, driven primarily by China.

However, it is at the corporate level that we are most positive about Asia.

The rise of the Asian consumer is fuelling domestic demand. Domestic consumers are young, less frugal than their parents and are spending more freely. Low inflation and record low interest rates translate to more readily available credit. As a result, the region is becoming less reliant on external growth, making it less susceptible to external shocks.

There has also been significant restructuring at the corporate level since the Asian crisis of 1997. Companies have been forced to cut costs and significantly reduce their debt levels. They are more efficient, more transparent and better regulated. Corporate governance has improved and management is more focused on creating shareholder value.

Asia today is in a much better position to weather global shocks than the Asia leading up to 1997. And despite higher corporate earnings growth than the developed world, Asian companies are significantly cheaper, even after last year’s stellar growth.

Now let’s look at India. With over 6,000 listed companies, India is the second largest market in the world (after the US) when measured by number of listed companies. At an aggregate level, these companies are the best quality in Asia. They have strong management teams that are focused on delivering shareholder value. This is due in large part to India’s strong accounting system, corporate governance and transparency, which have evolved within an Anglo-Saxon legal system.

India has experienced a dour macro environment over the past decade. But forced to survive these lean conditions, Indian companies have become very efficient and now operate off tight margins.

Structural change over the last few years has turned India’s economy around. GDP growth for 2004 is expected to be around 9 per cent. The incoming government has committed to continue liberalising the economy and opening it up to foreign competition. Indeed, the Congress party was the initial instigator of the original economic reforms back in the early 1990s. What we see today is a virtuous cycle with companies feeding off an improved macro environment, resulting in improved corporate earnings. These earnings in turn are being distributed to shareholders.

Unlike India, China has experienced very high levels of GDP growth for the past two decades. Despite this, China is still characterised by very poor quality companies. They are inefficient, illiquid, poorly regulated, and lacking in transparency and corporate governance. Often run for the benefit of larger shareholders (that is, the Chinese state), the focus is on maintaining market share rather than delivering profits to shareholders.

However, significant benefits can be derived via investment in offshore companies that source either profits or assets from China. The main market for these companies is Hong Kong, where Chinese incorporated companies can list on the ‘H’ share market.

Emerging markets in general and Asia in particular, provide some very good investment opportunities. However, these are stock- pickers’ markets.

Prospective investors must identify investment managers who do their homework at a stock level to control risk and ensure the companies they are buying are of suitable quality.

Brett Jollie is associate director — manager sales and marketing with Aberdeen Asset Management.