Rethinking investment in emerging markets
Some of the biggest companies in the world are based in emerging markets. Perhaps it is time to let go of old-fashioned views and seriously consider this sector, writes Janine Mace.
Here’s a quick quiz of your investment knowledge:
Who is the world’s top mobile phone vendor? Samsung.
Who does Forbes rank as the world’s fourth largest energy company? Petrobras.
Which mobile phone company has the most subscribers? China Mobile.
What do all these companies have in common? They are all based in emerging markets.
Surprised? Well, maybe it’s time to let go of some of old views and take a fresh look at just what emerging market investments have to offer to advisers seeking to grow their clients’ wealth in the years ahead.
This message is one emerging market specialists are keen for local advisers and clients to hear – particularly in light of Australia’s fading resources boom and the limited growth prospects for companies in developed markets.
Stuart James, senior investment specialist at Aberdeen Asset Management, believes emerging market companies should no longer be an afterthought.
“Emerging markets are home to some of the best companies in the world. They are not just regional players but global players,” he explains.
Schroder Investment Management’s London-based head of global emerging market equities, Allan Conway, agrees the differences between emerging and developed markets are far less relevant in the wake of the GFC.
“Financial advisers need to make sure investors understand the world has changed dramatically in the past 10 to15 years,” he says.
Misleading labelling
The distinctions between investable companies are increasingly blurred, with many emerging market companies now operating across borders and enjoying strong revenue flows from outside their listing country.
“As investors we are besotted with labels, but the difference between developed markets and emerging markets is getting less relevant every day,” explains James.
“Labels can be misleading. Samsung is not a Korean company, it is a global company. Investors need to look at companies on their merits, not on a preconception or an out-dated view of their performance.”
He argues emerging market companies like Samsung can no longer be seen as mere imitators of their developed market counterparts, but are innovative in their own right.
They also have significant resources to support future growth.
“In India, for example, many companies are cash rich, which has allowed them to buy offshore technology and expertise – such as Tata Group’s purchase of Jaguar Land Rover – and use it to create products to sell overseas,” James explains.
“Investors need to re-think their preconceptions and invest on the basis of current realities.”
This also means recognising the advances in corporate governance that have seen emerging markets companies transformed from “tin pot” fiefdoms.
“It is an old idea that these corporations are family companies not run to benefit shareholders. These are old ideas, not the current reality,” he explains.
“Today, a UK or US listing is no longer a guarantee a company will not go broke. This is something investors should have learnt from the GFC. Investors need to take away the label and look at the underlying company.”
Lonsec senior investment analyst Steven Sweeney agrees things are changing rapidly in terms of corporate governance and reporting.
“You will find the bad old days in some companies, but ESG is quickly emerging in emerging market companies and they are increasingly modern, well-run corporations,” he says.
Premium China Funds associate director Jonathan Wu believes many Australian investors need to become better acquainted with the options on offer.
“For many local investors it is a matter of familiarity, as they are used to buying Woodside versus Malaysia’s Petronas, Petro China or Petrobras in Brazil.
However, these companies have a better growth trajectory,” he explains.
James agrees many offshore companies have excellent growth prospects and notes emerging markets currently represent over 50 per cent of the global economy on a purchasing power parity (PPP) basis.
“Emerging markets should be part of people’s long-term portfolio due to their size and growth prospects,” he argues.
Drag from international concerns
Although the transformation of emerging market companies is good news for investors, the bad news is they continue to be affected by the problems plaguing developed markets.
This is something Australian investors cannot ignore, but the experts believe it does not outweigh the long-term benefits of investing in these growing companies.
“You can’t ignore these global events as emerging markets are hostage to them, but you need to block it out and look further down the road. You need to take a long-term view and allocate to future growth opportunities,” Sweeney says.
Conway believes the impact of developed market problems on emerging markets is slowly diminishing.
“Their local economies are so much stronger than developed markets and there is still growth in their economies,” he explains.
“The support for emerging markets is from domestic demand – especially in China – where it is now more important than exports. There has also been a change in trade patterns, with emerging markets exporting more in total to China than the rest of the world.
“Emerging markets are no longer relying just on exports to developed markets, which is leading to a significantly greater ability to resist problems in the developed markets.”
Institutional investors have already begun making the switch and are allocating more and more assets into emerging markets.
“In the last year or two, institutional investors have dramatically increased their exposure to emerging markets, while retail investors are removing money as they see it as risky,” Conway says.
He believes retail investors and advisers need to reassess their views on emerging market risk.
“A lot of retail investors think of emerging markets as they were before the Asian crisis or the GFC, but they have changed.
"Retail investors need to think of emerging markets as the ‘safe haven’, as they have strong fundamentals and are now the driving force in economic growth globally. They need to adjust their view as they are no longer risky,” Conway argues.
“If retail investors want an element of growth in their portfolios, emerging market equities are really the only game in town.”
Time for reappraisal?
Wu believes it is time for a rethink by advisers.
“Developing markets are likely to severely disappoint over the next few years. Financial planners need to educate themselves and broaden their knowledge base outside the major markets. They need to reconsider their asset allocation strategy going forward,” he argues.
The lack of diversification available through the local share market means investors sticking to an Australian-only approach will miss out.
Wu points out the Asian listed property market has a combined market cap of US$850 billion, compared to $100 billion for the Australian property market; most of which consists of the Westfield Group.
Although many advisers and clients have been slow to embrace emerging markets, James believes they are well placed to see the new reality.
“Australia is a nation of travellers, and when we travel to Asia we see it is a developed part of the world and not a backwater anymore. So we need to invest that way,” he says.
“To ignore emerging markets would be at your peril and to ignore a large part of the economic growth occurring in the world at the moment.”
Sweeney agrees: “Financial planners need to think about the portfolio’s home bias. We are seeing increasing adjustments by industry funds and institutional clients towards emerging markets, so retail clients should not miss the boat.”
He believes advisers “can’t squib it anymore” when it comes to emerging markets. “You need to take a five to 10-year view and we expect emerging market allocations to increase in portfolios both in terms of equities and debt.”
Easy path no longer
Calls for advisers to rethink their view of emerging market companies are gaining more urgency given the slowing of the resources boom and Chinese economic growth.
Although many advisers and clients took the easy path of riding the Chinese growth story by investing in Australia’s large resources companies, that path is unlikely to be as profitable in the years ahead.
“Australian investors need to look at Asia from a slightly different view than resources,” James argues.
A reorientation of Chinese economic growth to domestic consumption rather than massive infrastructure projects means less demand for resources – and more limited growth prospects for local resource companies.
Historically, Australia has been seen as a commodity play and has tracked the emerging market index, Sweeney explains.
“But that relationship is breaking down and India and China are increasingly reliant on consumption growth. As China shifts gear, it will be difficult to obtain growth exposure from Australian commodity stocks only.”
James believes much of the easy money has already been made by playing the China story in this way.
“When Australian investors invest in Asia, they have often invested in the two big resource companies, but with potentially less demand they need to look to the broader story of services, banks and domestic growth companies,” he says.
“If you focus on resources companies, then you are not diversifying risk as much as you think. The long-term opportunities are in domestic consumption growth, so Australian investors need to think a bit differently about it.”
Although Australian resources companies may suffer, the reorientation of the Chinese economy means its outlook as an investment destination is far from bleak.
“Investors shouldn’t get too carried away by China slowing as it is still growing by 8 per cent plus, but the 10 per cent growth days are over. That is still extremely good growth,” Conway argues.
Many experts believe the reorientation is a good move.
“If China is increasing its domestic economy then it will be shielded better from external shocks and there is a better case for domestic equities,” Wu argues.
James agrees the shift is a beneficial, rather than an negative, change.
“Chinese growth is slowing, but this is a positive as 10 per cent yearly growth is unsustainable without bubbles developing. The Government’s desire to moderate and diversify growth is a positive. A greater focus on consumption demand should help avoid a hard landing in China,” he notes.
Finding the money
Once advisers accept the necessity of embracing allocations to emerging markets, the question is how they fit into a portfolio.
Sweeney expects any increase in allocations to initially be sourced from clients’ existing global equity allocations, “but eventually it will come from the Australian equity allocation”.
He believes advisers need to think carefully about the home country bias in most client portfolios – despite the success of this strategy in recent years.
“With emerging markets you are opening up the portfolio to more diverse growth opportunities.”
When it comes to the best investment style for these assets, the advice is clear.
“Lonsec recommends active over passive at the current time as it is better chasing alpha than beta,” Sweeney notes.
“We prefer specialist emerging market managers with on-the-ground experts. You get beta from an ETF, but there are definitely opportunities for specialist managers to find good companies and opportunities.”
Wu agrees: “In inefficient markets you can’t be inactive, you need to be active to make money. But I don’t think you should be company specific, as it is too difficult for retail investors and planners.”
Lonsec recommends a tiered approach to manager selection.
“The first step is a global emerging market manager with a broad mandate across borders. Then for increased Asian exposure you can use an Asia (ex Japan) mandate manager, which will give you exposure to India, China and emerging Asia.
"Finally you go to single country funds, but this leads to exposure to the full beta swings of those countries,” Sweeney explains.
Although this may be a good way to ease nervous clients into an emerging market allocation, Wu believes most global funds “look too much like US equities funds” to be worthwhile.
“Go by region and find a good fund manager with a high tracking error. If they benchmark performance it should have high tolerance levels.
"For example, within the MSCI Asia Index the Malaysian allocation is 5 per cent, so the manager should be able to go 6-7 per cent either side of the benchmark,” he says.
Conway takes a contrary view, arguing a regional approach to emerging markets is inappropriate.
“We do not believe in a regional approach as the country is more important. For example, Russia is different to Hungary, as Russia is an oil play,” he says.
“We gain 50 per cent alpha from country and 50 per cent alpha from stock selection. It is wrong to do either just country or just bottom-up, as the country factor can be the most important.
"Historically, 50 per cent to 70 per cent of emerging market return comes from country selection, so this is the best approach.”
As a bottom-up manager, James believes the key to success in emerging markets is ensuring you are investing in well-run companies.
“Then what happens at the country level is less important, as companies can still blow up even if the country is doing well,” he says.
“It is about identifying the good companies and not overpaying. The economic growth will provide a good environment.”
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