Emerging markets: enter at your own risk

As this is Money Management’s first magazine of 2019, it’s as good a time as any to investigate what looks to be one of the year’s biggest dividers amongst the investment industry.  

Emerging markets have long been a space where active, bottom-up stock picking managers thrive and find gold mines for their investors, but this year, a lot of active managers have indicated they’re going to steer clear.  

So, what really is the case for EMs, and should investors enter at their own risk?

A long-term investment?

While the 12 months to 30 November 2018 saw EMs take a big hit, with data from FE Analytics posting the sector average as -3.84 per cent, they’ve still had a pretty good run across the 10 years, five years and three years to the same date. 

The sector average sat at 7.02 per cent across 10 years, dropping to 5.71 per cent across five years, but climbing again to its high of 8.12 per cent across three years. 

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What’s clear though, is that a real stalwart in emerging markets has been Colonial First State, whether it be as a distributor or a fund manager.

The top spot for the 10 years to 30 November 2018 was held by Stewart Investors Global Emerging Markets, which is actually distributed to local clients through CFS. In fact, Stewart Investors have held a top 10 spot across the 10 years, five years and 12 months to 30 November, only dropping out across three years. 

CFS Wholesale Global Emerging Markets Sustainability and CFS Realindex Emerging Markets took the top spot across the five years and three years to 30 November 2018 respectively, with CFS Wholesale Global Emerging Markets Sustainability taking it out again in the 12 months to 30 November. 

Interestingly, CFS and Stewart Investors are famously sustainability focussed, which suggests that the key to a top performing EM fund is actually finding sustainable stocks. 

Who should invest, and why?

Stewart Investors’ portfolio manager, Jack Nelson, confirms that investing in EMs is best suited to those with a genuine long-term perspective, because the nature of the economies in emerging markets are such that in any given year, a political crisis or currency weakness is likely to be affecting one country or another. 

But, patience is a virtue, and if an investor can ride those bumps, they can sleep soundly knowing that well-run companies in emerging markets benefiting from sustainable development have the potential to deliver attractive returns over a long period of time. 

Nelson adds that the opportunities afforded by EMs lie in investing in companies that contribute to and benefit from sustainable development. 

“There are many hundreds of millions of people who have and continue to leave poverty in Asia, Africa and Latin America,” he said. “Companies catering to the emerging consumer in these countries are particularly well-positioned to benefit.”

What really makes a good EM investment, though, is that the company grows profitably, for instance if it owns a strong brand, and that the owners of the company are willing to allow minority shareholders to benefit. 

“Governance risks are all too large in emerging markets, and a focus on alignment with the controlling shareholder is an absolutely essential criterion for investing in emerging markets with acceptable levels of risk,” said Nelson. “In such risky markets, the best approach to capital growth is to focus on capital preservation.”

Sectors looking strong in 2019

Nelson told Money Management that broadly, EMs had suffered primarily as a result of slowing growth in China, rising US interest rates and commodity price weakness. 

But it’s actually not all doom and gloom, and some economies have shown strong growth and limited inflation, enabling some very strong returns to equity investors. 

Nelson said India in particular has been a hotspot for high quality companies, with the country breeding a large number of entrepreneurial family companies that have built impressive business franchises.

“Some of these are globally competitive service companies, like in IT outsourcing, whilst others are leading domestic consumer brands. India is a market which offers a unique combination of a huge potential for growth plus a range of highly profitable and well-run companies for us to choose from.”

Going forward, Nelson remains wary but optimistic on the opportunities for attractive, risk-adjusted returns over the long-term.

“Emerging markets remain vulnerable to various macroeconomic shocks,” he said. “Yet clearly we are at a point where sentiment towards emerging markets is near a nadir. At some point in the future, capital flows will likely return to EM during a period of slower developed market growth and the opportunity for outperformance from EM will return.”