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Hidden gems

Turmoil in North Africa and inflation fears are having an impact on short-term opportunities in global emerging market funds but investors willing to take a longer view are discovering a sector that is regaining its confidence. James Smith reports

Emerging markets have seen considerable outflows this year as investors took profits and recycled money into Western regions. But consensus suggests the longer-term case for investing in the East remains intact.

Charlemagne Capital chief investment officer Julian Mayo says this correction is down to two main factors, a recovering US economy presenting beneficial asset allocation opportunities and lingering inflation fears in emerging countries.

He says: “Inflation concerns are justifiable, with a recent 9 per cent level in India, for example, but we feel pressures are now peaking in line with tighter fiscal policies and higher food prices beginning to come off. Meanwhile, various indicators, such as the long-term debt downgrade by Standard & Poor’s, suggest the recent growth spurt from the US is dissipating.”

Mayo says recent market corrections provide a good entry point and that out-flows have put an end to expectations of a bubble in these equities for the time being.

Looking at the top-performing global emerging market funds over five years to the end of April, the usual suspects of Aberdeen Asset Management and First State are in place, alongside funds from Dimensional Asset Management and Barings.

Top of the pile is Aberdeen emerging markets, with a return of 139 per cent.

Head of global emerging markets at Aberdeen Devan Kaloo says emerging markets have already rebounded after a weak start to the year and that outflows have stabilised.

Like Mayo, he acknowledges ongoing inflation concerns but adds that continued monetary tightening suggests that emerging central banks have become more vigilant about price pressures.

“That said, continuing unrest in the Arab world and supply chain disruptions resulting from the disaster in Japan could exacerbate inflationary risks, while uncertainty over the impend-ing end to the US Federal Reserve’s second round of quantitative easing may hamper market momentum in the short term.

“We remain sanguine over emerging markets’ long-term fundamentals. The recent rotation into developed markets as well as export-driven companies in the asset class has thrown up opportunities, enabling us to add to a number of holdings that have fallen significantly from previous peaks.”

Kaloo rarely makes big changes on the portfolio but focuses on long-term opp-ortunities in quality companies with strong brands.

His bias in recent years has been towards domestic demand, with bigger positions in areas such as discretionary spending, healthcare and real estate.

This focus has fed through to the group’s latest emerg-ing markets launch, a small-cap focused investment trust, with Kaloo high-lighting smaller companies as the best way to access domestic consumption.

At country level, the broad Gem fund has long held core positions in Brazil, India, Hong Kong and Mexico, with mainland China underweight across Aberdeen’s portfolios on quality concerns.

First State has the second and third best-performing funds over five years, with the First State global emerging markets fund returning 127.7 per cent and First State global emerging markets leaders fund returning 126.9 per cent over five years. Manager Jonathan Asante has a similar focus on quality.

He recently sounded concerns on valuations of such companies listed on the popular exchanges of Brazil, India and China, although stressed that several stocks with big franchises in these countries but listed elsewhere, such as Taiwanese firms operating in China, remain reasonably valued.

He says: “Emerging market consumer companies perceived to be offering a defensive growth profile have become very popular with investors and, in many cases, it has been difficult to see potential for absolute returns from current valuation levels.

“As consumer companies have become overly favoured, we have moved into less popular areas such as telecommunications and the best-run technology companies. It is more important than ever not to sacrifice quality for valuation, given how risky things are becoming.”

Against this backdrop, Asante has become more cautious, homing in on companies with strong cashflows and robust price-giving franchises.

Looking at recent performance, he notes contributions from several Taiwanese stocks, with Taiwan Semiconductor, President Chain Store and Delta Electronics all rising as investors were drawn by attractive valuations and the broader backdrop of improving relations with mainland China.

Over three years, the lesser-known McInroy & Wood emerging market fund, run by ex-Guinness Flight manager Francis Seymour has fared well, returning 44.4 per cent.

His portfolio has benefited from diversified exposure across the region, with the bulk of investments in Asia and Latin America.

Seymour has continued to avoid the volatile Russian market, with 55 per cent of his assets in Asia, 39 per cent in Latin America and the rest spread across Africa and Eastern Europe.

Despite the recent correction, he says emerging markets have gained from renewed investment con-fidence about the global economic recovery.

He says: “In retrospect, the consensus view on the outlook for growth for the developing world a year ago was far too pessimistic and economies have responded strongly to the various fiscal and monetary stimuli applied by the monetary authorities.

“Looking ahead, there are concerns over inflation and asset bubbles are resurfacing as potential problems. It is also apparent that developing economies need to encourage private consumption in order to lower their dependence on exports.

’Investors in emerging markets find themselves in uncharted valuation territory where there is no set of historic criteria upon which to base an overall value judgement’

“This transition will be no small undertaking and will involve a degree of social, political and cultural upheaval, as well as purely economic change.”

Despite these risks, as well as potential currency appreciation, Seymour says the longer-term case for investing in emerging markets remains intact, albeit with more limited short-term opportunities.

He says: “Emerging markets have generally been priced at lower valuations than developed markets in spite of their faster growth, largely due to perceptions of political and economic risks.

“As these risks appear to have eased, the valuation discount has narrowed and it now seems only natural that emerging markets, given their strengths, should be valued at a premium.

“To some extent, investors in emerging markets find themselves in uncharted valuation territory where there is no set of historic criteria upon which to base an overall value judgement.

“However, at company level, there are many well run businesses with successful franchises priced at reasonable valuations, which will likely reward the patient investor.”

While Aberdeen’s Kaloo is bullish about small caps in this area, another small-cap specialist, JP Morgan emerging markets small-cap fund manager Greg Mattiko says there are concerns.

His fund benefited last year from exposure to selected stocks in Turkey, Thailand and Brazil but despite the good performance over three years, this has fallen back in the last year as small caps underperformed their larger counterparts in the first part of 2011 due to lower energy exposure amid surging oil prices.

His portfolio gained on relative basis due to underweight positions in India and Taiwan, with both markets in negative territory for the quarter.

“Markets have remained firm in the face of recent events in the Middle East, Japan and Europe and are well supported by liquidity from developed market central banks.

“Inflation concerns are better reflected in equity prices and we have greater visibility on the degree of policy tightening needed.

“Given the strength of economic growth, there will be persistent inflationary pressures and a few central banks are arguably still behind the curve. The biggest risk today is an oil supply shock, which would damage global growth just as emerging markets begin to cool down.”

Fund focus

Global emerging markets are no longer just about the Bric countries and nor are they just about commodities or cheap manufacturing based on exporting to the West. As these economies continue to mature, more investment options present themselves. Three fund managers give their views on where they see investment opportunities

Catcher in the eye and a short history of Turkish tractors

Emery Brewer, manager, JO Hambro Capital Management emerging markets fund

Technology is one of our favoured hunting grounds. And the boom in smartphones and tablets is certainly proving to be good news for Taiwan’s Catcher Technology. The company is the leading player in a small niche, being the number one producer of unibody aluminium casings for smartphones and tablets. The special casing it manufactures enables the production of ultra-thin devices which are both attractive and technically superior. Catcher is the sole supplier to HTC and one of the biggest suppliers to Apple, giving it tremendous exposure to the insatiable demand for mobile consumer technology.

Elsewhere, Hong Kong-listed Macau-based casino owner and operator SJM Holdings has been a solid performer for us since we launched our fund last year. The company has roughly one-third of the rapidly expanding Macau gaming market. As well as attracting high-rolling, big-spending gamblers to its tables, it also caters to the higher-margin mass market. Recently announced first-quarter earnings beat expectations, building on 2010’s very strong performance which saw the company increase its gaming revenues by 68 per cent and report a 292 per cent rise in net profits.

Tractor production may seem a little prosaic in comparison with the worlds of smartphones and gambling but Turk Traktor is a core holding that is benefiting from a favourable combination of top-down and bottom-up factors.

The Turkish economy has emerged from the global financial crisis in good shape, characterised by strong GDP growth and falling inflation.

At the stock level, the company is positioned strongly in both domestic and overseas markets, with a 60 per cent share of the Turkish tractor market – bear in mind that Turkey has the second-biggest agricultural sector in Europe after France – and major export success in the US.

With a consistent record of beating earnings’ expectations, the firm has hit a sustainable growth sweet spot that should prove highly profitable for some time to come.

Goodluck and good fortune with the frontier spirit in Africa

Nick Price, manager, Fidelity International emerging Europe, Middle East and Africa fund

In recent years, Turkey has made good progress in terms of implementing reforms and improving its infrastructure while retaining its fiscal discipline. GDP per capita has more than doubled in the last decade while the country is set to benefit from favourable demographics, with around a quarter of the country’s 70 million-plus population under the age of 15.

Africa remains off the radar for many Western investors as a result of the negative perception of the continent, shaped by images of poverty, famine and conflict. The gap between perception and the reality on the ground leads to some very exciting investment opportunities.

More fashionable emerging markets have been getting a lot of attention but the long-term growth stories that investors should be getting excited about are in the frontier markets. Countries such as Nigeria offer good diversification and low correlation to other more established emerging markets.

I find some of the most interesting opportunities in the consumer-related sectors. The banks in Nigeria are now highly regulated, well capitalised and set to benefit from the penetration tailwind that exists with one of the lowest levels of retail credit penetration in emerging markets.

Investing in frontier markets is not without its risks. Nigeria is still a nascent equity market and relatively illiquid. From a political perspective, the country has experienced periods of social unrest in the past. However, the outcome of the recent elections has been positive for the continuation of reforms put in place by re-elected president Mr Goodluck Jonathan.

Shift from exports to consumption changes structure

Hugo Rogers, co-manager, Thames River global emerging markets absolute return fund

Emerging markets are no longer a “new” asset class, valuations have converged and there is plenty of mobile capital invested in this area. This justifies a more active approach with a commitment to capital preservation. It is also important to realise that the investment story is changing rapidly.

GDP growth in Gems has historically been driven by the expansion of exports and significant investment in infrastructure. Looking head, domestic consumption and the appetites of the middle classes will become increasingly important. As consumption replaces exports, there will be many structural changes which will create opportunities for us as long/short investors.

Our long positions will be those companies supplying desirable items to the emerging market middle-class consumer – colour televisions, cars, foreign holidays, education, healthcare.

The losers, where we will have most of our short positions, will be, for example, those businesses who in the past relied on cheap emerging market labour to manufacture products for the West. The developed market consumer is not so willing to part with their money and these models will struggle against falling margins – this is where we will look for short opportunities.


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