Another country
Charles Mesquita reviews the risks and opportunities when it comes to investing in emerging-market equities
Since stock markets around the world reached their trough levels in March 2009, emerging-market equities have recovered particularly strongly.
In sterling terms, emerging markets, in aggregate, returned +93.9 per cent over the 12 months to 3 March (the anniversary of their 2009 low), while the world index as a whole delivered a return of ‘just’ +60.7 per cent to the UK-based investor.
In this article we examine the case for charities to invest in emerging markets and the means by which they might gain exposure to the favourable trends in those markets.
Valuation changes
The strong performance of emerging-market equities over the last 12 months means that those equities are not as attractively valued collectively as they had been previously.
As figure 1 shows, while equity markets around the world, even after their strong recovery of the last year, are less expensively rated on average than they were between 1980 and 2007, equity markets in the Asia Pacific (ex Japan) region and in emerging markets are now more richly valued than they were.
In the context of ultra-loose monetary policy and significant uncertainty about the outlook for economic growth in much of the developed world, emerging markets have risen sharply, and they have attracted considerable capital inflows in recent months (in sharp contrast with the flight from riskier assets that occurred during the global financial crisis).
Prudential’s announcement at the beginning of March that it is in talks to acquire AIG’s Asian life interests underscored the attractions of higher-growth regions of the world to investors in lower-growth areas. Twenty years ago emerging economies accounted for just 3 to 4 per cent of the growth in the global economy, but they are expected to provide about two-thirds of overall growth in global output in 2010,1 thereby offering continued opportunities for investors.
With monetary policy in the major developed economies remaining highly accommodative, we believe there is scope for emerging-market assets generally to continue to perform well, and the case for investment in those assets has certainly been strengthened by significant changes in emerging markets over recent years.
Since the various crises that befell them in the 1980s and 1990s, many emerging markets have made notable progress on a number of fronts. Relative political stability has spawned sound economics and stable domestic finances, with resource-rich economies, in particular, benefiting from rising commodity prices.
In general, the household and financial sectors of emerging economies exhibit much lower levels of debt than their developed-world counterparts. In response to the credit crisis, authorities in emerging economies were generally well-placed to put in place stimulus measures (given the relatively healthy state of their public finances) to support activity as exports slowed, and households and businesses were equipped to respond to those measures.
The influence of the developing world on the global economy continues to grow, and developing nations ultimately are on a convergence course, in terms of demographics and consumption trends, with the industrialised world. Figure 2 compares a number of features of emerging and developed economies and captures the long-term drivers of the former.
Socio-economic factors
The map in figure 3 below illustrates in particular the significance of many developing nations in terms of their population sizes (each country’s size in the map is shown in proportion to its population), and we believe that the population dynamics of a number of these nations give rise to significant investment opportunities.
The shift of economic power from the developed to developing world has been a theme which has been in place for the last few decades and has been one of the trends that has been a long-term driver of our investment thought process.
The long-term, secular growth of developing economies is likely to entail a number of significant changes, including: Strong growth in incomes (from a low base), high savings rates and, in contrast with many developed economies, low household and institutional indebtedness.
- The ‘Westernisation’ of tastes and the convergence of corporate governance standards.
- Resource and infrastructure constraints (particularly in relation to water, oil and agricultural commodities).
- Urbanisation, declining agricultural productivity, ageing populations and rising dependency ratios in some developing nations.
- ‘Mercantilist’ policies and possible frictions regarding trade policies.
- Increasing exports of value-added products and services.
- The expansion of western-style health and social security systems.
Although these trends are broadly applicable across the developing world, underlying economies may diverge significantly in the period ahead and we believe that investors must be selective about the nature of their exposure to developing markets.
Furthermore, companies based and/or listed in developed markets may have exposure to the favourable trends evident in developing economies, which may make them attractive investment prospects. In an increasingly globalised world, the location of a company’s stock-market listing is not necessarily indicative of where that company’s opportunities lie.
HSBC and Standard Chartered, for example, are listed on the London Stock Exchange but have significant exposure to emerging markets, and the London market plays host to a number of mining companies whose activities are concentrated outside the UK.
By taking a holistic, global approach to investment by investing in long-term themes (rather than one focused simply upon geographic silos), investors may also benefit from higher standards of corporate governance and responsible investment (factors which are, in our view, critical to our appraisal of investment opportunities), as well as in meeting their requirements for income.
Given the significant advances that have been made in emerging markets in the fields of corporate governance and responsible investment, and in light of emerging-market companies’ propensity generally to pay higher dividends to their shareholders than they used to, many such companies are highly attractive investment candidates in their own right.
However, by widening their investible universe, investors may harness strength in such areas not merely by direct investment in emerging market securities, but also via companies listed in developed markets which possess the attributes that investors favour.
Back to basics
Whether seeking to invest in the developed or developing markets, we believe fervently that it is necessary to look in detail at the fundamental attributes of companies (including balance sheets, cashflows, corporate governance, responsible investment issues and operational practices) and to analyse particular companies rather than where they are domiciled.
There are a number of opportunities that are inherent generally in companies that are either located in the emerging markets, or are based in a developed economy but trade in or earn revenues from emerging markets, including those with a focus upon:
- Domestic consumer goods and services.
- Finance, real estate, food retail, healthcare, travel and leisure.
- Infrastructure and environmental spending.
- Agriculture and food production.
- Western brands and luxury goods.
Risk
While we believe that emerging markets should continue to create attractive investment opportunities, they are not without risk.2 In the near term, sovereign (country-specific) risk has risen around the world and, amid the increasingly parochial concerns of policymakers in much of the developed world, protectionist threats are likely to grow (and with them the hazards of some emerging countries’ over-reliance on exports for their economic growth).
Risk also surrounds the prospect, following a period in which monetary conditions have been remarkably loose, of higher interest rates, particularly in China where authorities are contending with significant capital inflows and incipient inflation concerns amid the economy’s still-rapid growth.
In seeking to identify the opportunities inherent in emerging-market growth, we are mindful of the prevailing risks but confident, in spite of strong share price gains in emerging markets hitherto, that a stock-specific approach to exploiting those opportunities should prove highly beneficial to charity investors in the
years ahead.
Notes
1. Source: International Monetary Fund, World Economic Outlook Database, October 2009
2. See also ‘Sum of the parts’ by Clarissa Dann in Caritas, Guide to Risk Management, May 2010, page 21
Author: Charles Mesquita
Charles Mesquita is a charities specialist at investment managers Rensburg Sheppards.
He advises charities and trustees on a wide range of issues from investment to strategic planning, sits on the board of the Charities Investors Group and is a member of CFDG and Acevo.
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