Investing in BRIC and beyond

 

As the global financial crisis recedes, the early winners appear to be emerging markets, fuelling a surge of capital flows into funds connected with them.

Several fund managers now use the phrase “emerging markets” only reluctantly, since the main components of global sector indices – Brazil, Russia, India and China (the BRIC countries) are fast challenging established markets, while those used to claiming “developed” status are taking on some of the characteristics long associated with immature financial systems.

The term “emerging” has built-in obsolescence. The BRIC countries alone account for 40% of the world’s population, and the gross domestic product growth gap between them and developed economies now stands at 5%, up from just 3% in 1982, indicating the developing countries are growing faster than the mature markets, according to figures from the International Monetary Fund. Demographics are the fundamental factor shaping economics and investment strategies.

 

Higher profile

According to the UK’s Investment Management Association (IMA), there has been a surge of interest in emerging markets funds from both retail and institutional investors. Data indicates equities were the biggest selling asset class in September, with investors choosing from a wide range of sectors, many of them non-UK, such as global growth, global emerging markets, Asia Pacific excluding Japan and North America. 

Schroders, quoting data from Morgan Stanley, notes that emerging markets now account for almost one quarter of the revenues of European corporates, against 16% for North America, 60% from developed Europe and 1% from Japan. Corporate sales in emerging markets are 60% larger than those from the US.

At London-based FPP Asset Management LLP, the institutional Global Emerging Markets long-only strategy managed by chief strategist Jonathan Neill is up 91.7% for this year compared to the MSCI Emerging Markets index return of 61.2%, an outperformance of 30 percentage points. Three of FPP’s long/short strategies; the FPP Global Emerging Hedge Fund, the FPP Seven Seas Fund (Emerging Europe and Middle East Fund) and the FPP Yellow Tiger Greater China Fund – have all risen by more than 99% year to date.

Joseph Wat, who manages several Asian funds for Atlantis Investment Management, including the Far East ex-Japan (but including India) fund, said the stabilising global economy is boosting the outlook for the region, especially for economies where there is still strong export dependence. “OECD indicators are bottoming out, and usually Asia lags by about six months,” he said. The uptick in investment flows from Europe and the US to Asia has been most noticeable in the last three months, when the total inflow has almost reached the outflow over the whole of 2008.

The argument that emerging markets have de-coupled from established markets has weakened. Importantly, the perception of risk has shifted. The past year’s slide has been quite different to the falls in the 1980s and 1990s, when poor fundamentals and weak policy characterised many emerging markets. It is now the major markets that face balance of payment crises, excessive debt and unstable banking systems, low economic growth and policy paralysis.

 

GDP ratings

Emerging markets have become net creditors, with high levels of foreign exchange reserves and personal saving. The total debt to GDP ratio of emerging countries averages 94%, while the ratio for developed countries is 233%. Japan’s ratio is 365%; the US is 240%, while China is 130% and Brazil 90%.

Baldwin Berges, marketing manager at specialist SilkInvest, which has just launched an income fund targeting Africa, the Middle East and Central Asia, said investors quickly get the picture when they are shown a bar chart of regions’ debt as percentage of GDP vs. foreign exchange reserves. “While the US, Europe and Japan have serious fiscal imbalances (bluntly: an unsustainable debt burden totaling multiples of reserves) Asia, Africa and the Middle East are in a privileged position. In some cases reserves even handsomely exceed debt levels.”

But it is China that dominates the sector. “China’s importance to us, as investors, grows with each passing day,” noted PSigma Investment Management’s head of global investment strategy, Tom Becket. “…Reference to China and opportunities in the East are increasingly commonplace and often the source of greatest excitement for analysts…China is now seen as the great red hope for financial markets, the sure-fire growth engine of super profits in the next decade.”

His strategy is to own the things China needs as its economy matures, including high-quality developed world companies that have strong and growing emerging world footprints. He cites Swiss pharmaceutical company Novartis, Polar Capital Healthcare and Henderson’s Technology fund as preferred plays. “We have also bought funds that have specifically invested in the Chinese consumerisation and infrastructure themes, such as M&G Global Basics,” he added.

But the market also prompts misgivings. Becket is concerned at growing overcapacity, while recent analysis from Société Générale described China as the greatest bubble in history. Lombard Odier’s chief investment officer Paul Marson observed that more generally, strong economic growth does not necessarily translate into growth for equity market investors, because of how emerging market firms choose to finance their growth. 

“They often prefer to obtain a cheap source of funding through initial public offerings, privatisation and equity issues. In which case, the spoils of growth do not go to the existing shareholder but, unfortunately, to the providers of the new capital,” he said.

The dilutive effect of new shares being issued in developed economies is typically around 3%, compared to a much higher 13% in emerging markets. “For existing investors this means emerging market stocks must perform very strongly to overcome this dilutive effect,” said Marson. 

 

Healthy results

After a torrid year, emerging markets valuations have reached attractive levels, and many economies have a strong small cap sector which could deliver substantial capital appreciation. Templeton Asset Management’s executive chairman Mark Mobius said the positive macro economic backdrop for many emerging markets is providing the sort of support that typically allows well-run companies in this sector to flourish.

Developing nations are also diversifying their economic strengths. Instead of a simple bi-lateral relationship with a few developed markets, many are choosing to focus on “south-south” trade and investment, bypassing the major financial centres with deals that involve combinations of capital, direct and indirect investment, trade, aid, and transfer of technology or expertise. Regional financial centres are flourishing.

Baldwin at SilkInvest cited the example of a group of Gulf region investors targeting AgriCap, a Moroccan food and investment company offering agricultural finance across North and Sub-Saharan Africa, and Kenya Commercial Limited becoming the first company to list on all four stock exchanges within East Africa.

In his most recent outlook, James Millard, CIO at Skandia Investment Group, which transacts between £100m (US$164.4m)  to £140m per day in retail funds and institutional mandates, was ‘very positive’ on equities in Asia Pacific ex-Japan, and ‘positive’ on equities in Latin American and Emerging Europe. He also favoured commodities and emerging market debt, a view likely to funnel further investment flows to target funds.

According to many fund managers, the uptrend has some way to go. FPP chairman Fabien Pictet said: “Although the extent of the rally in emerging markets in the first 10 months of the year has surprised many, opportunities still abound across the emerging markets universe. Currently our favoured markets are Taiwan, South Korea, Russia, Brazil, and China. We strongly believe that the rally in the emerging markets will continue, albeit at a potentially slower rate than heretofore.”