North American investors have pulled billions of dollars out of emerging market funds in recent weeks. But that reflex reaction to rising commodity prices and unrest in the Middle East may prove short-sighted.
"It's the funniest thing. I hear people saying the emerging market story is over, as if all the people in these countries are going back to bed," says Vikash Jain, portfolio manager with archerETF Portfolio Management, in Oakville, Ont.
According to Mr. Jain and other observers, emerging markets are still a solid investment opportunity, but one that is changing in nature.
Ever since the end of the Asian economic crisis 13 years ago, developing nations have taken advantage of the cost advantage created by their cheap currencies to rapidly increase their exports to developed nations. But today the recession has dampened the West's appetite for goods, and emerging market currencies, from the real to the rupee, are no longer depressed against the U.S. dollar.
To keep their economies expanding, developing nations are going to have to rely more on domestic consumption than they have in the past. That translates into tougher times for emerging market firms that rely upon exporting, Mr. Jain says. Instead, he favours sectors that serve local consumers, which include wireless communications, retail and financial services firms.
"The long-term strategic story for emerging markets is still strong," he says, but it will favour investors who act selectively.
One factor to take into account is a narrowing valuation gap. During the last decade, emerging market equities have generated an average 16-per-cent annual return, compared with just 4 per cent for stocks in developed economies. But the double-digit gains by emerging market stocks means they're no longer particularly cheap when compared to stocks in the developed world.
Since 2001, the price-to-earnings multiple on North American and European stocks has dropped to 15.4 from 23.4, while the average multiple on stocks in developing economies has increased to 14.5 from 10.6, according to John Higgins, senior markets economist with London-based Capital Economics Ltd.
While it is undeniably harder to find bargains in today's emerging markets, investors buying a very broad fund such as the Vanguard MSCI Emerging Markets ETF, which includes stocks of about 750 companies, should do well if they hold for the long term, Mr. Jain said. But there's also an opportunity to take advantage of differences within emerging markets right now.
He favours India, where inflation seems to have peaked, over China, where it is heating up. He also likes Malaysia and South Korea for their strong exports into the Chinese market. Additionally, Mexico and South Africa look attractive because their inflation rates are "tolerable" and they have large exposures to oil and gold respectively.
He adds Brazil and Indonesia to his list of countries to avoid right now because of their high and increasing rates of inflation.
Other money managers believe in the merits of individual companies. "Emerging markets are neither an obvious bargain, nor are they egregiously overvalued," note Pierre Lapointe, global macro strategist, and Alex Bellefleur, financial economist, at Brockhouse & Cooper Inc. They favour emerging market companies with dominant positions, high operating margins and strong sales and earnings growth. Top on their list are Chinese software company Tencent Holdings Ltd., Chinese industrial Sany Heavy Industry Co. Ltd. and Russian wireless player Mobile Telesystems OJSC.
Sukyong Yang, global portfolio manager with Cumberland Private Wealth Management Inc. in Toronto, also focuses on individual companies.
One company she has invested in is Hengdeli Holdings Ltd., China's largest watch retailer. The Hong Kong company is trying to capitalize on the Chinese love affair with luxury goods. Hengdeli is growing at 30 per cent a year and counts LVMH Moet Hennessy among its biggest stakeholders.
She also likes South Korea's Hyundai Motor Co., even though she is concerned that South Korea will feel the pain of higher energy prices. Hyundai continues to gain market share and is now the world's fifth largest auto maker. When the stock dropped briefly last fall, Ms. Yang bought more.
Ms. Yang derives much of her exposure to emerging markets through stable global leaders that produce strong revenue from developing countries. The cigarette-maker Philip Morris International Inc., for example, gets about 15 per cent of its earnings before interest and taxes from Africa and the Middle East.
Vodafone Group PLC sells wireless service in Europe, Africa, Asia, the Middle East, and the U.S. And London-based Standard Chartered PLC provides banking services in India, China, Malaysia, the Middle East and Africa.
EMERGING MARKETS: STOCK MARKET PERFORMANCE
|MSCI Index||YTD %||1-yr %||3-yr %||5-yr %|
|EM (broad emerging markets)||-1.4||15.2||0.6||8.7|
|BRIC - Brazil, Russia, India and China||0.4||9.0||-1.9||10.6|
|EM Eastern Europe||12.0||23.0||-7.4||1.5|
|EM Europe & Middle East||8.4||21.5||-3.4||2.9|
|EM Far East||-0.5||17.4||1.3||9.0|
|EM Latin America||-2.1||11.1||1.2||13.5|
|Based on U.S. currency. Source: MSCI Inc.|
© 2007 The Globe and Mail. All rights reserved.
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