There are many obstacles to investing profitably in emerging markets. In November 2011, Investment Magazine and Neuberger Berman gathered superannuation experts to trade stories about the risks of investing in emerging market equities. SIMON MUMME reports.
Conrad Saldanha is sceptical of companies debuting on emerging market stock exchanges. Reliable information about these businesses is scarce, and the bankers underwriting share sales often use underhand sales methods, says the New York-based portfolio manager of Neuberger Berman’s $1.3 billion emerging markets equity fund.
“If it’s a good company, the bankers put a gun to your head and say: ‘You’ve got to buy it’,” Saldanha exaggerates. “You don’t know enough history to do due diligence on the company, but you meet these guys once and you have to make a decision. If it sounds attractive it will be heavily oversubscribed and you’ll get very little. You waste your time.”
New listings that Saldanha wants to avoid, meanwhile, will describe Neuberger Berman as a “great client” and offer a large allocation of shares. “So I’m a little sceptical. If we like the company, we do the work, and buy it afterwards if we still like it,” he says. His doubts are the reason why Neuberger Berman has bought shares in just five initial public offerings in emerging markets in the last three years, and show why it is important for investors to know the risks affecting the performance emerging markets stocks.
“Fickle” capital flows
Foreign institutions invest large amounts of capital in emerging markets. These sometimes “fickle” capital flows can “determine performance more than fundamentals,” Saldanha says.
Many investors get spooked when global markets fall and retreat to the most heavily traded securities in the world, particularly US government debt, even if emerging market companies remain strong, he says.
This “indiscriminate” selling stops when markets stabilise and “bargain hunters” return, or when emerging market governments provide fiscal stimulus. In some markets, large pension or sovereign wealth funds, such as Malaysia’s Khazanah Nasional Berhad, can support their home markets when foreign investors retreat, Saldanha says.
Despite this, emerging markets have performed better than developed markets since the collapse of Lehman Brothers. The MSCI Emerging Markets Index gained 13.88 per cent between the market close on September 15, 2008, until the close on January 03, 2012, Investment Magazine calculates. Meanwhile the MSCI World Index declined by 1.79 per cent from the market close on September 16, 2008, to the close on January 03, 2012.
“Day-to-day, week-to-week and month-to-month, everything is going to move up and down together when it’s risk-on, risk-off,” says Innes McKeand, head of equities at the $42 billion AustralianSuper. But over time “the returns from emerging markets have way outstripped developed markets”.
Outside the index
Ben Samild, CIO at the $2.8 billion LUCRF Super, questions if superannuation funds should invest in emerging markets through an index funds manager or one or more “very active” funds managers.
Many investors choose not to invest only in emerging markets stock indexes. They say the gauges don’t present the full range of investable companies, list state-owned enterprises that do not issue free-float securities, and are dominated by large-cap stocks (at one point, 85 per cent of the MSCI Emerging Markets Index was comprised of companies with a market capitalisation of $5 billion or more, Saldanha recalls). Because many of these large-cap stocks are raw materials companies or export goods to developed-world consumers, their revenues are not gained from domestic consumption, which is what investors seek.
JANA Investment Advisers, which consults 81 institution investors that collectively manage $174 billion, does not follow emerging market indexes. “We really try to focus on active management instead of worrying about the index,” says James McKinlay, head of fixed interest at the company. Investors in emerging markets must be “very accurate” when they target investment opportunities.
JANA is advising clients to increase their exposures to emerging markets by investing less in Australian equities, and targeting mid- and small-cap equities, private equity, infrastructure and property. Saldhana says small- and mid-cap emerging market stocks are usually less affected by hot money flows and have domestic or regional customer bases.
Investing in Chinese infrastructure is made easier because authorities can approve new investments fast. “If they decide to fund something, it happens. They start the crew and the excavators come out in a couple of days,” he says. Other emerging markets do not plan new infrastructure as decisively. “To try and set something up in India could take years to get clearance. In Indonesia, the absolute same thing.” However some Chinese infrastructure companies are forced to undertake projects that are more beneficial to local people than foreign investors. Saldanha recalls a conversation with the CEO of a state-owned infrastructure company, who said: “Whatever we took as part of a stimulus plan from China was zero-margin.”
Such state-owned enterprises do not have shareholder interests at heart. “A lot of these businesses are run for the benefit of the local population. This is reflected in their business models and that is why the returns are so low,” Saldhana says. “Whether it’s Petrobras or the Chinese or Indian oil companies, they subsidise locals to fill up their gas tanks and that’s why they lose money in parts of the cycle.”
Buying Australian and emerging market equities can cause a “doubling” in investors’ exposure to resources companies, says Oscar Fabian, CIO of the $8.4 billion VicSuper. The strength of Australian resources companies link its stock market with China’s economic growth and make it correlated with the resources industries of Russia and Brazil. Fabian asks why VicSuper, which invests 15 per cent of its global equities allocation in emerging markets, should keep “carving out Australia”?
“Why do we have Australian equity and international equity? Why don’t we just have global? “There are many reasons, which are mainly marketing-driven, for why that is the case.”
One-third of the money that Cbus, the $17 billion superannuation fund, commits to global equities is invested in emerging markets. The fund believes the financial strength and workforces of emerging markets will underpin stock market returns. But it worries that many other institutional investors believe the same thing.
“We’re all thinking the same way here. Is it possible that, because we’re thinking in the same way, that it’s not going to eventuate? Maybe a lot of it is already in the price,” says Tim Ridley, manager of investment strategy, says.
The rise of emerging markets exchange-traded funds (ETFs) shows how deeply the stories of China’s economic rise, India’s thriving businesses and Brazil’s plentiful natural resources have penetrated the minds of institutional and retail investors. The instruments “scare the living daylights” out of Samild because they indicate that too many people seek high stock returns from emerging markets.
“About two years ago I must have had at least 20 meetings offered to me each month with managers who pitched this: ‘We’ve just started a new fund, it targets emerging markets wealth’. They were trying to play the same thematic,” Samild says.
“Then some managers would say: ‘Forget that, we’ll take it as an ETF.’ I don’t know how much money has been put into emerging markets consumer-themed ETFs but it seems like a disaster waiting to happen because too much money is following too few assets.”
Saldhana says Eastern European countries will suffer more than other emerging markets if the Eurozone sovereign debt crisis forces the region’s banks to retract offshore lending to support their home economies.
“People say European banks have about $1 trillion in emerging markets lending, but my guess is that it’s closer to $3 trillion. That is significantly more than the $600 billion to $700 billion that US banks have lent to emerging markets,” he says.
European banks support businesses that generate about 40 per cent of Eastern Europe’s gross domestic product (GDP), while European bank lending as a percentage of Latin American GDP is 18 per cent. In Asia, it accounts for about 11 per cent.
“Eastern Europe is the predominant risk. Pockets of Latin America – because of the [European] banks that have been set up in Brazil, Chile and Mexico – have exposure but I think they will do fine. Chinese banks will step in and fund so I don’t think that systemic risk will transpire to China.”
Should European banks withdraw funding from well-capitalised large companies, such as conglomerate Astra International in Indonesia, other lenders will probably step in and “take that good credit,” Saldanha says.
Thirty-four Australian insurance and super funds have signed the United Nation’s sustainable investment guidelines, the Principles for Responsible Investment (UNPRI), which can be more challenging to apply in markets where language, business practices and legal and regulatory frameworks are unfamiliar.
“How much weight do funds put on corporate governance and shareholder rights relative to investment opportunities” in emerging markets? Newfield asks. “What transparency and protections do foreign investors receive, and do they receive information as quickly as locals?”
Visiting China in May, one of the Cbus’ aims was to assess companies’ corporate governance practices. Ridley recalls meeting a private equity manager whose governance rules have helped him invest successfully in Chinese companies for the past decade.
“He actually signs off on major cashflows in all the companies in which he invests. It’s a mechanism to control fraud. That would be unheard of in developed markets,” Ridley says.
“Sometimes we look at emerging markets as this alternative to developed markets that is growing faster and has got better public debt-to-GDP ratios and smaller budget deficits. We need to be cognisant of the underlying risks, particularly corporate governance and property rights.”
Developed world “peaking”
Investors should gauge how much of an emerging market’s growth is driven by the technological advances unleashed by the industrial and computer revolutions, says Paul Newfield, Melbourne-based senior investment consultant at Towers Watson.
“Most of the developed world has grown in the last 150 years on the back of the industrial revolution, which is peaking. The computer revolution has not peaked but has certainly filtered throughout the economy, while developed markets are slowed down by ageing populations,” Newfield says.
“If you go into any emerging market you will find they haven’t used all the efficiencies of the industrial revolution. They haven’t used all the efficiencies of the computer revolution. And they don’t have an ageing population or the social security costs that come with it. On these premises alone, there is logic to say that you will get more growth there than elsewhere.”
But not all emerging markets can rely on large, youthful workforces in the coming decades. In China, “the wave of people born in a one-child family is having pretty serious effects,” says Innes McKeand, head of equities at the $42 billion AustralianSuper. Xinhua, China’s state-owned news agency, reported at the end of 2011 that the nation’s recent most census showed it had 177 million elderly people, or 13.26 per cent of the population. An ageing society is defined as having 10 per cent of its people aged 60 years or more, the agency reported.
Newfield says investors must also question how much of an emerging market’s growth is driven by domestic consumption and advanced industry versus manufacturing and resources exports to offshore economies. Conrad Saldanha, portfolio manager of Neuberger Berman’s emerging markets equity fund, says China now relies less on exporting cheap consumer goods to developed markets.
“The Chinese have realised that they’re not going to get rich by shipping shoes and cheap t-shirts to the US or Europe,” he says. “They’re moving up the value chain, producing automobiles, rail and telecom equipment.
“In many cases, funds managers are not based in emerging market economies. They’re sitting in London or New York,” says Paul Newfield, Melbourne-based senior investment consultant at Towers Watson. “How can they give you an information advantage?”
Conrad Saldhana, portfolio manager of Neuberger Berman’s emerging markets equity fund, says the company used to have offices in emerging markets. The information provided by analysts in these markets was “more news-driven” and did not explain the valuations of companies. It was difficult to make investment decisions based on this information. “You spend more time trying to manage a team across different geographies as opposed to trying to fundamentally suss out ideas.”
The company now employs senior analysts who in New York who travel to research companies in emerging markets. “It’s not surprising for our analysts to spend two or three weeks in emerging markets. Not just in meetings with management – because managements are the best salespeople – but their competitors, suppliers, regulators.”