There is long term growth potential for emerging market investments and emerging economies are becoming important drivers of global growth.
However, market volatility, capital constraints and macroeconomic factors mean that stock selection and fundamental research are important factors for active management of an emerging market equities portfolio.
Emerging market equities have attractive characteristics – real GDP growth forecasts are outpacing developed markets and emerging markets will be responsible for an increased share of global GDP in future, said Dr. Ghadir Cooper, global head of equities, Barings.
“Economies in emerging markets are responsible for more than 50 per cent of global GDP as measured on a PPP basis and because they are growing at a premium to developed markets, that share of GDP will continue to increase,” she said. “So you cannot ignore looking at emerging markets and emerging market companies.”
Dr. Cooper pointed to several macro themes that signal the attractive macro characteristics of emerging market equities– potential for earnings growth from companies, with room for improvement because return on equity in emerging markets “is still lower than of developed markets”. Additionally, she pointed to the increasing growth of the middle class in markets such as China.
“China has experienced massive, rapid growth and change in the last few years,”she said. “There are about 1.8 billion millennials in the world, and 400 million are in China. In fact, in those developing countries, that story, that affluent youth growth is very exciting, indeed nine out of ten millennials live in emerging markets and with that comes a very strong consumption story going forward.”
As part of that, there are increasing trends of financial inclusion, tech adoption and participation in the sharing economy, Dr. Cooper noted.
Asset owners are interested in emerging markets and emerging market managers, but the space is not without risk, said Chris Trevillyan, director of investment strategy at Frontier Advisors. “Last year has been a particularly difficult period for active emerging market managers so we are reviewing the manager universe closely,” he said.
“In addition, emerging markets is an area where there is some capacity restraint and therefore we are generally seeking out new manager opportunities. We have also been undertaking research on more regionally focussed strategies, for example Asia, and some clients are looking at dedicated China equity managers. Emerging market equities have had an extended period since 2010 of underperformance of developed markets.”
China presents an interesting case analysis for Barings.
“We think China today is a different China than the one that we looked at over the last 30 to 40 years,” Dr. Cooper said.“The challenges that China is facing today are different to what they were a few years ago. What seemed like an endless supply of cheap labour is now gone. The labour force has peaked, and they’re going to have less labour force going forward.
“China is an economy transformed and continues to evolve. Where previously, the majority contribution of GDP came from agriculture and manufacturing, more than 50 per cent of GDP now is coming from consumption. It’s now a different China to analyse, and we are looking to the drivers of consumption within China. The labour force is actually more expensive, and efforts to clean up the environment are a priority.”
The $3.5 billion WA Super holds emerging markets allocations across the equities, fixed income, real assets and alternatives portfolios, notes Chris West,general manager investments, WA Super.
“Our investment belief to emphasise the importance of diversification, combined with our competitive strengths and weaknesses, leads us to an approach to include emerging markets in the investable universe of mandates and strategies where appropriate and enable the appointed funds managers to determine the appropriate emerging market allocation within the mandate,” West said.
“Aligned with our investment belief of simplicity in implementation, we will generally appoint global equities managers on ‘all country’mandates rather than carving out a specific emerging market specialist allocation. There are certain areas, such as alternative credit and some private markets where we would view a specialist as the most appropriate way to access an emerging market exposure.”
Barings notes that the investible universe and liquidity of debt and equity presents an increasingly diverse and growing opportunity set over the last 20 years. Barings has been investing in emerging markets since the 80s. Its strategy is bottom-up, finding companies with sustainable, unrecognized growth in the medium to long-term.
“The way we manage money and the way we pick companies in portfolios, you need a few conditions to be able to say that a company is attractive in an emerging market,” Dr. Cooper said. “It needs its own investment case and growth potential. We are looking for growth companies with reasonable price. We look over a five year time horizon, because we think that’s where the inefficiencies lie. Market participants usually look over the very short term, one to two years, but actually don’t have a strategic view. Our analysts are analysing companies over five year time horizon where we believe that we can identify inefficiencies in the market.”
Capital flows can impact on emerging markets as well, Trevillyan said.“A key driver of emerging market equity performance is the USD and US interest rates as they impact the flow of capital into the region,” he said. “The strength of the USD and rising interest rates have been a key reason for the emerging market equities relative underperformance.
However, with the US Federal Reserve now stating that “the case for raising rates has weakened’ and it will undertake‘a patient wait-and-see approach’, this headwind may moderate going forward.”
Currency as a diversifier
To compensate for the potential capital flow and currency risks, Barings constructs its portfolios such that there is increased potential return for additional risk, Dr. Cooper noted.
“When it comes to currency, we’reinvesting in the hard currency,” she said. “What you want to do is to be compensated of owning that company over your horizon. For us, that means that we need to be compensated for systematic risk of being in that particular company. If you want to be invested in Turkey, for example, to compensate you for the actual currency risk, you need to have the companies to be able to give you growth far and beyond the systematic cost of equity in a country.
“We imbed the cost of equity in the valuation of the company. So the macro risks are taken care of by requiring return on equity that hurdles the country’s economic factors, economic risk, social risk, political risk. In an emerging country, the hurdle rate is the risk-free rate which we define as inflation expectations for the next five years plus 2.25 per cent, with an additional 5 per cent equity risk premia. In a frontier country, it’s the inflation expectations plus 2.25 per cent,plus 6 per cent extra.”
WA Super does not run a currency hedging program for its emerging market investments, West noted.
“We view emerging market currency exposure as a diversifier as part of a broad basket of exposures to foreign currency,” he said. “We generally do not hedge residual emerging market currency exposures as we are comfortable with the overall contribution to risk and return net of manager level hedging.”
When evaluating an emerging markets manager, many of the same principles that apply to other management specialities also apply to that sector, Trevillyan said.
“Investment personnel quality, depth,experience and stability,” he listed.“Business management, stability and alignment. Structured investment process and detailed research. Fees and consideration of environmental, social and governance (ESG) factors. Given the geographic spread of emerging markets, we do not believe it is necessary for managers to be based in certain locations, but expect that they undertake significant travel and in country research.”
Barings notes that ESG integration is part of its strategy as well.
“We imbed ESG in our company analysis, we look dynamically and see how each company is impacted,” Dr. Cooper said. “We look at nine key topics, including employee satisfaction, resource intensity, traceability/security in the supply chain,we look at management, and we look at the social impact of what they make and the impacts of their products, because that affects the companies’ sustainability and franchise. All of these topics can affect the material outcome of the company. When we do our analysis, this gives us a unique and innovative insight into a company.”
The common thread to emerging market investment is to find the inefficiencies and invest in them.“We are truly active investors,” Dr. Cooper said. “We believe that markets are inefficient and the best way to analyse inefficiency is to look for companies with unrecognised growth over five years. To do that, we need an experienced investment team, which we have. You need a differentiated process to analyse companies in such a way that you can compare them and make sure that the risks you’re taking in constructing portfolios is via the company, not via unintended consequences or factors.”