A panel of four top investors see lots of opportunities in developing markets, especially those in Asia.
Adolescence is tough. Changes come fast; many are dramatic and not what’s expected. And everyone stands in judgment.
So it is for the emerging markets now. Long revered for their rapid growth and promise of an exploding middle class that can gobble up the world’s goods, they’ve also been marked by periods of dramatic upheaval. This past year alone, we’ve seen a potentially game-changing political election in India and a contentious one in Brazil, along with the start of major economic and political reforms in China that have had repercussions throughout the developing world. Plus, as the bigger countries—notably Brazil, India, and China—mature, their growth has slowed, raising questions about the promise these nations actually hold. Anticipation over the Federal Reserve raising interest rates has added another level of volatility for emerging markets.
This awkward stage of development has led many investors to become wallflowers. As a result, developing markets are cheaper than they’ve been in years, even after recovering a bit earlier in the year. The MSCI Emerging Markets index trades at 12.7 times earnings, below its 10-year historical average of 13.7, and cheaper than the U.S. and other developed markets.
Plus, as a group, emerging-market economies are still growing at double or more the rate of the U.S. or Europe. Some nations, however, are maturing more rapidly than others: Asia’s developing markets are among the healthiest, with the International Monetary Fund projecting growth of 6.5% for them this year, compared with 4.4% for all emerging marts.
But more important than these sweeping assessments, says our panel of experts, are the signs of economic and market reform in particular nations. Narendra Modi’s landslide win in India’s election for prime minister, for instance, should pave the way for political reform that will cut through that nation’s notorious bureaucracy, jump-starting its flagging economy. And while China’s growth rate keeps slipping—it was 7.3% in the last quarter, down from 9% in 2011—as that giant land matures, smaller neighbors, such as the Philippines, Thailand, and Sri Lanka are becoming a low-cost alternative for manufacturing and other services, helping their fledgling economies.
On the horizon, however, is the expectation that the Federal Reserve will raise interest rates—and higher rates have not always been kind to emerging markets. Higher rates prompted a wave of currency devaluations during the 1997-98 Asian financial crisis, ravaging economies and scarring investors. But a lot has changed since then: Asian countries are no longer as debt-laden as they were—and, more importantly, a greater percentage of their debt is in local currency, and not dollar-based, which was the crux of the problem. Other emerging markets—such as Brazil, Turkey, and most of Africa—could be hurt much worse by rising rates, because they have larger deficits.
We gathered four emerging-market managers, each with a long history of investing in Asia, and asked them to assess the risks, trends, and opportunities they’re watching.
Robert Horrocks is chief investment officer of Matthews Asia, which has invested in the region for decades. He also co-manages the $4.6 billion Matthews Asian Growth & Income Investor fund (ticker: MACSX), which has outperformed its peers during downturns, partly because of a focus on dividend-paying stocks and bonds.
Justin Leverenz manages the $42 billion Oppenheimer Developing Markets fund (ODMAX), whose 10-year record tops Morningstar’s emerging-market category. Leverenz favors companies with sustainable advantages and strong cash flows, often finding them in hard-hit markets.
Laura Geritz co-manages the $1.4 billion Wasatch Emerging Markets Small-Cap fund (WAEMX), which has beaten its peers over the past five years, and the newer Wasatch International Opportunities (WAIOX). The sweet spot for Geritz is off-the-radar companies that generate enough cash to fund their growth, which offsets the risk of far-flung and smaller markets.
Dara White manages the $1.5 billion Columbia Emerging Markets fund (EEMAX), which has about 70% of its assets in Asia. White also favors companies that are generating lots of cash and using it effectively.
Barron’s: What are the most notable issues in the emerging markets today?
Leverenz: What’s not notable are those events that have been regarded as the most notable: The elections in India, Indonesia, and Brazil. One person fundamentally cannot change anything, but the markets get terribly excited. I’m a long-term investor, and I’m interested in a narrative, not headlines—and the biggest narrative is the reform in China, which involves changing historical policies that have been extremely egregious to land and labor; corporate-governance policies; and reform—although slow and passive—around interest rates and exchange rates.
White: One of the most significant reforms that has been announced in China is the deregulation aimed at opening up key sectors like health care, rails, banking, oil and gas, and making them more efficient.
Horrocks: I would broaden the most notable events to hope of reform elsewhere, as well, such as India.
How does emerging Asia compare with other emerging markets?
Leverenz: We have had a wonderful decade with no big crisis, no significant inflation, and above-average growth. From a growth perspective, hands-down the winner has to be Asia. They have productivity and savings to fund growth, in part because social and educational mobility is better than in most other developing markets. Consumer and government savings haven’t changed in places like Turkey and Brazil.
White: Another difference between emerging Asia and elsewhere is the depth of the stock market. There are more stocks with much more liquidity, so you could find companies in China, like Internet or gaming stocks, that did well, even when the market did poorly.
Does strong economic growth translate into good stock markets?
Leverenz: Not over the past decade, but growth and opportunity may start to converge in the next decade. The domestic Chinese market, or the A-shares market, which has suffered in the past decade, will be the best-performing equity market in the world because the biggest theme is going to be a path to significant reform.
Can U.S. investors buy Chinese A-shares?
Leverenz: It’s changing, but there are still ownership issues.
How is China’s evolution influencing other emerging markets?
Geritz: As China has opened up its economy, we have seen a massive supply of labor moving from the hinterlands into the cities and into manufacturing jobs. That was round one. Now, round two is in places like India, Bangladesh, and the Philippines, which offer lower-cost labor. Manufacturing wages in Bangladesh are 50% of those in China. The world is awash in workers, and because emerging markets save, they are awash in capital, too. We have a market-share theft game going on in the world. The growth will be in countries with cheap labor.
What does that mean for China?
White: The cost of doing business is consistently rising. Wage inflation in China is 10% to 15%. But that’s a big benefit to smaller markets as manufacturers move there, for example. As foreign investment goes into smaller countries like Thailand and Vietnam, even Indonesia, there’s been a big boom for those economies.
So Chinese companies are facing higher costs, but that is creating a new wave of growth in smaller countries?
Geritz: Manufacturing creates a virtuous cycle. Those are good jobs and have a multiplier impact on the economy. Manufacturing took 300 million people out of poverty in China.
Horrocks: I’m less concerned about wages in China because productivity has risen. As a result, the cost of producing a good is still near mid-to-late 2000 levels because companies have become more efficient and workers have become more productive. Chinese companies have lost demand from the U.S. and Europe—about one or two percentage points off China’s gross domestic product. That will be replaced over time, though, because rising wages in China will fuel demand internally. That consumption is still the main driver of China’s economy.
What about investors’ concerns that China could face a potential crisis from bad debt and a property bust after years of credit-fueled spending and real estate gains?
Leverenz: Some investors are mistakenly using the U.S. housing bubble as a playbook. While there was a speculative component to the Chinese real estate boom, price increases were largely a result of property-market reform and strong underlying demand for new homes, and the leverage used to buy property was nowhere near the scale used here. I’m not dismissing the possibility of excesses, nor saying there won’t be significant problems with credit and banks, but this is a side story to an economy that’s $10 trillion and growing 5% to 6% annually for at least the next five to 10 years.
Enough about China. What have you noticed on the ground elsewhere in Asia that differs from conventional wisdom, or from your last visit?
White: We have seen big changes in India. I disagree with Justin—elections are important, especially this one, with Modi and the Bharatiya Janata Party getting the first majority in Parliament since 1984. You see it during the morning rush hour in New Delhi, which has been moved up by two hours because government workers are now being held accountable. Many changes are simple, like the recent loosening of the government project-approval process and digitizing how they track projects and bottlenecks.
All that happened since the May election?
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White: A lot started with the previous government. Modi’s biggest benefit is timing. Unlike China, India’s economy has already gone through a long deleveraging cycle. The repo rate [the rate at which the central bank lends to banks] has risen from 4.75% in 2010 to 8%. Balance sheets have been repaired. We are already seeing signs of the economy picking up, in industrial production data and passenger-car sales. The better economy will be a long-term driver for the market.
Leverenz: There’s extreme enthusiasm about all things Modi. I think it’s misplaced. He may be able to break through some bottlenecks, but he is not going to change the constitution. Some of the highest-quality companies and extraordinary management teams are in India, but in the next three years, at these prices, you won’t make money.
Geritz: Expectations have gone up, and there’s also a hockey stick in corporate earnings estimates rising. The market may be potentially setting itself up for some disappointment. I’ve been taking money off the table.
The emerging-market consumer has been the draw for many investors. How is that consumer changing?
Leverenz: The fundamental shift on the ground is cultural. I’m not sure how this shift manifests itself. Confidence is extremely high, probably like America in the 1940s. About 20 to 30 years ago, the Chinese looked for sophistication and culture elsewhere—often to the West. But the younger generation is much more experimental. You see that in literature and the film industry. The Internet and e-commerce have revolutionized the way people interact, shop, and think versus decades ago.
Horrocks: They call it the “China dream.”
Does that translate to a preference for local brands?
Horrocks: Foreign brands like Cartier and Richemont [CFR.Switzerland] are still successful.
Geritz: Pigeon [7956.Japan], a Japanese baby-products company, benefits from the Chinese choosing high-quality branded products.
Horrocks: They had a great marketing campaign. Because of China’s one-child policy, almost every mother is a first-time mother. They set up teaching sessions on how to feed and wrap a baby at the hospitals, using Pigeon products. It’s a brand that says, “I’m wealthy enough and care enough for my son to buy their products.”
Geritz: Chinese consumers are also traveling more overseas for vacation. Thailand’s Minor International [MINT.Thailand], which owns restaurants and hotels, is a beneficiary.
Horrocks: There are stages of growth, from commodity exporters to branded goods to leisure, entertainment, and media. Earlier, there was a focus on basics like food and mobile phones. At this point, there’s interest in ways to share affection, self-worth, or gift-giving, and people are willing to pay up for emotions. That gives power to brands. We like quick-serve restaurant Café de Coral [0341.Hong Kong] because it sells convenience to consumers, is well run, and has good return on capital.
White: Another beneficiary is online discount retailer Vipshop Holdings [VIPS]. It does flash sales, helps its 9,000 brand partners clear inventory at the end of the season, and has a competitive advantage of owning its warehouses. There is no TJMaxx in China. It’s all online, and the growth prospects are huge.
Demand for luxury items has taken a hit amid China’s anticorruption efforts to curtail gift-giving. Does that continue?
Horrocks: It’s not going to be cut back for long! The Chinese continue to get wealthier. The human condition won’t change. They still want to make themselves and those around them feel good, and these stocks are not pricey.
Leverenz: When you remove the very large impact from anticorruption efforts, underlying luxury spending has been stunning. An overvalued euro has obfuscated this further.
Internet stocks have been one of the bright spots in China. Is there still upside?
Leverenz: I still have 8% of my fund in these companies. Prices are significantly higher, but there’s still enormous opportunity because the alternative—whether traditional advertising or media—is not that good. There’s an opportunity to serve new, aspiring customers that are more educated and have more international experience with new content, such as fashion, sports, and celebrities. And over the next decade, as the economy shifts toward consumption, every branded company will have a China strategy. That means advertising grows faster than consumption, and online takes a lot of that. Baidu [BIDU] is a really interesting opportunity still—not just for Internet search. It is also investing in new businesses, including online travel and video.
How vulnerable are emerging markets to a Fed interest-rate rise?
White: Rates are certainly going higher and will be a head wind, more so for other areas like South Africa and Turkey than Asia. Both countries have large current-account deficits, or the amount they spend exceeds what they take in. They have benefited in past years as low interest rates in the U.S. pushed many investors toward countries with higher interest rates, which in turn helped countries like Turkey finance their spending. But that makes them vulnerable now to money flowing out if Fed policy shifts. And unlike some Asian countries, central banks in South Africa and Turkey don’t have as much room to make adjustments to improve the situation.
Last summer, India was at the crux of the problem, with its currency and stock markets taking a sharp hit amid concerns about the ramifications of the U.S. eventually raising interest rates. But India has made significant improvements in its current-account deficits, helped by shrinking its trade deficit by $8 billion since last May. That makes them less vulnerable. We would see any significant volatility around rates rising as a buying opportunity.
Horrocks: Everybody thinks about 1997, but valuations and inflation rates are not as high, and current accounts are healthier. It’s more like the 2000s, when we had more than 17 rate hikes.
White: Yes, 2001 to 2005 was the best period for emerging markets. If rates are going higher, it’s because the developed-market recovery is better, and they’re buying more. If [emerging market] exports are higher, earnings are rising. Commodity prices are lower, so it could create a nice boost to emerging-market companies’ margins. It could be an ideal environment, and get us out of this melee of the past four to five years.
Geritz: Emerging markets also have a bigger cushion than they did before. As developed nations traded goods, their economies collected capital and spent it on roads or infrastructure. Emerging markets haven’t spent appropriately on their own development. Instead, they’ve been saving that capital and buying U.S. Treasuries. That gives their central bank more room to maneuver against shocks than in the past.
Doesn’t that lack of spending limit growth?
Geritz: Emerging markets were, and frontier markets are, completely reliant on the developed markets’ purchasing their goods to build the buffer. Now, they need to spend some of that buffer on domestic growth by investing in infrastructure like roads and power grids to keep them growing.
Are they?
Geritz: That’s the pivotal question. In the past, investors flocked to emerging markets because they moved differently than U.S. or European markets. That hasn’t been the case lately because of the recent interdependence with developed countries, which are buying emerging-market goods while the emerging-market countries are buying U.S. Treasuries. If countries like Indonesia and China tap their savings to invest in things like health care or railroads, they could become less correlated.
Leverenz: Emerging markets are deeply correlated with developed-market credit and equity. That’s not something we grew up with, which is why people are investing in frontier markets, even though they shouldn’t.
Why are you skeptical about the frontier markets?
Leverenz: I don’t think they are real. What’s the total market capitalization of frontier markets? $50 billion?
According to MSCI, investors have access to about $106 billion in frontier markets.
Leverenz: My point is that Kuwait is a quarter of that, and Nigeria is another quarter. There just isn’t capitalization and liquidity. If you want to make an economic fund without outrageous management fees, you have to invest in countries that are ultimately not frontier markets.
Laura, you like smaller companies and smaller markets. What do you think?
Geritz: Indices and liquidity are a reflection of where growth has been. I want to capture where it is going to be. It’s all about incremental change. I have been to Sri Lanka every year for the past three years, and this year was vastly different. They had two brand-new highways, which shortened the distance from town to port by four hours. The productivity gain is incredible. Sri Lanka is the best country for its mix of growth and valuation.
What is the draw of Sri Lanka?
Geritz: Foreigners are putting their money in as the country rebuilds after a 26-year civil war. It is an island nation of just 20 million people, so it falls below people’s radars. It also has many oligopolies and monopolies, creating companies with tremendous free cash flow.
What constitutes a frontier market, and how small are they?
Geritz: In Asia, it’s often countries with lower development or lower GDP per capita than emerging markets. Some are not fully open; Bangladesh is more liquid than Sri Lanka. You may have to own companies doing business there, but based elsewhere. But I feel very confident in the future growth and liquidity of countries with low-cost labor, resources, and young, educated people moving back, because the hope of tomorrow is better than the past.
How do all of these countries—frontier and emerging—develop?
Horrocks: Convergence—or countries closing the gap with rich economies in terms of per capita GDP—just doesn’t happen. In general, over the past 30 years, only Asia has managed to do so, largely through savings and productivity enhancements. If you find a poor country that is saving, investing in infrastructure, educating its citizens, and building productivity improvements in the manufacturing sector, that’s the path by which half of the world’s population has closed the gap with the wealthiest. Sri Lanka is already halfway there, and owning something like well-managed conglomerate John Keells Holdings [JKH.Sri Lanka], which owns virtually all of the hotels, along with ports and food businesses, makes sense.
Leverenz: Frontier-market investors seem to think kicking the tires is a competitive advantage. I travel a lot, too, but I don’t believe in this romantic notion that you need boots on the ground to invest in these markets. Everything looks new when a port is inaugurated or a road is opened. The problem is that some of these investors see a lot but don’t read much. It’s not just about seeing, but rather understanding.
Geritz: When spending nine months of your year flying from country to country, and sitting bored in a hotel in Bangladesh and unable to leave the hotel, it’s not uncommon to read four to five books a week. And there’s a lot to be learned on the ground. If you’ve ever stepped foot in these frontier markets and done company meetings for a week, you realize all meetings are held in just one restaurant because it’s the one that everyone knows is safe and good. Everybody knows everybody. Investors link poverty and fraud too often. Most of the frontier and small countries are poor and [their problems] get a lot of undue attention, but both big and small countries have fraud. If you do your homework, it’s much easier to uncover the dishonesty in a small or frontier country. Boots on the ground means that I know exactly where that fraud is sitting.
Horrocks: We are often asked about the institutions that surround investing in Asia: Is corporate governance acceptable? Can we trust the numbers? One way to deal with fraud is to test them. That’s why we put a lot of weight on whether management pays dividends and is committed to growing the dividend. It tells you they have the cash and are willing to share it, which is ultimately the whole point of investing.
One smaller market that has been a standout in recent years has been the Philippines. What’s going on there?
White: It’s the best macroeconomic story in Asia. It has fantastic demographics, with 60% of the population under the age of 30. It looks like a frontier market in terms of things like car ownership, with 30 vehicles per 1,000 people; in Thailand, it’s 160. Yet, it’s a notch above investment grade. It’s unusual for a country to have such sound finances and still be so early in its development.
What companies do you like there?
White: It’s not the cheapest market, but one stock that trades for less than the market is GT Capital [GTCAP.Philippines], which has a stake in one of the country’s largest banks and a stake in a power business. It also has a 51% stake in Toyota Motor Philippines, which has the biggest car-dealership network. The country’s GDP per capita recently crossed the $2,500 level, an inflection in car ownership in neighboring countries.
What’s the biggest wild card?
White: China. If something were to go really wrong there, it would create a big disruption.
Horrocks: Irresponsible behavior by developed-market central bankers. If they raise rates amid weak growth, it would hit markets. It could be a long-term buying opportunity, as long as it doesn’t lead to a deflationary period. For anyone trying to invest in these markets, the No. 1 ingredient is patience.
We’ve heard that before. Thank you.