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Emerging performance

John Baron reminds readers of the attractions of emerging markets, and increases exposure in both portfolios
September 4, 2014

My series of columns last autumn focused on various unfashionable sectors where sentiment trailed fundamentals. The column on emerging markets ('Emerging from the gloom', 4 October 2013) suggested long-term investors should buy the sector. Despite outperformance year to date, I suggest investors have not missed the boat as their best moment is yet to come.

Poor sentiment

Investors are understandably cautious about emerging markets. Economic growth rates have been slowing - with concern focused on China. Various countries' finances have been deteriorating. Meanwhile, there has been no shortage of commentary and uncertainty about the extent and speed of the Fed's intention to taper its quantitative easing (QE) programme - the prevailing view being that these markets have particularly benefited from this largesse.

Other factors have contributed. Uncertainty caused by an unusually large number of elections in countries accounting for over 25 per cent of emerging markets GDP, the perceived lack of structural reform and continual evidence of corruption, as well as geopolitical tension such as Ukraine, have all weighed on sentiment.

And this is an asset class where confidence reigns supreme, where sentiment is particularly important. Superior economic growth is not always reflected in buoyant equity markets at the best of times, but there is even less symmetry when it comes to emerging markets - as investors in China can testify over the last decade.

Perhaps a key reason is emerging markets' tendency for volatility. But if volatility was simply a measure of risk then investors would always be underweight good opportunities. This helps to highlight the importance of investing for the long term.

Only the very gifted few know, with any certainty, where markets are heading in the short term. For the rest of us, our best chance of outperforming is to identify value, look for catalysts which may help unlock that potential, and adopt a long-term approach. Such investors should therefore view volatility as an opportunity rather than a risk - something to be embraced rather than shunned. The issue then becomes one of timing.

And emerging markets represent compelling value at present. They had a horrendous 2013 and a very poor 2011. Indeed, during the last three years, most developed markets have risen nearly 50 per cent, but emerging markets have fallen in value. Despite modest outperformance so far this year, emerging markets equities still currently stand at close to their largest discount - around 25 per cent - to developed markets in nearly 10 years.

The market is certainly pricing in bad news. Sentiment remains poor.

Better fundamentals

But I suggest the fundamentals are not as bad as feared. Economic growth rates have been slowing. But some have been levelling off, and most still compare well with developed markets - many western governments would give their back teeth for growth rates of 4-5 per cent. Furthermore, some countries such as China have the financial strength to 'buy' growth for some years to come.

Borrowing levels are a concern in some countries, particularly if the economy is slowing. Investors have to be aware of the individual dangers - Argentina being one recent example. But, overall, as an asset class, the danger is exaggerated.

Some estimates suggest debt amounts to around 40 per cent of emerging economies' GDP. This compares to debt levels, on average, exceeding 250 per cent in developed economies. If one was simply focusing on economic fundamentals, many emerging markets represent safer investment opportunities with less credit risk than a large number of developed economies - some close to home. Furthermore, faster-growing economies allow more headroom - debt can still rise in absolute terms but fall as a percentage of GDP.

Other factors suggest optimism. Evidence of structural reforms in a number of countries, improvements in corporate governance combined with resolute attempts by governments to reduce corruption, particularly in China, and market friendly election results, such as in India, are all positives and conducive to a market's re-rating.

Meanwhile, the market's tiring obsession with the speed and extent of the Fed's slowing QE programme, the so called 'taper tantrums, must by now be largely in the price. Markets tend to climb walls of worry - so let the column inches roll!

We should perhaps remember one other factor when it comes to active investment. It is well understood that faster-growing economies do not always equate to better performing markets. But what is sometimes forgotten is that such economies provide a richer pool from which the better fund managers can fish with relish. Faster emerging markets growth rates are not an irrelevance in this regard.

Portfolio changes

With this in mind, I have added to both portfolios' emerging markets exposure.

In the Growth portfolio, Templeton Emerging Markets (TEM) has been introduced when on a discount of over 10 per cent. Historically, my emerging exposure has been focused on specific themes, asset classes, regions or countries - and these have done well. But the portfolio lacks a good 'generalist' - one that can roam the world weighing opportunities.

TEM fits that bill with an experienced and extensive team and sound long-term performance. The fact that it is the only generalist to be overweight China - a market I like - adds to the attraction. The potential to add to its underweight position in Russia at this time is a further positive.

Meanwhile, in the Income portfolio, I have replaced HICL Infrastructure (HICL) with Utilico Emerging Markets (UEM). The infrastructure story in developed markets is a good one and HICL has performed well. But a 15-16 per cent premium to assets reflects the good news.

By contrast, the investment case for emerging markets infrastructure is under-rated. The greatest urbanisation the world has ever seen is creating an enormous middle class with tremendous buying power. The rating of consumer stocks largely reflects their potential. But this is less so when it comes to infrastructure.

An emerging and increasingly expectant middle class will need investment in their country's infrastructure and utilities. The population's health and the country's economic potential deserve nothing less. Some authoritarian regimes will need to keep investing in their infrastructure for political reasons.

Step forward UEM. The trust invests in utility, transport and infrastructure companies - ports, water and waste, gas, electricity, toll roads and airports making up around three-quarters of the portfolio. These are 'GDP+' assets - less correlated to the stock market and more to the underlying economy. This is a real positive. They are also real assets often with decent and growing yields. An 8 per cent discount and 3 per cent yield add to UEM's attraction.

The hunt for value in this uncertain world goes on.

View John Baron's updated Investment Trust Portfolio

John's book is out now. It explores the merits of investment trusts, the stepping stones to successful investing, and how to run and monitor a trust portfolio. Available from Amazon and other bookshops. For more portfolios and commentary, please visit John's website at www.johnbaronportfolios.co.uk