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The best emerging markets

FEATURE: The honeymoon period might be coming to an end.Rory Jones highlights the risks and opportunities
December 20, 2010

We've all experienced the honeymoon period. It's usually a few short months of whirlwind romance - if you're lucky, the euphoria lasts for longer – and the relationship gives you a high emotional return. Sadly, though, the sheen inevitably fades.

And it seems that the honeymoon is ending for companies obsessed with emerging markets. Once mesmerised by sexy figures of GDP and population growth, companies are now learning that breaking even in developing markets is no easy feat. Let alone trying to offer a voluptuous return for eager shareholders.

Proving the point, a new report from big four accountancy firm Ernst & Young canvassed the views of 1,400 business leaders worldwide and found that 60 per cent of respondents reckon their growth will come from the developed, not emerging markets this year. Many chief executives are shifting their focus back to the West. UK companies were the only group to buck the trend, deciding instead to concentrate on the East. But David Bonderman, co-founder of private equity firm TPG Capital, and highly regarded investor, recently epitomised the trend: "There will be dislocations. Emerging markets are volatile. And at some point there will be despair just as there is euphoria now."

But is the euphoria among investors now fading? The notion that emerging markets will grow indefinitely while developed economies decline is being usurped. It's now widely held that there's significant variation in performance across emerging countries and investors have to be choosier about where they're putting their cash, particularly from a valuation perspective.

Take current cyclical price to earnings multiples, which compare prices with average earnings over a decade. Research from investment bank Morgan Stanley found that India, Indonesia, Peru and the Philippines all trade on multiples more than 50 per cent above the average of the MSCI emerging markets index over the last five years. Meanwhile, Korea, Russia and Poland trade 25 per cent below this level.

It's also vital to understand how indebted a country is, says Brian Coulton, emerging markets strategist at Legal & General Investments. "The ability of emerging markets to bounce back from the financial crisis has ultimately been determined by the level of leverage going into the whole mess." Eastern & Central Europe is a good example of the divergence between emerging markets. For various reasons, Poland, the Czech Republic and Turkey were the least debt-laden, while Hungary, Romania and the Baltic States ran large current account deficits. Bank credit as a proportion of GDP rocketed and these are the markets that are now spluttering. "Start considering each emerging market separately," Mr Coulton advises.

Currency war – who is it good for?

Currently though, you can't help but be bombarded with warnings of currency wars, inflation and excess liquidity due to quantitative easing. So how do we know where to invest in these circumstances?

Well, two important points to consider are the direction of the local currency and the extent to which the government influences that currency through capital controls. The best result for investors would be to park cash in an emerging market, take advantage of growth, then exchange cash out of that market when the currency has appreciated. Understanding an exchange rate’s direction is therefore important in getting a nice uplift on your investment.

Currently, there are a number of countries that have high real exchange rates compared with their long-term averages, according to a recent report from HSBC. These are Brazil, Russia, China and Indonesia, while South Korea and Argentina are particularly depressed.

Yes, emerging markets might have lost some of their sheen among investors and companies. But even so, the Institute for International Finance predicts that the net flow of external capital into emerging markets will reach $825bn this year, up from $581bn in 2009. Moreover, quantitative easing and continued low interest rates in the developed world are likely to mean the inflow of capital continues into 2011, putting pressure on emerging economies' currencies to appreciate.

Many countries are trying to combat currency appreciation through capital controls. China is of course being frequently lobbied by the US to let its currency appreciate. But Brazil and Thailand have also announced taxes on capital inflows, Taiwan has placed administrative restrictions on capital, while Colombia has put reserve requirements on non-resident holdings of domestic securities.

But these controls, Mr Coulton says, will have limited impact on overall inflows, "other than shifting the onus towards longer-term securities". He also predicts that the advantages to emerging central banks of letting their currency appreciate will be clearer as inflationary pressures from low or negative real interest rates mount. An appreciating currency would certainly help offset the expected price increase in dollar dominated commodities on domestic consumption. With this in mind, the outlook appears positive for investors from a currency perspective. But as Mr Coulton noted earlier, we should examine each emerging market separately to find the most attractive. And so here are our picks for 2011.

Turkey

Although Turkey's not the immediate star performer that springs to mind when you think of exciting emerging markets, it does have some vocal advocates. Sitting lodged between the Aegean and the Baltic seas, Dr Stephen Barber, head of research at Selftrade, calls it the "gateway from West to East". The advantage for the European investor is that you get a European style market with all the trappings of the emerging world. For example, the quarterly Genworth Index, which measures the financial vulnerability of consumers in various countries, recently scored Turkey above the European average and on a par with the UK and France. "It's the perfect balance," Dr Barber says. "You get access to growth through the stability of Europe."

This growth comes from two angles. The first is exposure to the so-called resource rich "Stans" such as Kyrgyzstan, Tajikistan, and Turkmenistan. The second is through growing consumer trends in the country. The average age of population is approximately 28 and only 15 per cent of the population is expected to be over 60 in 2025. This provides a large workforce to bolster growth and spending. And after learning the lessons of their own banking problems in the early noughties, Turkish banks entered the financial crisis in relatively good shape. So loan growth is expected to reach 25 per cent this year, while overall leverage is still quite low among both households and corporations. Dilek Capanoglu, chief investment officer for emerging markets at Allianz Global Investors, says the mid cap arena is the most interesting because it will give you exposure to the "real" growth drivers in the economy.

How to gain exposure:

At a very low cost and little hassle, an ETF is probably the best way to gain exposure to the national investment themes in Turkey. iShares has a Turkey fund or alternatively, you could pick an actively managed fund. HSBC Asset Management offers a UCITS III compliant Turkey fund that seeks long-term capital growth and achieved a total return of 64 per cent in the last year.

Russia

The US Federal Reserve's decision to embark on another round of quantitative easing is likely to cause a surge in global liquidity of commodities, bonds and equities. And for all three assets classes, Russia will top the emerging market list capital inflows in 2011, says Michael Kart, managing partner and fund manager at Marshall Spectrum. "The risk and reward dynamic is very attractive in Russia," he says. "Investing provides access to hard commodities such as nickel, coke and iron ore, as well as soft commodities like grain, corn and agriculture." And the fact that the country is a commodity power means it will be able to cope with inflationary pressures far better than other developed and developing nations.

The government also managed its books sensibly running up to the financial crisis, with public debt falling from 2005 to 2010. This means the country has a low public debt/GDP ratio of about 10 per cent, according to David Reid, analyst for the BlackRock Eastern European Trust. "Unlike certain troubled countries in Europe, Russia can afford to fund its deficit for a period of time by borrowing," Mr Reid says. "This will give them time to implement their plan to manage down the deficit, with the caveat that it is sensitive to the oil price."

Finance minister Alexei Kudrin recently said the deficit would be trimmed from 5 per cent of GDP this year to 4 per cent in 2011 and 3 per cent in 2012. This fiscal stability is positive, but what’s also very attractive for investors is that the government is spending some £60bn on privatising 900 companies across many sectors from banks to oil & gas. Finally, Russia’s admission to the World Trade Organisation could provide a major fillip as the World Banks estimate this could increase GDP by up to 3 per cent.

How to gain exposure:

Russia’s forecast PE valuation of 6 for next year is at a stark discount to emerging market peers. And considering the estimated growth in company’s EPS of 25 per cent, the discount looks wholly unwarranted. We recommend gaining low cost exposure to a re-rating through an ETF, which can be bought online from a retail broker such as Selftrade, TD Waterhouse or Barclays Stockbrokers.

South Korea

On paper, 2011 looks like a great time to invest in South Korea. The stock market is certainly cheap, trading on a PE valuation of 9.8 times, below both the global and emerging market average. Companies are expected to grow earnings in double-digit figures, and crucially, the won looks under valued compared to its long term average. So if you invest now, you could be on the right side of currency appreciation.

Under the spotlight last month as Seoul hosted the G20 conference, the country is slowly building relations globally and continues to make solid inroads into the Chinese market. This makes it an interesting play on the Middle Kingdom, and at a fraction of the price. What's more, negative real interest rates in China have caused large inflows of capital into property and equities, which has lead many economists to speculate that asset bubbles are forming. These trends have not been so prevalent in Korea and the country's exports are well diversified, ranging from the manufacture of heavy duty goods and capital machinery, to world renowned high tech products.

How to gain exposure:

One of the easiest and quickest ways to buy into the Korean story is through a UK-listed company that has operations in the region. This won't give you exposure to some of the fillips discussed above. But it should reduce risk. Standard Chartered has a large presence in Korea, having snapped up a domestic bank in 2005 and is also adviser to South Korea's landmark deal to build nuclear power stations in the UAE. Meanwhile, Tesco's business in Korea has been lauded as the jewel in the supermarket giant's international crown. Sales were some £4.16bn last year and the group's market share is close to the market leader Shinsegae's E-Mart. Carmakers Samsung and Hyundai will provide nice exposure to both the growing consumer base in Korea as well as the global recovery through their exports. So will memory-chip maker Hynix, with its strong ties to China. But for those without the time to stock pick, iShares offers a Korea focused ETF.

Brazil

Will Landers, manager of the BlackRock Latin America fund, describes Brazil as the "best combination of a strong macro story and the most attractive valuations". With EPS growth expected to reach 23 per cent next year and a valuation that's one of the cheapest among emerging markets, we tend to agree.

The growth of Brazil's middle class under current president Luiz Inácio Lula da Silva has been very strong indeed, and it's likely to continue next year under the president-elect Dilma Rousseff, who was previously Lula's chief of staff. In the past eight years, economic growth has averaged nearly 4 per cent and the percentage of the population living in poverty has halved. Hosting both the 2014 football World Cup and the 2016 Summer Olympics is also likely to create growth in 2011.

A more consumer-based society will mean that the country is less susceptible to cyclical sectors such as commodities – although this is still a major driver of growth for the country, especially with increasing oil revenues. If the commodities boom continues, the country is likely to experience heavy capital inflows that could push up the value of the real. This is particularly true now the quantitative easing taps will be turned on once more.

How to gain exposure

In a similar manner to South Korea, the Brazilian market can be tapped from the comfort of Blighty. Many UK-listed companies have large operations in Brazil that are driving revenues. Experian is a good example as the credit checker witnessed 22 per cent growth in the first half of its financial year. Credit is being lent freely as the middle class grows, resulting in high demand for Experian's services. A number of recruiters, in particular Michael Page and Robert Walters, have successful operations in Brazil.

An ETF will give you direct exposure to the expected re-rating in the Brazlian market, which has underperformed emerging markets this year. Or you could get an expert to pick the best stocks to benefit from the growing wealth in the country. Allianz launched an open-ended fund for retail investors this year, while JP Morgan Asset Management launched an investment trust. For wider exposure, BlackRock offers a Latin America fund.

PE ratios compared

5-year average PE2011 forecast PE 
Argentina 2910.2
Brazil 11.49.8
Chile 25.217.8
Mexico 15.612.8
Peru 15.213.7
China 16.111.3
India 18.916
Indonesia 1313.3
Korea 11.59.8
Taiwan 24.712
Russia 12.75.9
South Africa 14.310.8
Turkey 7.19.5
Europe 16.48.6
Emerging Markets14.310.8
Global18.410.6

Dividends compared

5-year average div. yield2011 forecast div. yield
Argentina 1.3na
Brazil 3.83.6
Chile 2.32.4
Mexico 1.83.5
Peru 3.83
China 2.33.1
India 1.51.4
Indonesia 3.23.1
Korea 21.2
Taiwan 34.3
Russia 1.82.5
South Africa 33.8
Turkey 2.23.3
Europe 2.94.1
Emerging Markets2.43.1
Global2.13.2

Source: Datastream & JPMorgan

2011 forecast EPS growth

%
Argentina 5.8
Brazil 23.3
Chile 6
Mexico 19.3
Peru 25.7
China 20.8
India 22.1
Indonesia 17.6
Korea 4.9
Taiwan 14.4
Russia 22.1
South Africa 25.2
Turkey 10.9
Europe 16.4
Emerging Markets16.4

Source: JPMorgan