Buying good companies in a dangerous environment

The speaker was Gary Greenberg, manager of Hermes Global Emerging Markets Fund (IE00B3DJ5K90), who has been investing in these regions since the 1990s. The lack of awareness among his audience on how far Chinese technology has developed concerns him, particularly as this was followed by US aggression towards China via trade tariffs – a source of anxiety for emerging markets investors.

Year-to-date MSCI Emerging Markets index is down 12 per cent compared with a 0.65 per cent rise for MSCI World index, a measure of developed markets. Much of this is due to the Chinese stock market, which has been hit hard by the imposition of US trade tariffs as well as weakening economic growth. MSCI China index, which accounts for 31 per cent of MSCI Emerging Markets index via Hong Kong-listed companies, is down 16 per cent. And the CSI 300 index of mainland Chinese stocks is down 21 per cent.

As a result, Hermes Global Emerging Markets Fund is down about 13 per cent in the year-to-date, in line with the Investment Association (IA) Global Emerging Markets fund sector average. 

“It’s a dangerous environment out there,” says Mr Greenberg. “China has allies and strong economic ties, but the US is looking to confrontation and containment. The only thing I know how to do in this environment is buy good companies."

Mr Greenberg’s strategy is built on buying large businesses – both growth and value stocks. He holds them for the medium to long term and this strategy has until recently been successful. Over three and five years, Hermes Global Emerging Markets Fund has returned 51 per cent and 57 per cent, respectively, versus 40 per cent and 31 per cent for MSCI Emerging Markets index over these periods, and the IA Global Emerging Markets fund sector averages 35 and 24 per cent. This is due to the fund's big weighting to Chinese technology names, and holdings in insurers, banks and consumer-facing businesses in China, India and Russia.

Last year MSCI Emerging Markets index rose 25 per cent, well ahead of MSCI World index's 12 per cent increase. The returns were due to strong company earnings growth, good economic growth, low US bond yields and inflation, and stocks being on good valuations.

“But it’s a different world in 2018,” says Mr Greenberg. “We still have most of the tailwinds, in particular cheap valuations, but earnings growth has gone down due to a stronger dollar."

He adds that while US threats of trade sanctions on Mexico have diminished, the imposition of tariffs on China have resulted in a situation that's even worse.

“China is 30 per cent of the emerging markets index, and another 30 per cent of the countries in the index export to China," he explains. "It is the biggest export market for South Korea and Taiwan. And Brazil, South Africa and Indonesia are reliant on exports to China. Any attempt to stop China developing is a distinct threat to emerging markets [overall].”

US trade tariffs are not the only thing hampering emerging economies. The oil price has risen 21 per cent in the year-to-date which hits consumers in many emerging economies. And many emerging market funds have a meaningful allocation to consumer-facing companies and technology companies that rely on consumer spending, such as Alibaba (US:BABA).

“Around 83 per cent of emerging market nations import oil and if you couple this with currency weakness, then the price rise effect is magnified," adds Mr Greenberg. "The oil price has gone up six times in Turkish lira terms.”

He says emerging market investors need to ask themselves two questions: can China survive the effects of the trade tariffs and have Chinese shares priced in the damage these could cause?

“China is an $11 trillion (£8.58 trillion) economy and should grow 6 per cent in 2018, and between 5 and 6 per cent in 2019," says Mr Greenberg. "That adds another $1 trillion. It’s a big country and there’s a lot going on. But how China will come through this is what we’re studying. It is not such a big net exporter as it used to be, and it could be that Chinese exports and imports both fall – which really is bad news for everyone. A global trade war doesn’t help anyone.”

Mr Greenberg expects China to stimulate its economy to keep the growth rate robust. This could be done by loosening banking regulations and making sure banks lend to smaller businesses. He says there’s also a chance it will let its currency devalue by around 5 per cent, which would help export levels, particularly in the face of tariffs.

“But Turkey and Argentina, which have also been big negative stories for emerging markets this year, could do something right," he says. "Argentina’s currency has corrected to its long-term average, which could signal more stability in future. You also have to look at the emerging market currencies which still look undervalued. Also, equity price to book and price to earnings ratios are also below the long-term average, and the return on equity in emerging markets is higher than in developed ones. Things look reasonable and you can’t call emerging markets a bubble that burst. And hopefully things will calm down: maybe the US mid-term elections mean that Donald Trump has other things keeping him busy.”

Mr Greenberg has made changes to Hermes Global Emerging Markets Fund to accommodate changes in the investment environment. But he won’t initiate any exposure to oil - the one area of emerging markets that has helped stem losses. “It has not helped me so far,” he says.

Mr Greenberg has reduced exposure to consumer discretionary stocks and Chinese banks, and the proceeds of these disposals have been reinvested in insurance and healthcare companies where he still sees good opportunities.

He says: “Banks will be used to stimulate the Chinese economy, but that will not end well for them.”

Hermes Global Emerging Markets (IE00B3DJ5K90)

Source: Morningstar, as at 01/10/2018 *Hermes Investment Management

Performance

Source: FE Analytics as at 29/10/2018

Top ten holdings as at 31/08/2018 (%)

Source: Hermes Investment Management

Geographic breakdown as at 31/08/2018 (%)

Source: Hermes Investment Management