Investors fall back in love with emerging market equities

Elliot Wilson
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Bullish investors – such as Jim O’Neill, chairman of Goldman Sachs Asset Management – reckon strong earnings growth will ensure emerging stocks can repeat their stellar performance in 2013. But with valuations less attractive than last year, only the smart money will generate outsized returns, with China and Russia looking particularly attractive, analysts conclude.

Like true love, cricket and – depending on your taste in music – a Kraftwerk box-set, emerging market (EM) equities, on a long-term investment horizon, are a gift that just keeps on giving.

In 2012, the fourth full calendar year since the onset of the financial crisis, this love story stayed on script. While developed-market stocks rose, emerging-market securities soared, handing investors a return of nearly 19% in US dollar terms, based on the MSCI EM Index.

With a few exceptions – notably Brazil, which handed investors a paltry country-weighted return of less than 1% – 2012 was another crackerjack year for the growth-fuelled emerging world.

On a regional basis, returns from emerging Asia stocks – which make up 60% of the index’s market cap – topped 20%, as did equities from emerging Europe, Middle East and Africa (EMEA), according to Thomson Datastream.

Thanks to massive underperformance in 2011 – amid the despair of the eurozone crisis – EMs under-performed their developed peers in the risk-off environment, creating big pockets of value in 2012.

Turkey, for example, which makes up just 1.7% of the MSCI EM Equity Index, delivered returns of more than 60% last year. Other standout performances came from China and India – despite localized economic and political tensions – with both generating returns of well over 20%.

While the price-to-earnings ratio of the MSCI EM index stood at 12.4 at end-January, emerging stocks were notably cheaper at the end of December 2011, trading at 10.4 times earnings. This year, sell-side analysts and investors are moderately bullish towards EM stocks.

However, after a generalized rally in 2012, analysts warn stock differentiation by region and sector, as well as good hedging, will be needed to generate outsized returns.

Jim O’Neill, chairman of Goldman Sachs Asset Management 
Jim O’Neill, chairman of Goldman Sachs Asset Management, sums up the bullish pitch, citing how global asset allocators are shifting to the emerging world in this risk-on environment. “The year has clearly started with a renewed focus on flows into EM [stocks],” he tells Euromoney in an interview.

Deepak Lalwani, head of India-focused investment consultancy Lalcap, adds: “Most EMs will do well this year. I see risk appetite being firmly on the table, and so long as there isn’t a blow-up, demand for [EM] stocks will continue rising.”

In Capital Economics’ quarterly report, the Capital Markets Analyst, issued January 30, it tipped EM equities to continue to outperform developed-market equities in 2013. “We forecast renewed outperformance of EM equities in 2014,” notes the London-based economic consultancy.

So far, so good – but where should the wily EM-focused investor put their hard-earned money this year?

Brics allure

For both O’Neill and Christopher Palmer, director of global EM at Henderson Global Investors in London, the answer is to look east and south, to Beijing and Brasília. Notes O’Neill: “It has become very fashionable to trash investing in China, but right now it’s looking pretty cheap versus other markets.”

The Shanghai Composite Index, a broad measure of mainland-listed shares, gained less than 5% last year, and recently touched lows last seen in late 2008. Yet many analysts see hidden value here. On January 30, Citi’s head of China research Minggao Shen tipped the MSCI China Index of Hong Kong-listed mainland corporates to gain 15% to 20% in value in the first of 2012, driven by rising profits at Chinese state-run corporates.

And China, perhaps keen to draw attention away from a recent decline in inward foreign direct investment, is encouraging global funds to plough capital into mainland stocks.

Last year, Beijing hiked the qualified foreign institutional investor ( QFII) quota – the amount foreign investors can use to buy mainland-listed stocks – to $80 billion, from $30 billion. In January, China’s stock regulator Guo Shuqing advocated expanding that quota 10-fold.

Investors should wake up to China’s aggressive courtship of institutional capital, says O’Neill, the famously unabashed EM zealot. “Given valuations, it seems that to me China stands out as a very attractive market, particularly with QFIIs being upped considerably.”

Other investors are looking to Brazil for returns. Low commodity prices and a sharp drop in the value of the real hit the Bovespa index hard in 2012, but many now see better times ahead.

“Brazil has been a big laggard in recent years, but expect to see stocks rise as the global cycle picks up,” says Henderson’s Palmer. “Brazil corporates offer good earnings growth and will benefit from the ongoing rebound in commodity prices.”

Palmer points to unrealized value in key stocks such as mining giant Vale, whose value has been eroded by a mix of internal bleeding – troubled projects in Argentina and Guinea – and external shocks at industry leaders Rio Tinto and Anglo American.

“Vale is a perfect candidate [for a stock rebound],” he says. “They have made mistakes but they have a new set of leaders busy rebuilding their balance sheet and cancelling unnecessary projects. If they were a western mining firm, they would be getting credit for their actions.”

Elsewhere, prospects look equally good. O’Neill tips Turkey – “a young country with a growing labour force increasingly seen as the acceptable face of Middle East capitalism” – to dazzle again.

Russia and India also offer hope for jaded western investors. Despite the global image of Russia as a hollow petro-state, the economy is substantially driven by domestic consumption, which rose by more than 7% in 2012, nearly matching spiraling salaries.

O’Neill says: “The big value trade is Russia: everyone knows it’s cheap.” Palmer tips the RTS-listed auto-maker JSC Sollers as a stock to watch: Russian auto sales jumped 21% last year to $71 billion.

India should also harbour hidden value. Lalcap’s Lalwani sees the Mumbai-based Sensex index of leading stocks, which gained 19% last year, “realistically” hitting 23,000 by year-end, from just north of 20,000 on January 30.

In a January 25 strategy note, Mumbai-based Kotak Equities highlighted several undervalued stocks, notably infrastructure plays GMR and GVK Power & Infrastructure, and utilities Adani Power and Lanco Infratech. “Last year was a good year for India, and I don’t think there’s any doubt that this will be one as well,” notes Lalwani.

The same could be said for emerging-market stocks, the gift that for the wise and canny investor can keep on giving.

Nevertheless, while cheap valuations and fund flows drove returns in 2012, investors could end up over-paying for EM stocks this year, banking on unsustainable earnings growth – or profit margins – at a time of weak global expansion.