Emerging market investing from a local authority perspective

December, 2012 Print



Matthew Craig

It is now eleven years since Goldman Sachs introduced the BRIC acronym, which encapsulated the idea that the four largest emerging market economies – Brazil, Russia, India and China – are an unstoppable rising power in the global economy.

Now all four BRIC countries are in the top 10 largest economies measured by GDP at purchasing power parity, with China close behind the USA at the top of the list. And there is still huge growth potential in the BRICs, according to experts. For example, China and India have relatively low GDP per capita figures, at $5,430 and $1,489 respectively, compared to nearly $40,000 for the UK and $50,000 for the USA. As the emerging market economies move from relying on exports for their growth, to domestic consumption as their main motor, these figures should rise. In Brazil, the poverty rate has halved to 10.8% between 2002 and 2010; however 69% of India’s population is living on less than $2 a day in 2010, showing the scope for these economies to continue to develop regardless of the state of the global economy.

Commenting on the state of the emerging markets, J.P. Morgan Asset Management emerging market equities portfolio manager, Emily Whiting, said: “The MSCI Brazil Index trades on a price-to-book valuation of just 1.4x, which is close to its 2008 and 2011 lows. This looks to be an attractive long-term entry point, as along with historically low equity valuations, the more competitive currency has raised our expected returns in sterling.” On Russia, she added: “The dividend yield is currently 3.6%, above that of the broader emerging markets asset class, which sends a positive signal about the management approach to shareholders and corporate governance. There are emerging investment opportunities as we see more companies coming to the market for equity funding.” On China, J.P. Morgan AM said that long-term opportunities are being created as the country rebalances its economy away from being export- and infrastructuredriven towards an economy that is driven by consumer demand.

For pension funds, there are a number of different ways to tackle the continuing growth of the BRICs and other emerging markets. One of the simplest is to hold emerging market equities either in a dedicated emerging market equity mandate, or as part of an international equities mandate. In either case, many local authority funds will have seen the proportion of emerging market assets in their portfolios rise as the BRIC economies have grown, with other emerging and frontier markets also now demanding investor attention. As an example of how local authority funds approach emerging markets, Richard McIndoe, head of pensions at Strathclyde Pension Fund explains that it has a relatively low dedicated emerging markets allocation, but this is not the full story. McIndoe said: “We are a very long-standing emerging market equity investor. We appointed a manager for our first mandate with a specific allocation to emerging markets in 1995. It was quite small – 1% of the total fund, split between three managers, one of whom is still there, Genesis. We now have 2.5% of the total fund of £4 billion in emerging markets. Genesis is the only dedicated emerging markets manager; most of the emerging market exposure is through global mandates with benchmarks that include the emerging markets.”




As McIndoe said, emerging markets might have still relatively small specific allocations in many portfolios, but their influence is now felt in other ways. Many blue-chip Western companies derive much of their revenue from emerging markets and a wide range of asset classes now seek exposure to the sector. Another local authority manager, who did not want to be named, backed up this last point. “The industry needs to get away from segmentation between developed, emerging and frontier markets. In practice, the boundaries are much more blurred; developed market companies like Proctor & Gamble, Unilever and Nestle have a high exposure to emerging markets; why artificially discriminate against certain stocks based on where they are listed? There are now Russian companies listed in London that I don’t consider to be developed market stocks.” The manager added: “We should go back to basics and focus on what a company does. For us, growth and income are now the most important buckets, that is how we think about our equity portfolio. I have pensions to pay, so I need income, but I also need growth in order to be able to meet my future liabilities.”

For many investors, emerging market equities are not the only way to play the emerging markets story, but they are too important to ignore. McIndoe commented: “There is a far from perfect correlation between equity markets and GDP growth but how else do you play it? There is no perfect means of doing this, but emerging market equities are the best proxy”. One attraction of equities is that they are relatively straightforward to understand and invest in, although access for outside investors can be difficult in some smaller or more guarded emerging markets and governance standards may not be as a high as in developed markets. Nevertheless, investors are keen to diversify and the Middle East and North Africa (MENA) region is one area that has seen interest grow among investors keen to find the next hotspot. Baring Asset Management head of EMEA equities, Ghabir Abu Leil- Cooper, said: “The developing nature of regional equity markets means that analyst coverage of the MENA region isn’t always as comprehensive as elsewhere and we believe this provides significant opportunities to invest in companies which are undervalued and unrecognised by the market.” The MENA region has a favourable demographic profile, Barings said, with one-third of the people in the region under 15, which should underpin long-term demand for housing, health care and consumer goods. Oil reserves will also mean that Gulf countries will invest in infrastructure, strengthening the investment case for the region.

While some investors approve or veto which countries their managers invest in, others take the view that this is something that a manager should decide, with the investors looking at broad themes. One theme which could drive interest in emerging market debt over the next decade is an appreciation in emerging market currencies. This is because the current model of emerging market central banks holding US dollar reserves is ultimately unsustainable. Ashmore Investment Management chief economist, Jerome Booth,commented: “The money so hoarded is not consumed or invested locally. There is the fiscal cost of sterilisation. There are substantial duration and currency risk associated with holding the reserves in low yielding bonds from the US and other heavily indebted developed countries. At some point these reserves will need to be diversified and reduced.” Booth added that once a few central banks see their neighbours’ currencies rising against the dollar or the euro, it will be easier to let their own currency rise. One way to benefit from this will be to hold emerging market government bonds denominated in local currencies. Another example is the rapidly developing market for so-called dim sum bonds, or corporate bonds issued in Hong Kong and denominated in Chinese renminbi. Investors in these bonds anticipate that a relatively low nominal yield will be boosted by an appreciation of the renminbi against the dollar over time.



Another growing theme is for investors to hold a range of emerging market assets. As well as equities and bonds, this could include private equity and other assets. For example, emerging market private equity firm Actis has recently announced two deals which show the scope for private equity investing in the emerging markets. In the first transaction, Actis invested in Bellagio, a popular casual dining chain in China. This will enable Bellagio to expand from its current 35-strong chain in top-tier and second-tier cities in China. In the second transaction, Actis announced it had invested $32 million in a Sri Lankan private hospital group, the Asiri Group. Actis head of South Asia, JM Trivedi said: “The rise of lifestyle diseases and increasing household income has created demand for highquality healthcare provision which supplements government led services.”

Over the past 10 years or so, the emerging markets have moved from a niche asset class in local authority pension fund portfolios to occupying a more central position, as an important driver for growth and also income. As well as holding emerging market equity mandates, many funds now gain exposure to emerging markets through global equities, as German car makers and English luxury brands export more to China and other emerging markets. Emerging market debt is also becoming more important in fixed income portfolios, particularly given the fiscal deficits in much of Europe and the USA. In addition, the emerging markets are now providing more opportunities for private equity, infrastructure and property investors. So it is hardly a bold prediction to say that the emerging markets will only grow in importance in the future, as the biggest emerging markets catch up, and indeed eventually overtake, the developed world, and as smaller emerging markets become more attractive to Western investors.

Emerging Markets FOCUS

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