Emerging Markets

A record of outstanding performance

Originally published in the June 2007 issue

The last five years have brought outstanding returns for equity investors in emerging markets (EM). The first quarter of 2007 saw EM equities rise in value for the seventh consecutive quarter, outperforming every other asset class.

The benchmark MSCI Emerging Markets Index, which measures returns in twenty six less-established economies, has now more than doubled in USD terms in the last five years, outperforming global equities by almost 100%. These markets are considered to be in an economic transition phase; countries that are experiencing rapid urbanisation and industrialisation as they establish the infrastructure and institutions that characterise mature markets.

The advance of globalisation has been a significant factor fuelling the development process. The emergence of worldwide production markets, where companies seek out economies offering competitive advantage, has boosted international trade flows. The trend of outsourcing labour intensive production processes has been particularly important in this context. The process has been enhanced by the shift from pegged to free-floating currencies in Asia and parts of Latin America, helping to ensure export competitiveness.

Globalisation is also allowing a vast group of emerging consumers to have access to goods and services that were not available or relevant a short time ago in subsistence-dominated economies. The valuations of leading stocks in the consumer staples and consumer discretionary sector have increased to reflect this.

The application of technology has speeded up the development process, allowing economies to bypass outmoded applications. This can be seen in telecommunications, for example, where fixed-line telephony has been superseded by mobile applications. As a result, the fastest growing market, India, is adding more than six million mobile subscribers each month.

Improving sentiment has taken place against a background of global growth. Output has increased at the highest sustained rate since the early 1970s, with strong increases in virtually all regions. Both developed and emerging markets have improved productivity, notably since 2002, which has made it possible for higher commodity prices to be absorbed without inflation moving up to concerning levels.

While rising stock markets have attracted significant amounts of capital, estimated at USD 42 billion in 2005 and 2006, the volume of private capital invested has also increased. The combination of enhanced investment, export-led growth and consumption has led to dramatic growth. The BRIC markets (Brazil, Russia, India and China) are estimated to have contributed 30% to the growth of world output since 2000, and are expected to play an increasingly important role on the world stage.

Are emerging markets a beta play on global equity markets?

The traditional view has been to identify investing in emerging market equities as a beta play on global equity markets. In essence, the assumption is that EM stocks reflect the influence of the underlying factors driving the global economy, rather than offering alpha; the potential for excess return.

The recent commodity boom, for example, could be seen in this context, with emerging economies such as Brazil, Russia and Peru benefiting from rising global demand for oil, iron ore and copper from the surge in construction in Asia.

Recent research has cast doubt on this view. Jonathan Garner, Michael Wang and Vinicius Silva at Morgan Stanley focused on changes to macro and micro market fundamentals since the financial crises in Asia and Russia in 1998. They highlight the sharp improvements in financial health that have taken place in EM. These include stronger balance sheets, with reductions in the ratios of public debt to GDP, the improved currency and maturity composition of debt and higher levels of international reserves. They argue that these changes mean that the returns that investors can achieve in EM have been de-coupled from the returns available in developed markets.

The hypothesis was tested by regression analysis of the performance of developed markets, using the MSCI World and S&P 500 indices as benchmarks, against the MSCI EM index. The regressions showed that there has been a statistically significant alpha element since September 1998, amounting to between 0.7% and 1.1% per month.

Potential sources of alpha

So what are the potential sources of alpha? The trend towards industry consolidation is one possible theme that can be identified in many industries across EM, from materials to telecommunications. It is the logical step that follows the opening-up of capital markets. Consolidation has helped fuel the four-fold increase in return on equity identified in listed corporates in EM since 2002.

Another significant source of alpha is the higher volatility evident within emerging equity markets. Global volatility has picked-up slightly since February 2007, but has been on a declining trend over the last five years. EM equities are characterised by less depth and breadth than mature markets. These characteristics, when combined with less-established information flows, tend to contribute to higher volatility levels. This in turn offers opportunities for well-informed investors.

EM also have less depth of coverage. According to Factset, the 1884 companies within the MSCI World Index have, on average, 13 analysts assessing their performance. In contrast, the 841 stocks within the MSCI EM index have just eight. The result is that investors with direct experience of the marketplace may have better fundamental insights into drivers of business. In this environment, long experience itself may be a source of alpha.

In spite of recent gains, EM shares are on average valued at a discount to stocks in developed markets, while the earnings outlook tends to be better. The average price-to-earnings ratio for the EM benchmark is 15.3; compared with 17.7 for developed market shares.

This does, of course, conceal the fact that some markets are influenced by unique domestic characteristics. Shanghai, for example, has restrictions on overseas investment that pushed valuations as high as 41 times forward earnings in May 2007. This situation is expected to ease as the government pushes ahead with moves to liberalise the investment regime in place for Qualified Domestic Investors (QDIs).

Investors should, of course, be aware that emerging status does bring with it some elements of risk, illustrated recently by political events in Venezuela. President Hugo Chavez’ second term in office, which began in December 2006, has been marked by a sharp turn to the political left, a commitment to create ’21st century socialism’ and a pledge to re-nationalise assets in the oil, telecoms and broadcast sectors. This has led to dramatic revaluations on the equity markets.

In spite of this, the broader picture is encouraging. Earnings estimates are on a rising trend in emerging Europe, Asia and Latin America, and both beta and alpha elements can be identified as driving performance.

At the same time, the credibility of policy management appears to have improved, as illustrated by China’s moves to slow the pace of fixed-asset investment or Turkey’s monetary tightening following rising inflationary pressures. Progress is also being made in enforcing better standards of corporate governance; a vital step in ensuring the successful functioning of financial markets.