In an otherwise gloomy global environment for stocks, emerging markets have been one of the few areas generating some healthy returns recently. Christopher Palmer, who is based in London and manages the Gartmore Emerging Markets fund (GEGAX), is finding plenty of opportunities in countries such as South Korea, Mexico, and Russia. He particularly likes financial stocks, given that many banks in emerging markets are recovering from past troubles, and energy plays, thanks to the strong price of crude oil.
Palmer has run the portfolio since its inception in August, 2000, with what he calls a "growth blend" style of investing. In other words, though Palmer is primarily a growth-oriented manager looking for companies that exceed consensus earnings estimates, valuations in emerging markets are so low that his investing methodology can take on a blended feel.
For the 12-month period ended Aug. 31, the fund gained 9.1%, while the average emerging markets fund rose just 1.5%. The fund's benchmark, the S&P/IFCI Index, gained 7.2% over that period. (With two years of operation, the fund is still too new to be awarded a STARS ranking from Standard & Poor's.)
Palash R. Ghosh of Standard & Poor's Fund Advisor recently spoke with Palmer about his fund's investing strategy, top holdings, and portfolio moves. Edited excerpts from their conversation follow:
Q: How do you select stocks?
A: Gartmore's stock selection process is based on a "growth-blend" style. Basically, we're seeking companies we think are likely to surpass consensus earnings growth estimates for the near and longer-term, based on our proprietary research. We invest in about 25 countries spread out over Latin America, Eastern Europe, the Pacific Basin, the Far East and the Indian subcontinent. The fund has 65 holdings.
Typically we want to invest in countries where the overall macroeconomic environment is supportive to providing companies with growth...such as export growth, growth in domestic demand, etc. Thus, what might be a poor macroeconomic climate for a company with a large domestic market might actually be a good environment for an exporting company. Our macroeconomic calls are largely based on the direction of a country or region's interest rates and the aggregate expectations for corporate earnings in those areas.
In addition, we tend to avoid countries that we believe are politically or economically unstable. However, we select individual stocks based on a bottom-up, stock-specific research. Thus, in our attribution analysis, the "country effect" is much smaller than the "company effect."
Q: What are your largest individual holdings?
A: As of the end of June, the ten largest positions were Samsung Electronics, the giant Korean chip-maker; Shinhan Financial Group, a Korean financial services company; OAO Tatneft, a Russian crude-oil producer; Siam Commercial Bank, a Thailand-based bank; LG Electronics, a Korean electronics manufacturer; China Mobile, a cellular telecommunications provider in China; SK Telecom, a Korean mobile communication service provider; OAO Gazprom, a Russian producer and distributor of natural gas; Kookmin Bank, a Korean bank; and Grupo Financiero Banorte, a Mexican bank. These 10 holdings represented about 32.9% of the fund's total assets.
Q: What are your top country allocations?
A: As of June 30, the 10 biggest countries in the portfolio comprised South Korea (22.7% of the fund), Mexico (12.8%), Brazil (9.2%), Taiwan (7.5%), Russia (7.3%), South Africa (5.3%), Hong Kong (4.5%), Malaysia (4.4%), India (4.3%), and Thailand (3.4%). [Note: According to S&P, the top five country allocations of the S&P/IFCI Index on June 30 were: South Korea (24.3%), Taiwan (14.2%), South Africa (9.1%), Mexico (8.7%), and Brazil (7.8%).]
Q: What are your top sector allocations?
A: The five largest industry allocations were financials (22.8%), materials (13.3%), energy (11.9%), telecommunications (10.8%), and information technology (9.2%).
Q: Financials is by far your largest sector. Why?
A: Most of our financials stocks are in core traditional banking names, rather than in financial services or insurance. One of the reasons that bank stocks in the emerging markets, particularly in Asia, have performed well is because they have been digging themselves out of a hole for the last five years since the Asian financial crisis. As such, these banks have been putting their own houses in order. They haven't had the time, nor money, to enter such risky ventures as backing WorldCom or Enron.
Also, since the local currencies in places like Korea and Thailand have been unstable, their banks have been aggressive buyers of U.S. Treasuries through their excess liquidity. Moreover, deposits have been rising throughout the emerging markets. There's little else for people in these countries to do with their money. As these deposits have grown, these banks have issued more and more bonds. As such, they have a steady and predictable earnings stream and a huge capacity to increase lending when the global economy improves. They're in a highly liquid state and need very little capital.
Q: Why has the Korean economy and market done so well over the past year and a half or so?
A: Keep in mind that from September, 2000, through September, 2002, a two-year period, the Korean market was actually flat. On a rolling three-year basis, the Korean market is down, [while] on a rolling four-year period, the market is up -- so it's a very volatile market.
But yes, since the beginning of 2001, Korea's market has performed relatively well. Along that time, the country has enjoyed some currency stability. Korea suffered a tremendous financial crisis in 1997 and 1998, leading it to devalue its currency. This has really helped its export economy. Along with this devaluation, Korean companies have enacted good cost-control measures allowing them to become more competitive and efficient.
Korea's three biggest trading partners are the U.S., Japan, and mainland China. The growth in trade between Korea and China over the past 12 months has really boosted Korea's export business, particularly in the areas of mobile telephones, low-cost computers, and petrochemicals.
The outlook for Korea's export economy is very positive. For one thing, Korea has price advantages in certain businesses that Japanese companies are exiting from. The Koreans are also in a better position than the Japanese to exploit trade opportunities with China. Inter-Asian trade is burgeoning.
However, there are many portions of the Korean domestic economy which remain weak. You could say they're still trying to recover from the crisis of 1997-98. To illustrate Korea's emergence as an economic power, in 1995, Korea only accounted for about 2% of the benchmark index. Today, it's over 24%. This means that the index providers have introduced a vast number of Korean stocks into their benchmarks, leading to some foreign money flowing into the Korean stock market.
Q: Can Korea really be considered an emerging market?
A: Yes. Korea is in no way a developed market yet. Democracy is tenuous at best in Seoul, and the government exercises a large degree of control over the economy. Moreover, Korea really hasn't fully integrated with the economy of the developed world. It's also struggling to improve its domestic standard of living.
Q: Are there regions of the emerging markets that you are avoiding or in which you are significantly underweight?
A: We are underweight in the Middle East, which basically comprises Israel, Egypt, and Turkey. These countries are besieged by internal political and economic crises. We have also scaled back our exposure in Central Europe, particularly Poland and the Czech Republic, since we're not happy with the growth outlook and with some of the domestic problems.
Q: What's your view on Mexico and Russia, both of which are highly dependent on their oil economies?
A: With oil now priced at about $30 a barrel, Mexico is a very good place to invest. So is Russia. Energy is a key theme in our fund, now even more so with the impending military conflict with Iraq. Moreover, energy is becoming an emerging-markets business, in the sense that more and more of the oil and other energy sources that is being produced in the emerging markets is being sold to other emerging-market countries. For example, in the last decade, China has evolved from being an oil exporter to becoming an oil importer. In the coming years, Russia will consume more of its own oil than its sells to other countries.
I also think we're reaching the end of a 10-year cycle of declining commodities and natural resource prices. As we expect commodity prices to rise modestly in the next few years, the emerging markets will be an even better place to invest.
Q: What's your fund's average price-earnings ratio?
A: As of June 30, the fund's average p-e was only about 10.4. But there are two aspects to this. The low p-e indicates that emerging markets are clearly less expensive to invest in than developed markets. This is a core part of our investment philosophy. However, people seeking to invest in the emerging markets rightfully want to pay at a discount, given the political and economic risks inherent in the emerging markets.
Another aspect to investing in the emerging markets is that they provide a higher dividend yield than the developed world. This feature should appeal to value-oriented investors, but we also have stocks which exhibit lots of growth. It's important to keep in mind that the emerging markets are vastly diverse, but many of the best stocks there are delivering high and consistent earnings growth.
Q: Do you think the emerging markets overall are still so volatile?
A: By our calculations, we have determined that volatility is actually decreasing. For the most recent 12-month period, volatility was about 20%, down from a figure of 25% for the recent two-year period. The emerging markets are becoming less and less volatile. I suspect this is because price multiples there are so low.
Q: Do you have a market-capitalization bias in the fund?
A: As of June, the fund's median market cap was about $1.38 billion, so it has more of a mid-cap nature. We are not restricted by cap size at all. We will buy a stocks as long as they are sufficiently liquid.
Q: What are your sell criteria?
A: We sell a stock after it has underperformed for a certain period of time, or when there is a significant negative change in the company's outlook -- i.e., a new competitor arrives into their marketplace, a key executive leaves, they lose a patent, etc. We also sell when a stock reaches our price target.
Q: Do you meet with managements of companies in your universe?
A: Yes. We think meeting with companies is a very important part of our investment process. We meet with our company managements at least once a year. We either travel to their headquarters or they visit us in London.
Q: Are companies in the emerging markets conforming to Western-style accounting standards?
A: We don't see the types of accounting abuse in the emerging world that we have been seeing lately in the U.S. The penalties for such acts are quite high. We believe accounting standards have greatly improved in the emerging markets. For one thing, many of these countries are reliant on foreign sources of funding, either loan funding or shared capital funding. The emergence of the Internet has also made it enormously easier to examine a company's financial statements.