Asia Predicted to Lead Global Economy's ReboundRita Raagas De Ramos
This is part of a mid-year AsianInvestor series on the investment outlook of fund managers with Asian equity portfolios. Ray Prasad is a Boston-based senior global emerging markets portfolio manager at Batterymarch Financial Management. He joined Batterymarch in 1997 to perform emerging markets research and was promoted to portfolio manager in 2000. In 2005 he was named senior portfolio manager, with primary responsibility for Asian markets.Prasad focuses primarily on the Asian markets within Batterymarch's emerging markets team, which manages around $3.4 billion in emerging market equities, including $2.1 billion in Asia. What are the biggest opportunities that you see in the markets you are responsible for in the coming 12 months? How are you preparing to take advantage of those opportunities? Prasad: Asia, and emerging markets in general, still have higher growth characteristics and greater profitability than developed markets. Two-year expected earnings growth is currently 11.8% for China and 10.2% for India. The figures are even higher for Taiwan and South Korea, at 19.5% and 21.5%, respectively. Compare this to the MSCI World Standard Index, with expected earnings growth of only 7.5% for the next two years. In addition, Asian debt-to-equity ratios have been relatively low ever since the crises of the late-1990s and early part of this decade, when many of these countries began deleveraging their balance sheets. Profitability, represented by return on equity (ROE) is also more attractive for Asia than the developed world. Thanks to their sound balance sheets, the ROE for Asian companies has held up reasonably well despite their low leverage, and profitability has remained somewhat stable. Companies in the developed markets have seen profitability plummet as they have been forced to deleverage. In our view, the most effective way to capitalise on opportunities in Asia or any market, for that matter, is to look at underlying company fundamentals, which we believe are the drivers of long-term returns. That's always been the focus of Batterymarch's bottom-up investment discipline. How different or similar is your 12-month investment outlook now compared to the start of this year? Our outlook for Asian markets is still very positive, based on their fundamentals. After a weak January—in line with the historical pattern for emerging markets—Asia has been on the upswing, with any remaining downgrades in analysts' estimates already priced in. We also continue to see strength at the macro level. Asian governments have the financial wherewithal to implement economic stimulus measures to offset the global slowdown, and they have done so. China, with interest-rate cuts and enormous infrastructure spending, is the most obvious example, but countries like India have also put forth stimulus programs. Emerging markets, led in large part by Asia, are expected to lead the global comeback. These markets don't have to go through the deleveraging process the way the developed countries continue to do, and they can move ahead without having to rebuild their financial systems. Have you made any significant changes to your asset allocation in terms of markets or sectors in the past few months? We're positioned somewhat less defensively than in the first quarter—we are no longer overweight in the telecommunications and food, beverage and tobacco industry groups, whose rankings have deteriorated in our quantitative, fundamentals-based model. We also increased our allocation to the more cyclical industries such as diversified financials and semiconductors as well as consumer discretionary-related groups like autos. The cyclical names have tended to do well in recent months. What are the greatest lessons you have learned from the global financial crisis and how will this affect the way you manage your portfolios? I think the greatest lesson has been a renewed appreciation for risk—in terms of both scope and time. The extent of the global crisis caused stocks to behave differently than their fundamentals warranted. Assets historically regarded as ultra safe behaved like risky assets. Volatility, a proxy for risk, has remained elevated for an extended period, although it is trending down. For a time, rising stock correlations and extreme volatility made it difficult to gain alpha from the market as investors fixated on risk to the exclusion of everything else. At the same time, analysts tended to lag in their estimates, so we had to be especially vigilant in assessing their earnings forecasts. In a broader sense, perhaps the greatest lesson that every investor learned is that no company is too big to fail. That said, none of this has caused us to make changes in our investment process, which is designed to add value across various environments. As with the earlier Asia-specific crises, which were also characterised by high volatility and deleveraging, strong fundamentals have been unrewarded during much of the current global slowdown. Following the Asian crises, rationality returned to the markets as investors shifted back to fundamentals. The same thing is happening now—starting with the March rally, companies with stronger fundamentals have begun to be recognised by investors. How has your view of Asian equities changed since the start of 2009 when investor sentiment was generally gloomier? Our view of Asian stocks has been consistently positive throughout the global downturn as their fundamentals remain positive. For the longer term, emerging markets, including Asia, are well positioned, and we view any possible declines as opportunities to add to our holdings. With the volatility of this asset class, it is always a good idea to take profits whenever greed becomes apparent and markets have run too far according to one's risk tolerance. How has the swine flu affected your investments? We take a long-term view at Batterymarch, so the flu hasn't affected the way we invest. Asia, like all emerging regions, is likely to be more susceptible than the rest of the world to flu-related fears because of their relatively high beta and the potential for increased risk aversion. If the pandemic leads to a market correction, this should create attractive buying opportunities for investors with longer horizons. What are your market weightings within an Asia ex-Japan equities portfolio? We are generally more positive on stocks with domestic growth drivers and reasonable valuations. This has led us to be close to neutral or overweight in most Asian markets except Taiwan and Malaysia, where valuations are a bit stretched relative to other markets in the region. What are your favoured markets in Asia? Based on their fundamental characteristics, we are currently finding attractive opportunities not just in large markets like China and India, which have been able to support economic growth and corporate profits, but also smaller markets such as Indonesia. Indonesia is a strong domestic growth story not unlike China and India. The political stability and positive investment climate engendered by the current Indonesian government have created numerous opportunities. Risks do abound, however, especially due to poor corporate governance and limited market liquidity. We recently initiated positions in Sri Lanka as well, where we expect accelerating economic growth now that the civil war has ended. Outside Asia, Turkey and Brazil also offer attractive investment opportunities based on cheap valuations and good growth prospects. In Turkey, recent political issues notwithstanding, the country's economic team has done an outstanding job in maintaining stability, particularly in light of the global increase in risk and severe economic slowdowns in the area. Brazil continues to benefit from declining domestic interest rates and a strong global appetite for its commodities. What are the markets you are going to steer clear of in the next 12 months? Our approach is to look at companies on a case-by-case basis, regardless of where they are located. We don't avoid any particular country as long as we can identify promising opportunities there. Within our broader emerging markets mandates, we are currently completely out of Eastern Europe given the issues surrounding leverage for both consumers and corporates. Which sectors do you expect to outperform in the next 12 months? Companies tied to domestic consumption and infrastructure development, which should continue regardless of the global economy, still score well in our models. Many of them sold off sharply in late-2008 even though they had stable earnings and good fundamentals. As the stimulus monies start coming through as real orders, we expect economic activity to pick up both at the industrial and consumer levels. This will be favourable for Consumer Discretionary and Capital Goods players as well as Financials. Which sectors do you expect to underperform? Names that rank poorly in our models can be found across a variety of sectors and countries. These include companies that have experienced a huge drop in orders or recently expanded their capacity to meet demand that has not materialised. Companies that took on leverage at the peak of the cycle are also likely to struggle. What are the main challenges that you expect to face in the coming 12 months? Although Asia and other emerging markets are positioned to lead the global economic recovery, this process will take time and can include some false starts. We expect continued volatility in Asian markets until a more consistent and positive global environment takes hold. During such periods, when stock prices may be driven by investor sentiment, it can be challenging to add value over the short run. Managers need to be nimble and flexible, especially in the current environment, where we have seen so many sharp turning points. What are the main risks of investing in Asia at the moment? How are you managing those risks?
The larger Asian markets are closely connected to the global economy in terms of trade and will therefore continue to grapple with the effects of the diminished export market. On the other hand, their demographics work in their favour. A growing middle class in these countries translates into rising domestic demand that to a degree has helped offset the drop in exports. Government stimulus programs, most notably in China, have provided incentives for local consumers in addition to supporting much-needed infrastructure development. All of this has helped sustain growth in these markets, albeit at a slower pace than in the past few years. How the demographics and stimulus spending interact and affect economic activity will be reflected in demand going forward. Asian markets are starting to price some of this into corporate earnings although they do have a way to go. In the near term, we expect some consolidation of markets given the spectacular run from the trough in 2008. As for managing risk, Batterymarch's investment process incorporates multiple risk controls at the industry and country levels. The stocks we own have to be liquid so that we can be flexible in all market environments, and we run diversified portfolios so that we can gain alpha from a variety of sources. It's also important to note that we evaluate stocks from multiple perspectives—at the global and local levels and by industry and country—to develop a comprehensive view of their relative attractiveness. The goal is to maintain a solid risk-to-reward ratio in our portfolios.