Emerging-Market Stock Funds Reach Beyond ConsumersDavid Bogoslaw
By now it's a familiar tale: While U.S. consumers struggle to get back on their feet, shoppers in emerging markets such as China, India, and Brazil are off and running. That drive to create a middle class in areas where there previously was none is a big reason why the World Bank expects real gross domestic product to grow 8.5 percent in China next year, 8.7 percent in India, and 4.5 percent in Brazil—vs. just 2.9 percent in the U.S. It also explains why consumer stocks have been a popular investment for managers of emerging-market stock funds throughout 2010.
But now it looks like those fund managers are branching out. While betting on the rise of the emerging-market consumer remains a popular strategy, analysis by Bloomberg Businessweek shows they are also targeting some well-capitalized banks and, increasingly, larger energy and technology companies. Stronger economic footing in the U.S. and parts of Europe could spark more demand for energy products and technology, making those kinds of companies "more globally balanced investment opportunities" in 2011, says David Semple, manager of the Van Eck Emerging Markets Fund (GBFAX), which ranked 10th in the Bloomberg rankings of top-returning emerging funds with a five-year return of 11.8 percent. Laura Geritz, who manages the Wasatch Emerging Markets Small Cap Fund (WAEMX), has doubts about whether the economic gains in some developed countries will extend over her three- to five-year time horizon, but says she's been overweight financials for a few years, since they have "been the backbone of the consumer story" in the small-cap world. Her fund ranked third with a one-year return of 44.9 percent and a three-year return of 8.8 percent. (The fund launched in September 2007.)
The challenge for emerging-market funds is to match or beat their torrid performance of the past year. To find out where emerging-market mutual fund managers are focusing now, Bloomberg Rankings screened for Bloomberg Businessweek the 20 actively managed emerging-market funds with the best overall scores based on one-, three-, and five-year returns and risk metrics. Funds that did not have updated portfolios as of Sept. 30 or later were eliminated from the ranking. Heading the list was the Fidelity Advisor Emerging Asia Fund (FEAAX), with a five-year return of 17.7 percent and one-year return of 20.4 percent, and the Invesco Developing Markets Fund (GTDDX), with a five-year return of 14.8 percent and one-year return of 21.6 percent. A handful of managers at those top funds agreed to talk, with varying degrees of specificity, about what stocks they're targeting now.
Managers agree that the high level of stock prices in emerging markets poses a greater challenge in 2011 than in the past two years. A total of $143.6 billion has flowed into emerging-market stocks since March 2009, according to EPFR Global, a Cambridge (Mass.)-based provider of fund flows and asset allocation data to financial institutions. With the MSCI Emerging Markets Index (EEM) up 134.2 percent since the rally began 18 months ago, it's fair to wonder how many attractively priced securities remain. Some of the recent money flow has come from institutional investors and other fund managers whose international equity mandate normally doesn't include emerging-market stocks, says Wasif Latif, manager of equity investments for USAA Investment Management.
Larger-cap stocks are more likely to have stretched valuations because fund managers who typically avoid emerging markets tend to concentrate in those better-known names. Those managers often lack the resources needed to scrutinize companies individually, says Latif. "In the entire emerging-markets universe, there are always names that are appealing because not everybody is going through that [detailed analysis]," he says. "If you're looking at details in individual companies and doing your homework, you can definitely find value in a lot of names."
Stephen Wood, chief market strategist at Russell Investments, says he has an optimistic call on emerging markets but agrees that finding undervalued stocks will require much more effort by fund managers. Investors need to be aware of the "tug-of-war between extremely strong fundamentals [economic growth outlooks and strong corporate earnings in many developing countries] and rich valuations." He believes it's risky to overplay the consumer angle since he sees improving standards of living in emerging economies coming off a very low base. That makes it a longer-term bet that doesn't always translate into an immediate market opportunity. The Russell Emerging Markets Fund (REMAX) came in fifth in the Bloomberg Rankings, with a five-year return of 12.8 percent and one-year return of 17.9 percent.
Van Eck's Semple often picks smaller-cap names to find growth even though his fund isn't exclusively a small-cap fund. That's enhanced his portfolio's performance in 2010, since small-cap stocks have continued to rebound after a steep decline in late 2008. Their average price-earnings ratios are narrowing the gap with large-cap stocks. "We're anticipating a move up the market-cap curve into larger-cap stocks," he says. That's partly because he expects energy and technology stocks to perform better in 2011 as the global economy strengthens and each sector is dominated by large-cap names such as CNOOC (CEO) and Samsung (005930:KS). Emerging-market small-cap stocks, which are generally more consumer-oriented, "are discounting too much growth too soon," he believes.
Semple is still finding value in smaller-cap stocks, though the one he cites is in the energy industry and not in consumer goods. Gujarat NRE Coke (GNC:IN) in India is still fairly cheap at 5.6 times projected 2011 earnings because it isn't well-covered by analysts or well-known among investors, he says. Gujarat specializes in metallurgical, or coking, coal, which is in great demand by steelmakers, and coking coal prices seem well-supported by supply constraints in Australia. Coking coal isn't nearly as abundant as the thermal coal used in power stations. Gujarat's main mine in Australia has more than doubled its production over the last two to three years and the company recently adopted a more efficient mining technique that will require investing in more expensive machinery. The strength of Chinese manufacturing demand for coking coal bodes well for Gujarat, says Semple.
On top of valuation concerns, fund managers are grappling with some big macroeconomic uncertainties. For example, there are mounting worries about the tough stance governments such as China's are taking to calm their overheating economies, such as hiking interest rates and raising capital reserve requirements for banks. The worry is those economies will overcorrect and their stocks will decline. China's fiscal and monetary tightening are one reason Rusty Johnson, who manages the Harding Loevner Emerging Markets Portfolio (HLEMX), sold his shares of China Communications Construction (1800:HK). His primary concern, however, was the struggle the designer and builder of transportation infrastructure has had making the transition from ports to rail and other more lucrative projects. The company's return on capital has been relatively low and its working capital was strained; the government is trying to reduce capital flows into the economy, which is expected to curtail orders for new construction.
Doubts about Brazil have centered on whether the newly elected president, Dilma Rousseff, a former Marxist, will continue the market reforms of her predecessor, Luiz Inácio Lula da Silva, which have spurred Brazil's economic growth over the past eight years. Confident about Brazil's expanding consumer base, Johnson recently added Hypermarcas (HYPE3:BZ), a diversified consumer-products company, to his portfolio. Hypermarcas is enhancing the brands of mom-and-pop health and beauty products that are strong in local markets and using its distribution scale to give those brands wider geographic exposure . The company is moving more into generic drugs, which aren't subsidized by the Brazilian government and attract consumers who want high-quality products that cost less than rival brands from multinationals like Procter & Gamble (PG), says Johnson. He thinks Hypermarcas can grow rapidly by strengthening local brands and convincing people to stick with familiar products as they move into higher income brackets.
Macroeconomic worries haven't stopped Steve Cao, senior portfolio manager for the Invesco Developing Markets Fund (GTDDX), from adding to his position in ICBC (1398:HK), China's largest commercial bank. Cao has increased the bank investment by more than 30 percent in the past six months and now it's one of the fund's top five holdings. Cao believes bank stock valuations remain reasonable due to the sector's underperformance. ICBC is trading at 9.3 times projected 2011 earnings. He likes ICBC's low loan-to-deposit ratio, which is under 60 percent, and its well-capitalized balance sheet.
Cao is also finding unconventional ways to play China's consumer growth story. His fund added Lee & Man Manufacturing (2314:HK), one of the two largest corrugated-board manufacturers in China, with slightly more than 10 percent market share. He dismisses concerns about lower pulp and paper prices squeezing margins and cites the company's track record of being able to raise prices and generate stable profits, except in fiscal year 2009, when lower volumes and high-cost inventories ate into profit margins. As a maker of boxes used in packaging consumer electronics and food products, Lee & Man provides indirect access to China's expanding consumer sector, he says. He expects it to benefit from China's push to shut down smaller paper mills in a crackdown on environmental pollution. Lee & Man's equipment meets international pollution standards and the company has its own utility power, Cao says.
Cao has exited positions where valuations have gotten too steep, usually after holding the stocks for at least a couple of years. Top Glove (TOPG:MK), China's largest manufacturer of medical gloves, was one of his top performers in the past year but now faces pricing pressures due to supply expansion that occurred in the wake of the H1N1 flu scare and rising rubber costs.
Even in markets such as Russia, where investors have been taken for a bumpy ride by unpredictable taxation and regulatory swings, fund managers are finding opportunities. Johnson at Harding Loevner says he's careful about companies in highly profitable industries, such as natural gas and other natural resources, which make them vulnerable to government meddling. He's been adding to his holdings of X5 Retail (FIVE:TQ), a leading discount-store operator "modeled crudely after Wal-Mart in consumer discounts," which brings Russian consumers fresh food products at lower prices than mom-and-pop grocery stores. Johnson sees X5 as safe because "the government is aware that the [business] model is helping to keep inflation down."
While signs of strength in the U.S. and other developed markets are encouraging some emerging-market fund managers to reach beyond consumer-oriented stocks, Wasatch's Geritz believes government stimulus programs are driving much of the recovery and she's not sure it's sustainable. "At some point, developed economies will be forced to grapple with their debt problems, so that has consequences for long-term growth," she says. "So we're sticking with our overweight consumer bias."