Emerging markets offer investment upside

Beaten down in 2011, emerging markets are now offering a lot of upside—and the risk is overstated.

The Lujiazui Finance and Trade Zone and Huangpu River in China (Photo: Jacky Lee/Getty)

For many years, billionaire investor Warren Buffett promoted a “main street” approach to investing that favours companies you know well over companies in far-off lands. But take a closer look at some of his recent investments and you’ll find buys that have significant exposure to rapidly growing overseas markets. In March of last year, for instance, Buffett bought Lubrizol Corp. for US$9 billion. Lubrizol is based in the U.S.—it’s an Ohio company that makes industrial lubricants—but about 65% of the company’s sales come from outside North America.

Certainly Buffett has always endorsed buying low and selling high, and as a group, emerging markets do seem to be at a short-term low. In 2011, the MSCI Emerging Markets Index lost a fifth of its value. Despite continued strong GDP growth, many investors still see that part of the world as risky. That’s created an opportunity to buy, at a reasonable price, international stocks and indexes that could help your portfolio thrive in the years to come.

Jerome Booth, head of research for U.K.-based Ashmore Investment Management, argues that the emerging world is not, in fact, as risky as some developed markets. While the U.S. and Europe are currently grappling with huge debts, a lot of the developing countries had their financial crises more than a decade ago and are now less vulnerable to shocks. Thailand, China, Indonesia and several others were deeply affected by the 1997 Asian Contagion. Russia and Argentina defaulted on their national debts in 1998 and 2002, respectively. As a result, their debt levels are extremely low today. Indonesia’s debt-to-GDP ratio is around 25%, compared to nearly 100% for the U.S.

The investor base in these countries has changed over the past 15 years too, Booth says. Back in the late 1990s, highly levered hedge funds and banks were the main investors in emerging-market securities. Today, it’s newly moneyed domestic investors looking to grow their savings who are propping up local exchanges.

Still, many investors remain concerned the growth will falter, especially in China. In 2010, the country’s GDP growth was in the double digits; in 2011 it was 9.2%, and it’s expected to fall to between 5% and 8% in the coming years. Phil Langham, a portfolio manager and head of RBC’s emerging-markets team, says the reason for the slower growth is that the government is pulling back on the stimulus measures that it implemented during the global recession.

Matthew Strauss, vice-president of portfolio management with Toronto’s Signature Global Advisors, adds that, since the recession, the focus has changed from buying export-focused companies to businesses that sell to the domestic consumer. Rising salaries in developing countries are making it more expensive to produce goods there while customers in the U.S. and Europe aren’t spending as much as before. And emerging-market consumers want to spend those rising salaries. So the growth henceforward will come from companies focused on internal markets. “You’re playing the consumption story,” he says.

Investors’ exposure to these growing markets could come from foreign companies or from a North American firm that exports there. Craig Swanger, the head of Macquarie Global Investments, based in Sydney, Australia, is partial to the latter. He says it’s safer for Canadians to own a TSX-listed company like Potash Corp., which sells fertilizer to Asian farmers, than one listed on a foreign stock exchange. He also likes Louisville, Ky.–based Yum Brands Inc., which opened 656 KFC outlets in China last year.

While either strategy can work, Strauss points out that foreign stocks and funds allow you to target the countries and regions that offer the most potential. His favourite part of the world is the ASEAN region (Association of Southeast Asian Nations), which includes Indonesia, Malaysia, the Philippines, Thailand and six other nations. Indonesia is forecasting 6.5% GDP growth and has strong domestic demand. The Philippines, he says, “could be a star.” Also expected to see 6% growth, it’s a less mature market than Indonesia, which means, longer-term, it could add more kick to a portfolio. In Latin America, Strauss favours Peru and Colombia. Both are commodity-driven—which may be a concern for Canadians with a high weighting to our own energy sector—but their domestic consumption is growing.

When choosing countries to invest in, Langham looks at the price-to-book ratio of the national stock indexes rather than price-to-earnings, as it’s difficult to predict profits in a weak economic environment. “The expectation is about 10% earnings growth this year, but it could be much lower than that,” he says. Emerging-market indexes usually trade between 1.5 and 2.4 times book value; the overall MSCI is trading at about 1.7 times right now. Investors shouldn’t just go for the cheapest buy, though. Look at P/B in conjunction with other metrics, such as national current account deficits and debt levels, which should both be low. As well, keep an eye on political problems that could affect a particular nation.

Knowing which companies to buy can be difficult, so many experts suggest buying an exchange-traded fund (ETF) that tracks a country-specific market index. Experts also recommend placing no more than 10% of your portfolio in emerging markets. The reason, says Swanger, is that global stock markets are still highly correlated. When western markets fall, so do exotic ones—usually harder because of their small size and perceived risk. Still, a 10% allocation should give your portfolio a big boost should markets continue to climb. “This type of position won’t significantly impact your overall risk,” says Langham, “but it will substantially add to your overall return.”

The CB Hotlist

WisdomTree Emerging Markets Equity Income Fund
P/E: 12 | Yld: 3.89% | 1-yr ret.: -8%
For broad exposure to emerging markets, Patricia Oey, an ETF analyst at Morningstar, suggests this index fund. Dividend funds are less volatile then non-paying ones. It also has exposure to some of the more promising markets, such as Indonesia, Thailand and the Philippines, and a longish track record—it was created in 2007.

Market Vectors Indonesia Index ETF
P/E: 13 | Yld: 1.52% |1-yr ret.: 0.6%
Many emerging markets investors are looking to Indonesia for growth and safety. Morningstar gives this ETF a five-star rating, saying its return potential is high.

P/E: 10 | Yld: 1.77% | 1-yr ret.: -16%
This is the second largest China ETF and, says Oey, it’s very broad. It has exposure to 10 different sectors, and its top weighting, China Mobile, accounts for only 7.76% of the fund. Investors who want more of the domestic market can buy the Global X China Consumer ETF.

iShares Latin America 40 Index Fund
P/E: 12 | Yld: 2.88% |1-yr ret.: -12.8%
If you want broad exposure to Latin America, ILF is a good bet. Its biggest weightings are in Brazil and Mexico, but Peru and Colombia are included.