Emerging markets and why they’re gaining popularity again

After several years out of the limelight, the emerging market investment sector is suddenly drawing a lot of attention. Here’s why.

After several years out of the limelight, emerging markets or EM is an investment sector that is suddenly drawing a lot of attention.

EM is a collection of investible countries across Asia, Eastern Europe, Latin America, the Middle East and South Africa. In recent months, EM valuations have improved on both a relative and overall basis.

This is in direct contrast to the past two years: EM had record outflows as an asset class in both equities and bonds combined as investors had taken a more defensive position in uncertain times.

Some investors will enter emerging markets through exchange-traded funds but active management is the rational way to gain exposure to EM.

If you look at simple index reading then the picture is flat: EM as an index has returned less than a third of the returns from the MSCI World index of 77 per cent against 225 per cent over the last decade.

At an index level China now represents over 30 per cent of all stocks.

However, active funds can outperform.

For example, there are two active funds — Northcape Capital in the last decade, and

Skerryvore in the past few years — which have shown EM solid outperformance against the indexes.

The reason I back the best active EM managers is not only due to the outperformance they have delivered but also because they have achieved this by taking a selective approach to the constituents of the investible EM universe with strong disciplines applied.

Consider this: They see China representing a large index component and have avoided Russia.

They also know China has autocracy risk as well as issues around corporate debt and demographics. Northcape approaches EM through a lens of whether in the long term you win by not losing.

In other words, protect capital and look to benefit on the upside as quality companies grow. What I specifically look for in selecting a manager is less downside participation, which means less downside in a correction than the index, especially in times when there are external shocks.

Here are the key issues you need to watch as an investor in emerging markets:

Country selection matters
As Northcape highlights, being a great stock picker is not enough — being in the right markets geographically is critical. This is due to sovereign risk and the relative risk/return characteristics of a country.

This would ensure you were never in Russia and the geopolitical events around this country, and would also avoid the volatility around many EM currencies and the cost of hedging.

Importance of sustainability
Governance — the “G” in ESG — is important in all investment decisions. ESG is therefore a strong aspect of success in delivering shareholder returns.

These are also strongest where there is a strong democracy at the sovereign level. This also reduces the overreach on governments to protect the rule of law, property and human rights as

well as freedom of speech.

Awareness of social and environmental risks is important to Skerryvore and they see companies being able to create advantage through positioning under these principals.

Stock focus
Northcape feel many investors underappreciate the capital adequacy and financial flexibility aspects of stronger, quality companies of EM on a long- term basis. They look for companies with:

● Net cash and therefore the ability to withstand exogenous shocks, with capital adequacy, being able to fund sensible acquisitions and pay dividends.

● Conservative attitude to debt.

● Price makers not price takers.

● Servicing large populations with favourable demographics.

● Sector or industry exposure that has structural growth.

● Balancing stakeholder interest with creating shareholder value with clear and transparent reporting.

Size of assets under management
Many fund managers run extremely large levels of funds in their strategy. Look for a manager with a size of AUM that allows them a level of liquidity.

Therefore, the ability for the manager to enter and exit positions is positive and they are not just drawn to only the large cap stocks due to the size of their AUM.

According to investment bank Jefferies, the valuation of EM companies on a free cash flow yield has never been more attractive.

Risks do exist in EM investing so you must always manage for the downside. However, with the right active manager you should be able to participate in an asset class that is attractive

on valuations both in real and relative terms.

Further security comes with the knowledge that risk management is balanced with the potential returns.

Will Hamilton is the managing partner of Hamilton Wealth Partners, a Melbourne based Wealth Manager.

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