Emerging markets are down but not yet out

Russia, China, India and Brazil are all still growing. Could 2009 be the time for investors to get back in
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The Independent Online

Investors in emerging markets took a hefty hit in 2008, with most of the major emerging indices losing more than 50 per cent of their value. Although investors in Latin American funds may have been lucky enough to escape with losses of about 30 per cent for the year – helped by a relatively robust performance from markets in the likes of Chile and Venezuela – those who put their faith in China or Russia could now be sitting on losses of 60 or 70 per cent.

This sharp collapse in most of the world's emerging markets was caused to a great extent by investors' migration away from perceived riskier assets. Historically, emerging markets have fallen faster and further during global recessions, as the world's biggest economies have bought less of their goods and services. Hence, many investors took the view that they would be the worst place to be as we headed into the worst global recession for decades.

Meanwhile, as credit markets dried up, increasing numbers of hedge funds and speculators were forced to cash in their holdings to pay down debts. Inevitably, positions in riskier markets were the first to be sold.

Sam Mahtani, a director of emerging markets at F&C Asset Management, also points out that emerging markets had enjoyed four very good years between 2003 and 2007, generating annual returns of more than 40 per cent. This had sent company valuations in some countries well above what many analysts believed to be fair value – causing many investors to take the view that these markets were due a correction. A good time to take profits.

In the case of Russia – which is the world's largest exporter of natural gas and second-largest exporter of oil – the collapse in energy prices during the second half of the year also played a big part in its market's collapse. The price of a barrel of oil fell from almost $150 (£109) in July to around $40 by the end of the year – prompting shares in many of Russia's biggest companies to fall by a similar margin.

So does last year's ravaging of emerging markets mean they're now great value? Or was 2008 just the beginning of a longer-term decline that won't be reversed until the major Western economies return to growth?

'A once in a decade buying opportunity'

Joanne Irvine, a senior emerging markets fund manager for Aberdeen Asset Management, believes that last year's falls in emerging markets have created a "once in a decade" buying opportunity, with many stocks now at very attractive valuations.

While she concedes that markets could remain volatile over the coming year – and may well sustain further losses – she believes that, over the long term, the demographic trends in countries such as India and China will ensure that these markets will perform strongly. Like most of the major emerging markets, these countries have young populations and a fast-growing middle class, who are spending, borrowing and saving on an ever greater scale. As a result, Irvine says, her team has been focusing on consumer businesses, which have been benefiting from these trends.

"In Mexico, for example, one of our largest positions is in Femsa, a beverage conglomerate, which makes Sol beer," she says. "They control 10 per cent of the Coca-Cola volumes in Latin America and they're the most profitable Coke bottler in the world. In India, an example would be HDFC, which is the No 1 mortgage bank in the country. They're first class at what they do, and well run."

In particular, Irvine says, HDFC does not carry the same kind of risk as many of the Western banks. It has no exposure to sub-prime loans, and its average mortgage customer borrows about 65 per cent of their property's value – much lower than the average loan-to-value in markets such as the UK. Irvine adds that the Indian property market has not seen the same kind of price inflation as has been witnessed in the West, and so is in less danger of suffering the kind of collapse currently taking place in UK house prices.



Growth remains strong

Robin Geffen, the managing director of Neptune Investment Management and manager of Neptune's Russia & Greater Russia fund, shares Irvine's optimism about the prospects for emerging markets, claiming the continued growth in these countries means that their stock markets are likely to perform much better than developed markets over the next few years."I really do think it's likely we'll see a decoupling of [emerging and developed] markets," he says, "because their economies are already decoupled."

Although growth is slowing in the major emerging markets, it is still at relatively high levels compared to developed economies – and prospects look good for the year ahead. China, for example, is expected to grow by about 7 per cent this year, while Russia and India are projected to grow by 6.5 and 5.5 per cent respectively. In contrast, some economists believe the UK could contract by as much as 3 per cent in 2009, while the US could shrink by 2 per cent.

Perhaps unsurprisingly, Geffen is particularly bullish about the prospects for Russia, which he believes holds much better prospects for investors than the UK or US. He believes the Russian government's response to the credit crunch – making capital available to three of the country's largest banks – has been effective, with new credit now reaching the businesses that most need it.

He also believes that the oil price is likely to increase, which will also have a positive effect on the country's markets. "Our view is that $40 a barrel is not a sustainable price going forward, and that supply will be shut off," he says.

Geffen is also optimistic about China, which he believes is "wilfully misunderstood" by many Western investors. "There seems to be a theory that China would grow until the Olympic Games and then stop," he says. "But my opinion is that the Olympics were not a major growth stimulus."

Geffen believes that the strong growth in domestic demand will be enough to offset any reduction in demand from struggling Western economies, and adds that demand for some Chinese goods could in fact increase as Western consumers trade down to cheaper models of electronic products, such as televisions, which tend to be manufactured in China.

Like Irvine, he points to the fact that Asian consumers have also avoided borrowing too much, and so are in a position of much greater spending power relative to debt-laden Westerners.

Trains, planes and power stations

F&C's Mahtani says his team are most interested in China, India and Indonesia in 2009. Mahtani says that, as net importers of oil, they have all been beneficiaries of the recent falls in the oil price. Second, he believes that government policy in all three countries has been geared towards re-igniting growth.

For example, towards the end of last year, China announced a 4 trillion yuan (£422bn) economic stimulus package, while the Indian government last year unveiled a £500bn five-year infrastructure investment plan. "They probably won't spend this much," Mahtani says, "but even if they achieve half of that, it's going to make a big difference to infrastructure."

Infrastructure remains one of the key themes in F&C's global emerging markets fund, with Mahtani pointing out that India has a massive deficit in power plants and transport facilities. One way in which F&C is playing this theme is by investing in VHEL, India's largest manufacturer of power plants.

Mahtani says F&C is also very interested in Brazil this year, claiming that its rolling programme of structural reform means it too has strong growth prospects for the years ahead.

In terms of valuations, the Brazilian market is now trading on just 6.5 times the predicted earnings of its constituent companies. India is now trading on around nine times forward earnings, compared to almost 20 times at the market's peak in 2007.

'This asset class is for the brave investor'

In spite of strong prospects for emerging markets, this remains a risky asset class that should be bought into in moderation by only the most sophisticated, risk-hungry investors. Still, Alan Steel of the financial advisers Alan Steel Asset Management says regular investors with a medium to high appetite for risk could consider allocating up to 10 per cent of their portfolio into the asset class.

The best way to get exposure is to buy a global emerging markets fund, which provides some diversification by investing across a range of world markets. For a list of funds open to private UK investors, and details of fund performance, look at www.trustnet.com. There are 34 unit trusts or open-ended investment companies (Oeics) in the IMA Global Emerging Markets sector, and six investment trusts in the AIC Global Emerging Markets sector. More specialist funds that invest in specific countries or regions, such as China, India, Russia or Latin America, can be found in the IMA Specialist sector.

Steel recommends First State's Global Emerging Market Leaders and Global Emerging Markets funds; he believes First State has one of the strongest teams of managers. He also picks out Allianz's BRIC fund, which invests in Brazil, Russia, India and China. For a more specialist investment, he says Jupiter's Emerging European fund now looks very good value.

"Emerging markets are for the brave, but I'd argue they present a far better opportunity than the UK at the moment." It is advisable to seek financial advice before buying in; to find an independent financial adviser in your area, visit www.unbiased.co.uk.

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