Overlooked opportunities in mid-caps
I’m sure most people have heard of middle child syndrome – some have no doubt experienced it...
Emerging market equities have certainly given investors a volatile ride over the past 20 years – but is now the right time to have exposure to these areas?
David Cali, head of portfolio strategy at Matthews Asia, believes they have a role to play within investors’ portfolios, even though they have disappointed over the past decade.
“It’s true that emerging market equities have underperformed, but the decade prior to that was almost the mirror opposite,” he says. “They dramatically outperformed the S&P 500 Index.” He also credits the “incredible performance of US stocks” during this period as one of the reasons why emerging areas appeared lacklustre in comparison.
As far as current positive factors are concerned, David suggests the relative underperformance of emerging equities could be on the verge of turning around for a couple of reasons.
The first is the prospect of US corporate earnings coming under pressure due to the proposed higher corporate tax rates and the forecast tapering of the Federal Reserve’s bond purchasing program.
He also points out that emerging and Asia equities have done well when the global economy has entered a period of economic growth with slightly higher inflation – which could be the case now.
“I believe that the emerging markets are compelling over the short term, and that’s because of the exposure to the cyclical recovery,” he said. “The next five to 10 years looks fairly compelling as well. One important reason is improving corporate governance and transparency.”
As well as the recognition of shareholder rights improving – and putting a larger share of profits into investors’ pockets – he cites robust profitability of the regions’ companies.
“Emerging market companies, especially those in South Korea, Taiwan, China, and non-Asian countries like Brazil, can be very profitable, rivalling companies in developed markets,” he adds.
Kunjal Gala, lead manager of the Federated Hermes Global Emerging Markets SMID Equity fund, agrees that reform within these markets will be a driving force over the coming years.
“Emerging markets account for over 80% of the world’s population and 40% of the world’s economy, but only 24% of the world’s market cap,” he tells us.
He points out that this is largely due to less robust macro and domestic situations compared to the developed world. “As emerging markets reform, the demographic advantage will accrue in the form of growing consumption,” he says.
Kunjal believes the “rapid usage of digital technologies” will offer emerging markets a chance to improve efficiency and productivity, resulting in sustainable growth going forward. “A combination of a growing middle-class population, digitisation and infrastructure will enhance emerging market economies to over 50% of the world creating value for investors over time,” he said.
Austin Forey, manager of the JPMorgan Emerging Markets Investment Trust, agrees the emergence of the middle class, along with consumer demands, remains the long-term structural story. “As the world adjusts to the new normal ways of living, we believe pre-existing structural trends in emerging market equities will continue to accelerate,” he says.
These trends include strong companies continuing to grow and develop market share, increased shareholder prioritisation, and greater investor focus on corporate behaviour.
“As investors, we look for exposure to companies with sustainable competitive advantages, consistent cash flow generation, and strong management teams,” says Austin.
He also believes emerging markets are becoming more like developed markets, in the sense that the value creation in the corporate sector is being strongly driven by very similar factors.
“Digitalisation, the development of internet-based business models, and the creation of intangible value rather than reliance on physical assets are far more widely seen in emerging markets today than in the past,” he says.
In fact, most of the Trust’s portfolio is invested in sectors that broadly fit this characterisation: software services; internet services; gaming; consumer brands; and even stock exchanges. “To harness opportunities in emerging markets, we believe that it is key to take an active, bottom-up approach,” adds Austin.
As far as his approach is concerned, focusing on the economic fundamentals and corporate skills are seen as the most important factors in determining long-term investment outcomes.
“Investors should consider the growth potential of specific companies, rather than taking a view on individual countries,” he says.
Of course, any investment must make sense from a financial perspective. The good news, according to Mark Hammonds, co-manager of the Guinness Emerging Markets Equity Income fund, is that valuations for these areas are looking attractive on an absolute basis. “Although at a premium to where they have traded historically, when compared with developed markets, emerging markets look very cheap,” he says.
Mark also points to several positive trends. “The vaccination programmes that are ramping up in emerging markets, meaning that the pandemic can be more effectively controlled, should help to boost sentiment towards emerging market equities.” He favours quality companies that have achieved persistently high returns on capital. “This requirement naturally steers us away from energy and materials companies, where returns are more lump’,” he explains.
He also aims for more predictable and consistent earnings growth in the portfolio, linked more closely to structural factors than the boom-bust nature of some commodities.
“This combination of strong cash flow generation and high returns on capital affords shareholders a sustainable dividend,” he says. “When coupled with earnings growth, we get the prospect of an income stream that can grow over the long term.”