Following a strong start to 2019, volatility has returned to emerging markets as the ongoing trade conflict between the US and China, which intensified into a battle over technology during the second quarter, continues to bite. With negotiations failing to break the deadlock, investors have sought safety in assets perceived as less risky and some commentators have questioned whether the continued tension is a further signal that the emerging market growth story is unravelling.
The economic evidence, however, tells a different story. In May the OECD lowered its headline growth forecasts for developing world GDP from 4.7% in both 2019 and 2020 to 4.3% and 4.6%, respectively[1]. Despite the downgrade, developing nations are still expected to grow more than twice as quickly as developed ones with only 1.8% GDP expansion expected of OECD nations in each year.
Further support comes from a recent IMF report which predicts that China and the rest of Asia will deliver nearly two-thirds (63%) of world GDP growth this year compared to 11% for the US, 4% for Europe and only 1% for the UK[2].
Regardless of whether the US and China can reach a trade deal, it is clear that economic growth globally is slowing, although monetary easing and fiscal stimulus are helping to offset falling business confidence and visibility. While the political environment remains uncertain, reduced external debt and stronger current account balances mean that emerging markets generally look more resilient to economic shocks and a global downturn than previous cycles. Companies should also be supported by current valuations with EM trading 22% to 33% below DM on a forward P/E or P/B basis[3].
While the trade tensions that are slowing global economic growth are inevitably impacting developing nations, the structural attractions of emerging markets remain compelling.
Powerful structural growth
More importantly, the powerful structural growth drivers that have seen Asia’s share of global GDP grow from 8% in 1980 to 34% today (see chart below) remain intact. Levels of wealth have risen alongside standards of healthcare and education while advancements in technology have enabled many developing countries to catch-up with more advanced nations and emerge as key links in global supply chains, rather than relying on traditional commodity-based economies. However, the link between GDP growth and equity market performance is spurious, particularly in emerging markets. If economic expansion is anticipated and has sufficient capital to support it, equity returns will typically be poor. The best opportunities often occur when growth is unexpected or underfunded and an unconstrained mandate like ours offers the best way to exploit these mispriced opportunities as we have the flexibility to invest where the supply-demand balance of capital flows and sector or country preferences is in our favour.
The most important determinant of returns for equity investors is valuation. India, for example, has many strong companies delivering strong earnings growth thanks to supportive demographics and government policies. However, this is reflected in high company valuations with Indian equities trading at almost 18x forward earnings[1]. This is 15% above their ten-year average and close to the level that has historically delivered losses over the following 12-months[2], which demonstrates the benefit of being selective and picking mispriced stocks in an overpriced market.
Stock selection key
The wide disparities between and often within emerging market countries mean that careful stock-picking, based on detailed company analysis, is the optimum way to exploit market inefficiencies, which are often more pronounced in the developing world. This bottom-up approach creates an attractively valued portfolio – SKAGEN Kon-Tiki currently trades 33% below the MSCI EM benchmark on a forward P/E basis[3] – meaning the fund is capable of beating the index.
Kon-Tiki’s largest divergence currently is its overweight exposure to Korean companies (24% of the fund vs. 12% of the MSCI EM index), which illustrate how mispriced stocks can deliver attractive returns. Our largest holding is Samsung Electronics (8.4% of NAV), which continues to deliver impressive financial performance and shareholder returns but remains valued at a significant discount to global peers. Despite producing world-class products, Korean companies are often undervalued due to perceptions of weak corporate governance and poor capital allocation but where treatment of minority shareholders is improving. Another example is Hyundai Motor (4.5% of NAV) which has launched a governance charter and is taking steps to increase dividends and simplify its chaebol structure. Finally, investors can access Korean companies via preference shares, which typically trade 20% to 60% below ordinary shares (see chart), with the most attractive discount currently on offer at LG Electronics (3.7% of NAV) where we potentially see 140% share price upside.
In addition to mispricing, stock picking allows investors to select businesses in charge of their own destinies, which is important as the investment case for many emerging market companies has evolved from riding globalisation and exporting cheaper goods abroad to serving increasingly affluent consumers at home. As countries emerge economically and become wealthier, the first customer contact with quality products is usually through foreign brands but as domestic manufacturers catch-up, consumers switch to buying their products which are similar in quality but often cheaper. Local companies can create further brand loyalty through a better understanding of customer behaviour and alignment with their values.
China illustrates this development and Kon-Tiki was able to take advantage of the market sell-off last year to invest selectively in companies creating value through domestic growth with reduced exposure to external risks beyond their control. We believe this is sensible given that the tensions between the US and China appear to be a structural trend, rather than merely trade-related. Examples included liquor producer Wuliangye Yibin and appliance manufacturer Hangzhou Robam, which have since been sold, while current top ten positions similarly well-placed are Bank of China (4.2% of NAV), China Unicom (2.8% of NAV) and Ping An Insurance (5.3%).
In conclusion, while the trade tensions that are slowing global economic growth are inevitably impacting developing nations, the structural attractions of emerging markets remain compelling. In the current late stage of the economic cycle, investors need to be increasingly selective and our broad mandate provides the flexibility to find the best opportunities. Our portfolio contains strong companies which are attractively valued and generally in control of their own destinies. If the current trade tensions continue, they should be well placed to withstand the effects, and we are equally well positioned to find further opportunities.
NB: Information as at 30 June 2019 unless stated
References:
[1] OECD Economic Outlook, November 2018 and May 2019
[2] Source: IMF / Standard Chartered, March 2019
[3] MSCI EM Index (P/E 12.1x, P/B 1.6x) vs. MSCI World Index (P/E 15.6x vs. P/B 2.4x), 30 June 2019
[4] MSCI India, as at 30 June 2019
[5] Source: Goldman Sachs
[6] As at 31 July 2019