This past year the news has been filled with stories about crises in Africa and the Middle East. There is the piracy on Africa's east coast, a smoldering insurgency in Uganda led by the reclusive self-styled Christian guerrilla Joseph Kony, armed thugs in the Congo region, corruption scandals in South Africa, and of course a chain of uprisings and civil wars across the Middle East, where the so-called "Arab Spring" has overturned seemingly unstoppable dictatorships even in large countries like Egypt and oil states like Libya.
So it comes as some surprise that on a list compiled by Lipper Inc. of the top performing emerging market funds, the top tier of leading funds includes several that specialize in Africa or in Africa and the Middle East, one that focuses only on smaller cap firms, and one that is so conservative in its investment strategy that it rarely finds itself at the head of the pack.
"The smaller markets in both Africa and the Middle East offer some opportunities for growth," Lipper research analyst Matt Lemieux says. "Sure there is a bit more volatility in those regions, but with questions now about growth in emerging markets in places like Brazil, China, India and Russia, all of which have become noticeably cooler, maybe the opportunities are better in Africa and the Middle East. I wouldn't say that China and India are being left by the wayside, but people are seeing that they are not as bullet-proof as in the past. Africa and the Middle East are the next big areas, and people are willing to go out on a limb to find the next growth story."
The top performer for 2011 is the Virtus Emerging Opportunity Fund A (HEMZX). The second-ranked fund is the Nile Pan-Africa Fund (NAFAX). Third is the Wasatch Emerging Market Small-Cap Fund (WAEMX). Fourth among the top five retail funds is the T. Rowe Price Africa-Middle East fund (TRAMX). Finally, in fifth place, is the Amana Developing World Fund (AMDWX), a steady performer that follows Islamic investment rules (no heavy debt, no alcohol, no tobacco).
Larry Seruma, the manager of Princeton, N.J.-based Nile Pan-Africa fund, which was ranked second by Lipper, agrees that there has been a lot of political unrest in North Africa of late, and that there has been plenty of negative news from the rest of the continent, ranging from droughts to coups to kidnappings. But, he says the bigger story is that Africa, a continent with more than one billion people, is growing rapidly. "People hear Africa and they think jungle," he says. "But in fact Africa has 52 cities [each] with over a million people, and as a result you are seeing tremendous demand for housing, infrastructure, and services."
Seruma, who hails from Uganda, argues that "people's perception about Africa is 15 to 50 years out of date. They hear about a polio outbreak somewhere in Nigeria or about a coup in Mali, and they think all Africa has polio and coups," he says. "The real story of Africa is not being told."
Oliver Bell, who recently took over as manager of the T. Rowe Price Africa Middle East Fund, which Lipper ranked fourth, agrees. "Nine countries in Africa and the Middle East had elections this year; 15 others last year," Bell says. "So democracy is slowly but surely taking hold. You're seeing rising GDP, increasing productivity and strong international investment, especially from China, with one-third of China's outward investment-$100 billion-going to Africa and the Middle East." Much of that investment is in the resource sector (oil and gas in the Middle East of course, but also increasingly in Africa, as well as minerals in Africa). Meanwhile, a growing middle class is also attracting investment interest from international companies like Walmart and Yum! Brands, the latter of which is putting up KFC outlets all over the place.
None of this is to say that the mainstays of emerging market investing are passÃ©. Indeed, Lipper's top-performer, Virtus, is still focused on the Asia-Pacific region. "Specialized Africa and Middle East funds did well last year," Virtus fund manager Rajiv Jain, says. "But, these are specialized niche funds. You cannot put serious money to work in these markets." He argues that outside of South Africa and Egypt, "you are really talking about a frontier market in Africa," while in the broader Middle East, "you have to go country by country."
The top performer among emerging market funds for the one-year period ending June 19, 2012, the Virtus Emerging Market Opportunity Fund A, benefitted from not having a hot-dogging strategy. In a year when emerging markets took a beating, with the MSCII emerging market index falling 20%, Virtus managed a gain for the period of 3.66%.
Jain's secret has been to stick with high-quality businesses selling at "attractive" prices. "Obviously nobody says they're buying low quality at high prices," the New York City-based Jain laughs, "but then the question I have is: Why is the `quality' people buy always so like the MSCII index?"
As Morningstar analyst Gregg Wolper notes approvingly, Jain chooses companies with clear, straight-forward accounting and with understandable business plans.
"This can make our portfolio a bit lopsided," Jain concedes. For example, he avoids investing in Russia, because he doesn't trust Russian accounting, and instead is heavy in Brazil and India. "Last year, half our funds were invested in those two countries," Jain says. "We pick companies, not countries."
Jain and his 12-member investment team only do bottom-up research in picking the 55 to 75 companies in the fund's portfolio. The key factor they look for is conservative accounting. They also focus on companies that are strong in their own domestic markets. "That way, we aren't hurt by the slowdown in the European and U.S. markets," Jain says. Among the fund's top ten investments are British American Tobacco (5.46%), ITC Ltd. (4.85%), Housing Development Finance Corp., Ltd. (4.8%), Companhia de Bebidas das Americas ADR (3.40%) and Walmart de Mexico S.A.B. de C.V. (3.20%).
Looking ahead, "the challenge is to keep trying to lower expectations," Jain says. "If commodities recover as growth recovers, we won't do as well next year. We have been avoiding commodities because they are tied to the performance of the developed economies. It's not everyone's cup of tea, but even if we don't outperform, we should do well, because our companies are strong."
Seruma, manager of the second-ranked Nile Pan Africa Fund, says he is a value investor but uses a macro research approach to begin with. "We don't invest in troubled countries," he says, which automatically excludes places like Zimbabwe, Angola and Chad. "We also want to see growth, and the rule of law, as well as well-regulated markets, which means countries like Nigeria, South Africa, Kenya, Uganda, Mozambique, Ghana, Rwanda and Zambia," he says. While he likes Egypt, Tunisia and Morocco, he says that valuations are currently high, so his exposure there is low. The fund took a hit in Egypt earlier when the local market fell 50% during the Arab Spring uprising, and since then Seruma has reduced his exposure there.
"We look at domestic companies that are partly owned by large multinationals," says Seruma, who has managed the fund since its inception. He says those global firms "have done some of the due diligence for us." Some 38% of this fund is invested in South African companies. This is because South African companies are, by and large, transparent and well-run. They, in turn, are invested heavily in other African countries, and provide a good way to get exposure to countries in Africa where local companies are not so easy to research, and where liquidity can be problematic. For the same reason, Nigeria is also 19% of the portfolio.
A big developing story in Africa is hydrocarbons, Seruma says. Oil has been found in northwestern Uganda, and there is a "huge" gas discovery along the east African coast.
With just $16 million in assets under management, this is a small fund to be sure, but as Seruma points out, it is the "only pure-play Africa fund" in the U.S. space. "We have the opportunity to prove that Africa is an investment destination, and not a place to throw aid at," he says.
Seruma certainly bested the competition in the emerging market fund field over the past year ended June 19, eking out a 1.67% gain over the period, making his fund the only one besides top-ranked the Virtus Emerging Markets Opportunity fund to end that 12-month stretch in positive territory. He has done dramatically better than the rest of the field, including Virtus and the other top performers on the Lipper list, in the year-to-date period, with a gain of 20.52%.
The third-ranked fund on the Lipper list, the Wasatch Emerging Small-Cap Fund, is broadly diversified fund geographically, invested in the BRIC countries, but also in many smaller countries. What sets it apart is its focus on smaller-cap firms, instead of just the big names that most emerging market funds favor.
"A few years ago, we decided that small cap was not getting much attention in the emerging market space," says the fund's lead manager Roger Edgley, who is based in Salt Lake City, Utah. While this fund had a net loss of -2.37% over the 12 months ended June 19, Morningstar senior analyst William Samuel Rocco gives it good marks for having a 6.4% annualized gain since inception in 2007, which he says ranks it second among all diversified EM funds, and compares favorably to a -2.3% annualized loss for the group over the same period.
"The risk aspect of small cap in emerging markets is counter- intuitive," says Edgley. "Investing in small caps in developing markets is actually less risky than large caps. Small cap firms are more tied to local economies, and are also less tied to commodities and global cycles." With large caps, he says, emerging market investors who are seeking non-correlating assets actually end up getting the same performance they would get by buying Exxon."
"We look for the highest quality growth companies, not necessarily the fastest growing ones," co-manager Laura Geritz, adds. "So, for example, we'll buy an Indian subsidiary of Colgate- Palmolive. The term small-cap in this fund means companies with sales of under $3 billion. "We're not looking to shoot the lights out in any sector," Geritz says. "We are looking for quality, as defined by strong cash flow, strong balance sheet, and a sustainable competitive advantage."
While they like Africa, and say they expect it to grow in importance over time, they feel "the epicenter of emerging markets remains Asia." In Africa, they-like the Nile Fund's Seruma-use South African, and to a lesser extent, Nigerian and Kenyan, companies as a springboard.
Meanwhile, there was a bit of turmoil last year at the T. Rowe Price Africa and Middle East Fund. The original manager, Joseph Rohm, had left after a two-year tour, and was temporarily replaced by Chris Alderson, head of international operations at T. Rowe Price. While he won plaudits for experience from Morningstar analyst Karin Anderson, last year she was advising investors to "watch this fund from the sidelines" until it named a new permanent manager because she felt Alderson's other responsibilities would make it hard for him to do the job well.
If they had sat on the sidelines, though, investors would have missed out. Not only did the fund rank fourth on the Lipper list for the year ended June 19, losing only -2.15% over the period. Since the start of this calendar year, the fund is up 8.38%. Of course, during that period the fund has been under the direction of Oliver Bell, the fund's new manager.
Bell claims that this fund, which focuses on Africa and the Middle East, has stabilized somewhat now that a lot of the "hot money" that flowed into these regions earlier has departed, leaving "a lot of investors who are after the 10-year story." He says that GDP growth in the region is "substantially above the rest of the world," and that debt-to-GDP is low, thanks to a lot of debt forgiveness offered to African nations in the early 2000s. He says that Africa and the Middle East, with a combined GDP of $4 trillion (larger than India) has been "overlooked" by most investors, including emerging market investors, but that with new oil and gas finds in Africa, that situation could change quickly.
"We have three themes," he says. "First, there are South African companies, which after looking at the U.S. and Australia, are now turning to their own continent both to invest and as a market. Many of these companies are being re-rated. Second, there are Nigerian banks, which were completely cleaned up recently after a big scandal, with a few CEOs put in jail. They are now very cheap, with the whole banking sector trading at one-times-book.
Finally, there's Saudi Arabia, which is investing heavily in response to the Arab Spring. Companies there are trading at historic lows." And, Bell says: "Those cranes that you used to see in Dubai? They are now spread out across Saudi Arabia."
Rounding out the list is the Amana Developing World Fund. This is a surprise entry. A steady performer, this Bellingham, Wa.-based fund has generally avoided most of the volatility that characterizes emerging markets thanks to a decision to follow Islamic investment rules. "That means no alcohol or tobacco, of course," says fund manager Nicholas Kaiser, "but it also means no financial companies."
Amana's funds were established as a vehicle for Islamic investors, though today only 10% of the investors are actually Islamic. Most are simply emerging market investors looking for a less volatile option.
"We take a long-term and, I believe, a more reasonable approach to emerging market investing," Kaiser says. "Because we take a conservative approach to investing, we took less of a hit last year than a lot of our competitors." Interestingly, the fund is not very invested in the Middle East. "Our best countries these days are Latin America, Malaysia and Indonesia," Kaiser says. "We're not used to being up at the top of the performance list like this," he says. "But we're up 8.34% this year so far."