It pays to be a global player. As the U.S. limped through a difficult recovery last year, emerging markets and international funds scored big gains for investors. Investors and analysts say that even though there will be the inevitable ups and downs for the emerging markets, they should be in every balanced portfolio. "The next five years will be an important period in which global demand — particularly from emerging markets — will be picking up. So emerging markets will be a crucial part of our portfolios," says Quincy Krosby, Prudential Financial's market strategist. "Similarly, companies selling to emerging markets from developed world indexes will be an important part of that story for decades to come," she says, while cautioning that it does not mean smooth sailing. Investors should expect the occasional selloff and volatility. "That's part of the investment landscape, but the essential thesis will remain sound for [years] to come," Krosby says.
According to Morningstar, the top 10 emerging market mutual funds notched gains of 25% and 31.2% in the 12 months ending March 31, 2011. In the same period, international investing in the developed world climbed between 28.4% and 51.4%. There were also themes that were sounded again and again among the top managers: a fondness for natural resources and the countries that have them-granted, hard to avoid in emerging markets economies-as well as for companies in the developed world that sell to emerging market consumers.
One of the top performing emerging market funds, Causeway Emerging Markets Institutional, leapt 26.6% in the last year. Arjun Jayaraman, the fund's co-manager, and his team try to quantify what drives stock prices. They found that last year the main driver was earnings growth, although valuation and quality factors played a role as well. They homed in on stocks that were being upgraded by sell-side analysts based on estimates of cash flow and sales. "We had a strong rebound in global growth in 2009, but then [we had] a more modest continuation of that growth, so when growth starts to slow, investors tend to pay up for stocks that can show superior earnings growth," he says.
Unlike many top-down managers, Jayaraman does not look solely at the country or sector level. He has found top performers across the board in all countries and sectors. Nonetheless, he ended up with an overweight position in South Korea — a strong contributor to the fund's performance — and continues to favor its relatively cheap valuation. A few Korean stocks that did well include, Honam Petrochemical — a natural resources play, as well as Hyundai Heavy Industries and Hyundai Motor.
Elsewhere in natural resources, commodity stocks worked well, including GHM Polska, a Polish copper and silver miner. On the more defensive side, were food manufacturers Thai Food Production Co., and Charoen Pokphand Foods, a producer of meat and seafood, which benefitted from a boost to shrimp prices following BP's oil spill in the Gulf of Mexico. It's also a strong play on increasing meat and protein consumption in Asia, as well as being cheap on a variety of valuations.
Jayaraman is positive on China because of the strong growth. He also likes neighboring Russia, which is strongly overweighted in the portfolio because of oil and natural gas. "These days, with all the problems going on in the Middle East and the resulting impact on oil prices, Russia provides a good hedge for the emerging market portfolio," he says. He also notes that Asia's high dependence on oil, plus China's and India's reliance on commodities for their growth, made all energy stocks a hedge for emerging markets portfolios.
Another contributor to Jayaraman's performance was his exposure to small- and mid-cap stocks. Aside from Hyundai, most of the stocks in his portfolio have been fairly obscure. "These are not the standard emerging market stocks people talk about, like Samsung and Petrobras," Jayaraman says. We generate a lot of alpha in mid- to small-cap ,where the greatest inefficiency lies."
George Iwanicki, manager of the JP Morgan Emerging Economies fund, makes a similar observation. He says that many of his competitors likely received a boost in the last year from the strong performance of small- and mid-cap stocks. But Iwanicki, whose fund notched gains of 26% in the last year, says that the trend had begun to reverse in the last six to eight weeks. Nevertheless, that won't hurt his fund. "We purposely run the strategy as an all-cap strategy," he says, adding that he sees size as more of a risk factor than as a source of performance. "It wasn't cap size that motivated why we performed. It had more to do with tactical views and views of over and underweights and value and momentum," he says.
One place where underweighting helped his performance in 12 months ending March 31, was in being light on China. The region underperformed for most of the period, as the government tightened interest rates. But in November and December, as the market got cheaper, Iwanicki believes the government was nearing the end of the tightening cycle, and he started to move back into Chinese stocks.
Iwanicki also rode Korean stocks to big gains last year, and continues to favor the market. By his reckoning, even after last year's gains, both the equity market and the currency are still cheap, a situation with the potential to add to returns for clients investing in U.S. dollars. He also likes Russia. While the risk of poor corporate governance worries other investors, Iwanicki says at these prices, Russia is "sufficiently cheap to take the risks." He agrees with Jayaraman that with all its exposure to energy, the country is benefitting from being a hedge against rising oil prices.
Within sectors, Iwanicki liked technology, and held a large overweight position in the portfolio. He also favors consumer discretionary. Both sectors worked well last year, but he has lightened his exposure to them more recently.
Within natural resources, a big sector for emerging markets countries, he likes energy more than basic materials, and continues to hold that view. He is now "moderately overweight" in energy and "measurably underweight" in materials. Over the last year or so, energy has done moderately better than the rest of the market, but it has really taken off in the last three months, as a result of the turmoil in the Middle East. But given the transience of that situation, Iwanicki favors energy because he believes the world economy is in expansion mode, a better place in the cycle for energy than materials. He notes that in 2009, the world was recovering from a recession and rebuilding depleted inventories, so a significant amount of raw materials was needed. But he now believes that the cycle is over, and the expansion cycle is on, there's more support for energy stocks.
Another energy advocate is David Nadel, co-portfolio manager of two of the top three funds in the international category — Royce European Smaller Companies and Royce Global Value. Each fund scored gains of just over 37% in the year to March 31. But unlike Iwanicki, he favors materials, with natural resources being one of the top sectors in both funds.
Nadel, who is director of international research at Royce Funds, favors the energy sector because of the overall global economic picture. He sees the developed world — the U.S., Europe and Japan — as having an artificially low interest rate environment, with an aggressive monetary policy. "In that environment, we're attracted to the parts of the economy producing things in finite supply," Nadel says. He and his colleagues like all natural resources, including oil or precious metals (they own mining companies for this exposure, not bullion). He adds that not only is supply finite, these commodities are getting harder to get out of the ground. He notes that as central bankers keep printing dollars, euros and yen, the less valuable the currencies become. "Metals, oil, rubber, copper, palm oil, all are shooting up in price because it takes more and more dollars to buy them," he says.
Favorite stocks are in the oil and oil services sector, as well as gold, silver and platinum mining companies. His picks include Lamprell PLC, an oil services company operating in the Arabian gulf; Medusa Mining, an Australian gold miner; Hochschild Mining PLC, a British silver miner; and Northam Platinum, a South African miner. All, save Medusa Mining, are in both funds. Medusa, not being a European company, is only held in the Global Value Fund.
Royce's philosophy is to focus on companies with very strong balance sheets. The companies must generate high returns on capital, typically 15%-plus. But this range is not a formal cut-off. Those standards eliminate a lot of sectors, such as banks, telecoms, utilities and media companies. So it leaves room for greater concentration in favored sectors, like industrials, which tend to have a predictable cash flow business — another quality favored at Royce.
What's more, the industrials Nadel and his colleagues favor touch on another big theme in the portfolio: the emerging market consumer. Because of the rapid growth of a middle class in big emerging market countries like China and India, European companies that focus on making products for those consumers are doing very well. An industrial near the top of both portfolios is Semperit, an Austrian company that makes specialized rubber products, including conveyor belts, industrial hoses and surgical gloves. It is the number one global maker of handrails on escalators. The company, which has been around for nearly 200 years and listed on the Viennese stock exchange since 1890, has survived many business cycles, and is masterful at managing costs. With the cost of rubber increasing, this is key to protecting their bottom line. The company has increased revenues and earnings in 19 out of the last 20 years without making any acquisitions, and consistently generates 20%-25% returns on invested capital, and has a strong balance sheet.
Another top sector that plays to the rise of the emerging market consumer is asset managers. The Asia-Pacific region was home to eight of the world's 10 fastest growing populations of high-net-worth individuals, according to the 2010 World Wealth Report from Merrill Lynch Wealth Management and CapGemini. With China's outsized gross domestic product growth, perhaps its not surprising that the country saw the number of millionaires climb 31% to 477,000, from 2008 to the time of the 2010 World Wealth Report. "Eighty percent of them didn't exist 10 years ago, and there's this whole class of people who need their money managed," Nadel says. His picks include Value Partners in Hong Kong, and Partners Group Holding AG, a Swiss company. Both firms aim to get growth from an Asian customer base. Ashmore Group PLC, out of the UK, focuses on emerging market debt, for a different take on the growing emerging market theme. Nadel favors asset managers because it's a business he knows well, and is fundamentally attractive, because it has predictable cash flow, can be highly profitable, and can often grow very well. He draws a sharp line between asset managers and banks, saying that banks "never have strong balance sheets; they're either levered or very levered. A bank has to pay you to be a customer, with interest. Asset management firms are the opposite."
Finally, the Encompass Fund, which led the international funds with a one-year return of 51.4%. Like the other top performers, Malcolm Gissen and his team also favors the energy sector, as well as other types of commodities, as a way to capitalize on increasing demands from emerging markets consumers. He describes himself as contrarian, deep value investor with a long-time horizon, and use both top-down and bottom-up stock picking. They use a more top-down approach to finding industries they think would benefit from global growth. "People want products; they want to live a better quality of life, that leads to wanting and needing various products and services that need commodities as building blocks," Gissen says. "There's an increased use of commodities to make refrigerators, build houses, and cars and the energy it takes to do those things — you need to generate electricity to do various manufacturing processes, to light homes and drive vehicles," he says.
The fund holds stocks of companies exploring for or producing gold, silver, copper, uranium, oil — and to a lesser degree — natural gas. Gissen and his team are also big fans of industrial metals, specifically rare earth elements, like Europium. China produces 95%-97% of the world's rare earth elements, and the country has been decreasing its exports, a move which has pushed prices higher. Avalon Rare Metals, a Canadian company, is a favorite pick, in which the fund has tripled its investment.
Among energy producers or explorers, there is GeoPetro, a San Francisco-based oil and gas company that has five new projects in development from Indonesia to Alaska. Last year they bought stock in a negotiated private offering for 45 cents per share; from a high of 85 cents, it is back down to 70 cents, they believe it is worth $2 to $3 per share. "We're long-term investors, we're willing to wait. We're patient as long as the company is making progress toward their goals," Gissen says. He adds that patience is what led the fund to 137% gains in 2009 and a 60% rise in 2010.
Patience is the one thing all the investors seemed to agree is key for an emerging markets investor. Krosby of Prudential Financial says that will be especially critical for emerging market investors in the coming months. During a period in which central bankers shift their positions by tightening interest rates — which many watchers expect from the United Kingdom, and from the Fed in the second half of the year — markets become volatile and investors get nervous and sell. "You'll see a selloff in the speculative element that's gone into commodities and commodity producers like Russia, which has been a beneficiary of the lower rates," she says. The good news is that selloff will take the "froth" out of the market and allow new investors to buy in at lower prices. "Ultimately, the tightening we see will end and demand for commodities will be even stronger, and then we'll see flows go back into countries associated so strongly with commodities. This is an economic global equilibrium. So be careful, do your due diligence."
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