By Jonathan Asante, fund manager at Framlington Four main types of argument are usually advanced...
By Jonathan Asante, fund manager at Framlington
Four main types of argument are usually advanced in favour of investing in emerging markets. Two of which, although relevant at present, are unlikely to deliver sustainable outperformance for a long-term investor, and two of which are quite compelling.
The first is cyclical. Developing countries, especially those in Asia, manufacture an increasing amount of the world's goods, taking advantage of a supposed cost advantage and also delivering jobs. The problem is that it is unclear why developing economies have a cost advantage in capital-intensive industries as the cost of capital is higher in these countries.
This all suggests that some non-market-based mechanism is being used to allocate funds towards these areas and, in many cases, shareholders' funds are being used to achieve government-directed development goals.
Cyclicality alone is unlikely to be a good enough reason to hold emerging markets for anything other than the short term. Some of the large cyclicals will offer brief periods of strong outperformance but will not offer long- term growth at a reasonable price until they are subjected fully to the capital discipline imposed by equity markets.
The second argument hangs on valuation, but is again found wanting. Having underperformed for half a decade, emerging equity markets, unlike those in Japan, offer significantly lower P/E multiples than elsewhere in the world. This does not guarantee that emerging markets are genuinely cheap, however as the present value of emerging market earnings streams depends crucially on what interest rate is used to discount those earnings. For example, how much would the earnings of a retailer in Zimbabwe or Iraq currently be worth to a foreign investor? The answer is very little, as the risk premium attached to those earnings is extremely high.
In practice, no one invests in the two countries mentioned. But using a simple two-period dividend discount model, the current emerging market average P/E multiple of 12 times this year's earnings is only really fair value if a sovereign risk premium of 2% is added to risk free rate and an equity risk premium of 4% is applied.
Emerging markets are therefore only cheap if they are becoming better run in terms of fiscal sustainability and corporate governance. Fortunately, the news here is good, as successive currency crises have focused the minds of emerging economy policy-makers on just these issues.
Improvements are happening across most investible countries. Russia is a good example, where Vladimir Putin appears to be making a genuine effort to put government consumption on a sustainable footing and also to tackle the worst abuses of minority shareholder rights.
The third argument in favour of the asset class is compelling and boils down to the notion that structural reform is happening.
Finally, it is becoming increasingly apparent that a world of low inflation offers lower equity returns because of pedestrian nominal economic growth.
Against this background, investing in emerging markets makes sense because the asset class does offer access to the superior growth that is fundamentally driven by young and growing populations.
Structural reform is happening.
Growth driven by young populations.
Corporate governance improving.
Markets cheap only if premium acceptable.
Cost of capital higher in emerging markets.
Uncertainty of Middle East situation.
Joined as head of strategy, multi asset, in June
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