EM stocks to regain lustre

EMERGING-MARKET (EM) equities, which have been unimpressive in recent years, will start to outperform over the next several quarters on the back of economic 'green shoots' in China, says Gabriel Wallach of BNP Paribas. Find out which growth stocks he is betting on.

Investors of global emerging-market equities haven't had the best of times in recent years. Plagued by endless worries of an acute economic slowdown in China as well as uncertainties in the global economy, developing-market stocks have turned in uncharacteristically dreary gains since their big rebound in 2009.

This group of stocks — as measured by the MSCI Emerging Market Index — delivered red-hot returns of more than 35% a year from 2003 to 2007. That winning streak ended in 2008, when they slumped more than 50% on the back of the global credit crisis. They rebounded strongly in 2009, surging nearly 80%, but have been "a big disappointment" since then, laments Gabriel Wallach, chief investment officer of global emerging-market equities at fund house BNP Paribas Investment Partners.

"The performance of emerging-market equities hasn't been great over the past three years, up around 5% a year. We had seen an initial bounce in 2009, but since then, gains have flattened quite a bit," says the Boston-based CIO in an interview with Personal Wealth when he was in town recently. Since hitting a peak in October 2007, emerging-market equities have lost an average of 26% of their value.

This year, these seemingly higher-risk stocks, which have felt the brunt of several sharp market sell-offs over the past 18 months because of the European debt crisis, have also underperformed their developed-market peers as the risk appetite of global investors remains subdued. "They underperformed developed markets partially due to the underperformance of China," observes Wallach. "We can't hide from that. China is large in the [emerging-market equity] benchmark and it has a big impact on commodities, which are also a big part of the benchmark as well."

Indeed, the developed-market benchmark stock indices such as the MSCI World Index and the Standard & Poor's 500 Index climbed 9.67% and 12.27% respectively in US dollar terms this year as at Oct 29. In contrast, the MSCI Emerging Market Index was up just 8% on a year-to-date basis.

Nevertheless, with economic "green shoots" appearing in China, the underperformance of emerging-market stocks could be a thing of the past, says Wallach, who manages around US$2 billion in emerging market assets and has more than 20 years of investment experience. The sanguine CIO is confident that emerging-market stocks "have turned a corner" and expects better returns over the next 12 months as China's economy rebounds from its low in 3Q2012.

"If we see a bit of rebound [in China], particularly post the [Nov 8] political transition, I think you will see a better environment for emerging-market equities in absolute terms as well as relative to developed equities. If China's economy improves, you will see a rotation [of funds] into emerging-market equities," he predicts. He foresees funds flowing from defensive sectors such as consumer staples and utilities into commodity sectors such as materials and energy.

Betting on a China rebound

China's economy grew just 7.4% in the July-to-September period from a year ago, marking the seventh consecutive quarter of slowing growth. Even so, many economists and market observers are seeing signs of it having bottomed out.

Chinese economic indicators for September and October showed that economic growth had accelerated faster than what most observers had anticipated. China's National Bureau of Statistics reported that official Purchasing Managers' Index (PMI) for October increased to 50.2 from 49.8 in September. PMI of above 50 shows a growth in manufacturing activities. "The latest data shows a fading drag from net exports, a pick-up in investment from both infrastructure and housing and resilient private consumption, all of which could drive recovery," says Ryan Tsai, senior investment strategist of Greater China at private bank Coutts, in a recent report. Tsai says the two-year slide in the Chinese economy seems to have ended and the market's focus is now shifting to the sustainability of its economic recovery. "We expect China's full-year GDP growth to recover to between 7.8% and 8.1% in 2013, up slightly from our estimate of 7.6% for 2012."

Bank of America Merrill Lynch's China economist Ting Lu is equally optimistic about the world's second-largest economy. In a recent report, Lu notes that 3Q2012 GDP numbers mark a "growth trough" for the populous nation. The economist, who also sees a trough in China steel prices, points out that "Chinese green shoots" are appearing — he cites the rebound in the Baltic Capesize Index, which tracks freight rates for ships carrying dry commodities such as iron ore and coal in the Baltic region. A trough in China steel prices is usually followed by an average 17% rebound in Chinese equities over the following three months, Lu notes.

For their part, Wallach and his team are seeing evidence of a pickup in Chinese exports on the back of an improvement in the US economy. "We are seeing, in recent times, a stabilisation in China and possibly an economic pickup in 4Q2012. It isn't a major pickup, but it will be enough to change the minds of some of the sceptics," he says.

With economic growth in China stabilising, Wallach is certain that emerging-market equities as a whole will start to outperform in the current quarter and that 2013 could be a double-digit year for the stocks. "I think people will start to buy emerging-market stocks [in expectation of] strong double-digit returns, which they have not gotten in recent years," says Wallach, adding that annual gains of 9% to 11% for the equity asset class going forward "will be good".

Growth style

The CIO, who manages the BNP Paribas L1 Equity World Emerging Fund, will be looking to beat those average market returns with his active bets on markets, sectors and individual stocks. The growth-focused fund, which underperformed its peers in recent years, was up 8.78% this year in US dollar terms as at Oct 25. "Our five-year track record was weighed down by 2008. We underperformed post the Lehman crisis in 4Q2008. Since then, we have been doing much better. We are slightly ahead for one and three years, which puts us in the top third of the Lipper universe," he says.

Emerging-market equities are "a growth asset class", says Wallach. And when the market is up, investors in these stocks should pursue a growth style to fully benefit from it, adds the CIO, who adopts a growth-oriented, bottom-up investment approach that focuses on growth stocks.

Among the emerging-market equities Wallach is most bullish on now are those of China, South Korea and Brazil — all of these offer growth at a reasonable price, he says. "We are growth investors, but on a valuation measure, China stocks have never been this inexpensive. It is a very cheap market," observes Wallach. He points out that Chinese banking and financial stocks are trading at basement a price-to-earnings ratio (PER) of just five times on average.

Many listed companies in Southeast Asia are trading at twice the valuation of their peers in China, Wallach highlights. "We have very, very distressed multiples for a lot of the Chinese companies. So you will get some price-to-earnings multiple expansion ahead of the evidence that China is recovering in 2013. There will be rotation [of funds] back into China."

Stock bets

At the moment, more than 15% of the BNP Paribas fund's assets are invested in China stocks such as computer maker Lenovo Group, car manufacturer Brilliance China Automotive Holdings as well as banks like China Merchants Bank and ICBC.

"In China, we like Lenovo and Brilliance China Automotive. Lenovo is now the largest PC manufacturer in the world, and despite the move to tablets, it is doubling its margins and has taken a huge amount of share from Hewlett-Packard and Dell. It is also moving to tablets, handsets and servers. It has become a very interesting company in the tech sector," says Wallach.

Brilliance China Automotive, which operates a car-making joint venture with Germany's BMW, is benefiting from the high demand for luxury cars in China, he observes. "I was just in China and [observed that] auto sales are picking up, especially luxury auto sales, which are growing faster than the average." Wallach adds that the company is manufacturing cars in record volumes and will hit record sales for BMW.

The fund manager is also positive on South Korean companies such as electronic gadget maker Samsung Electronics, auto manufacturer Hyundai Motors and ship maker Samsung Heavy Industries, all of which are benefiting from "strong secular trends" in the respective industries.

"Samsung Electronics is our largest active [bet]. It is growing because of its handset and smartphone business, which is experiencing expanding margins. It is the No 1 manufacturer of Android handsets. Hyundai Motors has the best operating margins in the industry, it has a growing market share versus the Japanese manufacturers in North America and emerging markets," Wallach says. Samsung Heavy Industries, meanwhile, is growing its offshore business, building deepwater rigs for the oil industry, he says. "It has strong demand from Europe as well as Brazil. It is No 1 in that space and is now less dependent on container ship [manufacturing]."

South Korea's GDP grew 1.6% in the three months through September from a year earlier, the slowest in three years. However, the slow economic growth has been factored into South Korea's stock prices, which are generally inexpensive, says Wallach, whose fund has around 21% of its assets invested in the country's stocks. "Our overweight in South Korea has to do with our view on Korean companies. Korea in general is very inexpensive and these three stocks are cheap, despite their leading industry profitability."

Another of Wallach's favourite emerging markets is Brazil, whose stock market — as measured by the Bovespa Index — has underperformed this year, turning in gains of less than 1%. But if China's economy turns for the better, the commodity-heavy Brazilian market will get a big lift, he explains.

"Brazil is one of our favourite markets for two reasons. First, you have the export sector, namely commodities, which have done poorly because of China. Those stocks will start to look more attractive especially when China rebounds. Second, you have the domestic sector such as [finance and consumer], which are responding very well to Brazil's aggressive interest rates over the past six months. Very strong cuts in interest rates have been positive for commercial property stocks and retail counters," says Wallach.

To boost economic growth, Brazil's central bank slashed its target lending rate for a 10th straight time on Oct 10, bringing it down from 12.5% in August 2011 to 7.25% currently. "This summer, the consensus was that Brazil wasn't going to cut rates as aggressively, and some observers thought it was going to raise rates. But they kept cutting rates. I am not sure how far [the cuts] can go politically. But inflation in Brazil is running at 4% to 5%, so real rates are still positive at around 2% to 3%. They still have a lot of room to cut to bring real rates to zero, which they would like to," says Wallach. He reckons the central bank can still afford a 100-basis-point rate cut to 6.25%.

His favourite Brazil stocks are banking counter Itau Unibanco, women's apparel maker Le Lis Blanc and shopping mall operator BR Malls. Itau Unibanco is undergoing a "short-term negative period" as interest rates in Brazil decline — Wallach explains that as interest rates decline, banks' interest margins usually fall. However, Itau's loan growth is picking up, he observes. "Earnings are hurt but the outlook over the next 12 to 24 months is very positive. Inevitably, lower interest rates in Brazil are positive for loan growth and asset quality."

Companies such as Le Lis Blanc and BR Malls are also benefiting from the country's lower interest rates. Le Lis Blanc, a fast-growing company with US$750 million in market cap, focuses on the mid- to high-end of Brazil's fashion apparel industry. Wallach says the company has a loyal consumer base. "Le Lis Blanc has doubled its store base this year and will triple it over two years." BR Malls, which is the biggest integrated company shopping mall company in Latin America, is also experiencing robust organic growth. "Vacancy rates remain extremely low and there is huge demand for office and retail space," he says.

Wallach also likes stocks in the frontier markets such as Panama-based airline Copa Airlines, Qatar banking group QNB and South Africa-based gold miner Randgold Resources. He says frontier stocks are invested in for their growth profile. "We buy them not so much as diversifiers, but because they are more attractive compared with the benchmark. We look for growth stocks and they can be anywhere in the benchmark or out of the benchmark." For instance, Nasdaq-listed Randgold offers a better growth profile than other gold-mining stocks in South Africa, he says. "That's why we own it. It offers the growth we are looking for."

US fiscal cliff

Although Wallach is confident that emerging-market equities will outperform over the next 12 months, he concedes that if the "US fiscal cliff" materialises early next year, plunging the US into recession, then all bets are off.

The "US fiscal cliff" refers to the US$600 billion of automatic across-the-board spending cuts and tax rises set to take effect on Jan 2 should the Democrats and Republicans fail to agree on a long-term deficit reduction plan for the US. This hefty fiscal reduction austerity plan is equal to more than 4% of the US GDP and if implemented, could push the world's biggest economy into recession, according to economists.

"I think the US cannot run deficits of this nature, but on the other hand, it would be very drastic to just increase taxes [early next] year when its economy cannot withstand that degree of increases," says Wallach. To be sure, any further significant economic slowdown in developed markets will have a negative impact on emerging markets, he admits. "We are all part of the global economy, so any problems in Europe and the US will affect the emerging markets."

But Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch, reckons that over the next several weeks, increased concerns about the fiscal cliff will cause fund rotation out of US equities to Asia and emerging markets, particularly to China's cheap stock market. Policy stability and the lower probability of a hard landing in China could result in fund flows into Chinese equities, he says in a recent report.

"Investors are nervous but not apocalyptic about the US fiscal cliff. In recent years, we've seen a stealth bull market in equities despite a number of great risks, including a perceived muni crisis, the US debt ceiling debacle, the European sovereign debt crisis, and fears of a China hard landing. The fiscal cliff could turn out to be the last of the great risks that the equity market overcomes. But at some point, the equity market may need to play the role of a 'vigilante' [via a sharp sell-off] in order to force politicians to quickly form a smart and credible US fiscal stance. But right now, we believe the cliff is causing rotation within equities, specifically from US equities to Asia, rather than reduced allocation to global equities."

For his part, Wallach remains hopeful that the US will avert the fiscal cliff. He admits, however, that its fate is likely to be determined by the Nov 6 US presidential election. "If [Mitt] Romney wins, you will likely see a postponement of those automatic tax increases and probably more aggressive negotiation with Congress on how to avoid a fiscal cliff. [President Barack] Obama has suggested that if he wins, he will let the tax cuts expire, which will have a negative impact on US growth and be bad for emerging markets. So it is really a binary outcome," says Wallach.

Reasons to buy

However, Wallach says any sensible long-term investor in emerging-market equities should buy if a sharp short-term market sell-off occurs because of the US fiscal cliff. As he sees it, emerging-market stocks remain among the few asset classes in the marketplace that are still reasonably priced. "You do see bubbles in fixed income, such as in high-yield corporate debt as well as sovereign, which are all trading at very, very low yields. Emerging-market equities are trading at around 10 times PER and there is no overvaluation in any sector other than consumption staples."

Despite the recent QE3 and bond-buying measures by global central banks, Wallach says funds flowing into emerging-market equities are insignificant compared with the heavy inflow into bonds such as emerging-market debt and high yields. "I am still waiting for the flows to come," he quips.

The lack of hot money flowing into emerging-market equities, cheap valuations and the bottoming out of the Chinese economy are all good reason to take exposure to developing-market stocks now, he adds. "You could argue that these are good reasons to buy into emerging-market equities because we have not seen a major rally. They have been disappointing for three years. With economic stabilisation in China and possibly a pickup in 4Q2012, I believe people will start buying emerging-market equities for strong double-digit returns."

This story first appeared in

The Edge Singapore weekly edition of Nov 5-11, 2012.


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