MONDAY, APRIL 5, 2010
Taming the Tigers
By CHRISTOPHER C. WILLIAMS
Emerging markets could suffer setbacks in coming months. But opportunities remain in Brazil, Taiwan, South Korea and Turkey.
THE GOLD RUSH IS OVER IN emerging markets, which have more than doubled from their March 2009 lows. Gains are likely to be much more muted in the next 12 to 18 months, at 15% to 20%, and bargain hunters will need to dig a lot deeper to find those countries and companies with the best fundamentals and cheapest valuations. Although the long-term trends driving emerging markets, including sturdier economic growth, sounder fiscal policies, lighter debt loads and a rising middle class, remain firmly intact, selectivity is the key to investment outperformance in 2010 and '11.
Among the world's major emerging markets, South Korea, Taiwan, Turkey and Russia still are selling at compelling valuations of roughly eight to 15 times this year's estimated earnings and have significant upside potential. Brazilian stocks are at all-time highs, but Latin America's biggest country is an economic dynamo whose ascent in the global economic pecking order could keep equity prices climbing, especially if the country elects another market-friendly president when voters go to the polls in October.
Markets in China, India and Mexico, on the other hand, are flashing warning signals and look ripe for a correction. While gross domestic product is expected to grow smartly in these countries in 2010, investors face the prospect of rising interest rates, and in China, a real-estate market that looks dangerously overheated. Moreover, all three markets are trading at premiums to other emerging markets, not to mention developed markets.
"The easy money has been made" in emerging-market investing, says Tom Leventhorpe, vice president of global emerging markets at J.P. Morgan Asset Management. "Now it comes down to earnings growth, and finding businesses that will be able to grow at a better-than-average rate."
Emerging-market experts say the best opportunities lie in telecommunications companies such as China Mobile (ticker: CHL), the world's No. 1 mobile-phone operator, banks, retailers and consumer plays. Some also like the prospects for Brazilian sugar and ethanol producer Cosan (CZZ).
SPURRED BY LOW INTEREST rates, government stimulus, higher commodity prices and stronger currencies -- as well as $83.3 billion of investment flows -- emerging-market equities registered their biggest yearly gains ever in 2009. The MSCI Emerging Markets Index of 22 countries soared 75% in dollar-adjusted terms, led by Brazil and Russia, easily outpacing advances of 27% in the MSCI World Index, representing developed markets, and 23% in the Standard & Poor's 500.
Emerging-market bonds also joined the party, rising 28% as measured by the JPMorgan EMBI-Plus Index. Bond prices benefited from credit upgrades in some markets, including Brazil, and sounder government policies.
This year, however, interest-rate fears and stretched valuations have put a lid on these rallies, leading some emerging-market experts to declare that a setback already is under way. The emerging-markets index, along with the popular iShares MSCI Emerging Markets exchange-traded fund (EEM) and other ETFs that track it, fell about 14% from mid-January through early February, and is up 4% year to date, while the S&P is up 6%. "If you're coming in now, make sure you dollar-cost average, and be ready for corrections," says Mark Mobius, executive chairman of Templeton Asset Management and a well-regarded veteran of emerging-market investing. Mobius expects emerging markets to post gains "in the teens or double digits in 2010, even with corrections along the way."
Any meaningful correction in emerging markets could begin in the year's first half, before investors start focusing on next year's anticipated profit growth. As Audrey Kaplan, co-head of international equities at mutual-fund giant Federated Investors, notes, country allocation accounts for 70% to 80% of the difference in investment returns. That is apt to prove especially true this year, as the terrain gets trickier for emerging-market investors.
ASIA
Asia, excluding Japan, is the speed-demon of emerging markets. Deutsche Bank estimates average GDP growth in the region's emerging economies could top 8% this year, double the growth rate expected in Latin America and the U.S.
After rising 70% last year, the MSCI Emerging Markets Asia index of eight countries is up about 3% in 2010. China is about flat. The Chinese government is trying to boost consumer spending, which will power long-term growth, but clouds are forming that could darken the near-term outlook. In a report cited last week in Barron's Up & Down Wall Street column, Boston money manager GMO said China "today exhibits many of the characteristics of great speculative manias," including rapid credit growth and a possible bubble in property prices. Fears that China will rein in government spending are rippling through Brazil and other commodity-rich markets, which depend on growing demand from China to help power their economies.
China is one of Asia's pricier stock markets, selling at 3.3 times book value, according to Bloomberg. For the quarter ended March 31, China-oriented equity funds recorded net outflows of $1.2 billion, reports fund-flow tracker EPFR Global. India funds, in contrast, brought in a relatively modest $236 million. The Indian market is up 102% in the past year and sells for 3.5 times book. It could be vulnerable, however, especially as the central bank unexpectedly raised interest rates in mid-March to curb inflation.
Kaplan of Federated is a big China fan; Chinese stocks account for about 12% of the $754 million Federated InterContinental Fund (RIMAX), which she co-manages. While she thinks corporate earnings will exceed expectations in China this year, markets in South Korea and Taiwan are cheaper and may be better ways to play China's growth. Both could move to developed-market status in MSCI's rankings as early as this year, which could lead to more investment flows.
Korea currently sells for less than book value. Kaplan thinks Korean equities could return 20% this year, on 25%-plus growth in earnings. She is particularly bullish on Samsung Electronics, which accounts for 14% of Korea's 766-company Kospi index. Samsung recently surpassed Hewlett-Packard (HPQ) as the world's largest technology concern, with $117 billion in annual sales, and its stock, which trades for 10 times expected earnings, is a compelling play on a global economic recovery. After doubling from a low last March, Samsung is up 11% this year. Kaplan's co-manager, Geoffrey Pazzanese, thinks the shares could rise 15% to 20% in the next year.
Investors leery of China's outlook could find bargains in PetroChina and China Mobile. PetroChina's American depositary receipts slid to 119 from a high of 136 in October, in part because of lower oil prices. Standard & Poor's thinks the stock could rebound to around 150 if oil prices and domestic demand for natural gas rise. The ADRs are selling for 10.4 times expected earnings, below the industry average.
China Mobile sports a P/E of 12.5. Its ADRs have risen 12% in the past year amid concerns that competition will erode the company's dominance in 3G telecom service. But Jerry Zhang, manager of Evergreen Emerging Markets Growth Fund (EMGAX), praises the company's "stranglehold" on about two-thirds of its subscriber base, and recently added to his shares.
LATIN AMERICA
Like temperatures in the region, some Latin American stock markets look to be overheated. Mexico's benchmark Bolsa is close to an all-time high, and its price/book and price/earnings valuations are above emerging-market averages of two times and 20 times, respectively, based on MSCI figures.
While GDP forecasts are being revised upward for Mexico, any hiccup in America's economic recovery could cause severe indigestion south of the border. That said, investors see bargains in stocks such as Grupo Televisa (TV), the Spanish world's biggest media outfit, and America Movil (AMX), Latin America's largest mobile-phone operator. Televisa reported a sharp drop in fourth-quarter results, due mainly to foreign-exchange losses, but the company boasts strong programming and a healthy balance sheet, and is moving aggressively to build out its franchise through deals. Zhang of Evergreen sees almost 20% upside in the ADRs, which closed Thursday at 21.12.
As for America Movil, the subject of a recent Barron's feature ("A Calling Plan South of the Border," Dec. 7, 2009), its ADRs have soared 83% in the past year but still sell at a 30% to 40% discount to the Mexican market. Federated's Kaplan and Pazzanese, who primarily buy local shares of foreign companies, see earnings climbing 19% this year.
Brazil's 63-stock Bovespa index is up 119% in the past year and trades for 2.2 times book. That gives some investors pause, not least because Brazil could see reduced demand for iron ore and soybeans if China cuts spending. Investors also worry about a higher-than-expected rise in interest rates, and the possibility that Brazilian voters will elect a new president in October with less market-friendly policies than outgoing President Luiz Inacio Lula da Silva.
Still, there is much to like about Brazil, which is benefiting from a rapidly growing consumer class. Even after last year's run, stocks trade for 14 times estimated earnings, while analysts see corporate profits rising 30% this year. One intriguing Brazilian small-cap is Cosan, the sugar-cane producer. Its ADRs have rallied to 9.27 from 2.48 last April, and Citigroup has a price target of 14.
EMERGING EUROPE, MIDDLE EAST AND AFRICA
Until fairly recently, emerging markets, for many investors, meant the BRICs, a term coined by Goldman Sachs to refer to Brazil, Russia, India and China.
But smaller markets are stealing some of the spotlight, driven by sounder economies and investors' rising appetite for risk.
Eastern Europe, Africa and the Middle East are home to some of the fastest-growing and cheapest stock markets, though hardly the safest. Mobius of Templeton considers frontier markets such as Nigeria, Kenya and Romania attractive, while Citigroup recently advised investors to increase their exposure to Egypt, given a sharp drop in the benchmark EGX 30 index in the past month amid concerns about the health of Egyptian President Hosni Mubarak.
Hungary's stock market has soared 179% in the past year, according to MSCI, but sells for less than two times book value, as does Poland's market. Still, the biggest and most liquid markets in Europe and Africa draw the bulk of investors' attention, and will continue to do so for awhile.
Investors have been flocking to the Russian market despite concerns about corporate governance, political uncertainty and the economy's reliance on oil. Russia's RTS index rose 129% last year, the best performance among major emerging markets, and could be a top performer again in 2010 if oil prices keep rising and the dollar stays stable, as expected. One stock poised to run is Moscow-based Mobile TeleSystems (MBT), the country's biggest mobile operator, which could benefit from growing consumer spending. The ADRs, which yield 6%, are up 17% this year, to 57, and could reach 60 in a year. Barron's highlighted the company's' prospects last month ("Russian Telecom Dials Up the Growth," March 8).
Turkey also is winning more fans; its stock market more than doubled last year and is at a three-year high, but sells for only 10.6 times this year's expected profits. So far, investors have largely shrugged off a constitutional conflict pitting the government against opposition parties. The Turkish economy is expected to grow 4% in 2010, after a 6% drop in '09.
TURKIYE GARANTI BANKASI (GARAN.Turkey) was a recent purchase of the JPMorgan Emerging Markets Equity Fund (JFAMX). Leventhorpe of JPMorgan likes the bank's earnings recovery, high return on equity and consumer focus. Garanti also has drawn interest from Russia's state-run Sberbank (SBER.Russia), which reportedly is planning to bid for the 21% stake in Garanti that General Electric (GE) is selling.
Citigroup recently downgraded its Turkey weighting in favor of South Africa, although stocks in Africa's biggest, most liquid market aren't a screaming buy, either. The Johannesburg All-Share Index rallied almost 70% last year, and now trades for 19 times earnings. Shares of Sasol (SSL), the energy and chemicals concern, are a bargain at 12 times earnings, even after rising 32% last year. The stock could keep climbing as oil prices rise.
Israel's market, too, was a big winner in 2009, up 51%, and it has risen another 10% this year. Stocks look rich at 21 times earnings, but they could attract more fans when Israel joins MSCI's developed-market indexes, a move scheduled for May 27.
ETFs such as iShares MSCI Emerging Markets and Vanguard Emerging Markets Stock (VWO), and mutual funds like Oppenheimer Developing Markets (ODMAX) and Goldman Sachs BRIC Fund (GBRAX), are a good way for most retail investors to participate in emerging markets, while country funds (including those listed in the table, Emerging Markets: An Overview) make it easy to choose among markets.
Emerging markets could suffer reversals in coming months, but the long-term outlook for these markets is robust. They are exiting the global recession on stronger footing than developed markets, especially countries like Greece and Spain, and investments from institutions such as pension funds are on the upswing. If the global economy continues to recover, emerging-market stocks and bonds eventually will be top performers again. Just tread carefully until then.
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