Almost all family office investors include “emerging markets” as an important part of their portfolios. These economies, such as China and India, are growing more rapidly than those in developed nations. This in part is due to strong demographics and the opportunity to drive productivity growth by embracing existing technologies. Given high underlying economic growth, emerging market companies can provide long-term stock investors with the potential for attractive returns. Similarly, bond investors can benefit from generally higher interest rates than in developed markets. Sophisticated family offices also tend to focus on the emerging economies of Asia in particular.
The largest constituents of Asian emerging economies include China, South Korea, Taiwan and India. These countries make up for more than 80% of the MSCI Emerging Markets Asia index, with a third of the index weight residing with China. The Asian emerging economies have a total population of 5.5 billion, more than 44% of the total global population. These countries are among the most vibrant and dynamic economies in the world, with many of them exhibiting stable growth rates and contributing significantly to global social and economic headway.
Asian economies outside of Japan generated 56% of global growth between 2007 and 2017 and economists expect this extraordinary growth to continue. In India, the current urbanization rate is 31%, versus 91% in the United States. In China, under the National New Urbanization Plan, the percentage of the population living in urban areas is targeted to increase to 60% in 2020, from 57% in 2016. This means 41 million people in China will be moving from rural areas to urban centers. This phenomenon provides substantial investment opportunities, as urban residents typically earn significantly higher wages and have very different consumption patterns.
In addition to compelling demographics, emerging Asia is inexpensive compared to the broader stock market. A composite valuation of emerging Asian companies - which combines metrics including price to sales, price to cash flow, price to book, price to earnings and dividend yield - shows that emerging Asian stocks are cheaper than the global market based on historical averages. This relationship tends to be mean-reverting over time.
The historical performance of emerging Asia has been persistently higher than that of emerging markets in general. The annualized return as of 7/30/2018 for the past 10 years of the MSCI Emerging Asia Index was 6.23%, compared to only 3.51% for the MSCI Emerging Markets Index. Although this region accounts for 35% of global GDP, it is currently only 12% of the global stock market. Over time, the market capitalization of emerging Asian companies should grow to match the economic importance of the region. Year to date MSCI Emerging Asia performed -4.95% as compared to MSCI Emerging Market -6.48% which may represent buying opportunities.
The wrong ways to invest in Emerging Markets
One widespread piece of bad advice is that you should buy ETFs (exchange traded funds) or index tracker mutual funds which focus on this part of the world. These assets are easily-tradable and the two simplest ways to invest in developing countries. There’s several reasons why you should stay away from these funds. Perhaps most important is that they don’t actually invest in emerging economies. Lots of emerging market mutual funds and ETFs don’t even live up to their name and are blatantly misclassified. They consist largely of stocks in developed nations. The largest such ETF in the world, iShares MSCI Emerging Markets has over 30% of its holdings in developed economies. Two out of the three top countries they invest in are South Korea and Taiwan.
China also takes up more than 30% of this ETF’s holdings. There’s now over $25 billiondollars in this fund even though it mostly invests in China and developed nations.
Emerging market index funds and ETFs are convenient. They’re the most common ways people invest in this part of the world. However, you should probably stay away from them.
Pick the right stocks
Buying equities is certainly a great way to invest in emerging markets if done correctly. Places like India, Vietnam and the Philippines have tons of undervalued small-cap stocks which barely see analyst coverage.
To achieve attractive returns investors should focus on domestic structural growth stories. This is where certain funds see the best opportunities, given the inherent growth in many Asian countries from demographics & rising urbanisation.
This domestic focus means two things:
Portfolio would be less sensitive to global growth. Asset allocation will not include stocks like Samsung, Hyundai, Tencent etc. Thus, portfolio is fundamentally much less sensitive to US Fed rate hikes, a weaker USD, increasing trade tension from the US.
Secondly, this relatively uncorrelated growth story is in stark difference to an ETF or to most peers. The outlook for India or Vietnam is much less linked to the US than China, Korea or Taiwan. In a world of increasingly correlated assets, the lesser degree of correlation is attractive.
Governance is also important factor when looking at companies in Emerging Asia. This means that poorly managed companies should be avoided. In Frontier countries, many regulatory and governmental institutions are in their early stages of development so there is a greater onus on management teams to set behaviour standards and maintain oversight.
One of examples of great internal governance can be noticed in Vietcombank where management has a positive attitude towards disclosure and protection of minority shareholders. A focus on corporate governance and minority shareholders is representative of a more efficient business, able to adapt more successfully to economic, environmental and technological changes.
Author: Sergey Yakovenko
You can contact me directly at sergey@ippfa.com to discuss further.