Fund Spotlight: Emerging Markets

October 24, 2017

Renewed dynamism seen in some of the world’s fastest-growing countries

Emerging markets have set the pace for global equity markets in 2017. In the nine months ending September 30, the MSCI Emerging Markets Index gained 19.1%, in Canadian dollars. While emerging market equities attract investors because of their higher growth potential when compared with developed markets, it is important to understand why.

Volatility and enhanced return potential are defining features

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Source: MSCI

Emerging markets are generally considered a riskier area of the equity investment universe. But this elevated risk also comes with the potential for higher returns over the long term. Our Fund Spotlight this quarter examines our emerging market investment options. Although the emerging market asset class accounts for a relatively small proportion of our overall investment strategy, it is an important component because it contributes a diversified source of additional return to our portfolios. MD clients have exposure to emerging market investments through:

  • The MDPIM Emerging Markets Equity Pool, which invests primarily in emerging market equities and provides a strategic allocation to the asset class. We manage the pool with the assistance of Boston-based Grantham, Mayo, Van Otterloo & Co. LLC (GMO) and Paris-based Comgest Asset Management International. Montreal-based CIBC Global Asset Management advises on the currency positioning of the pool.
  • The MDPIM International Equity Pool, MD International Value Fund, MD International Growth Fund and MD Growth Fund, which invest primarily in developed-market equities; however, when the right opportunity arises, we consider investing in emerging-markets.

The emerging market equity strategies of GMO and Comgest complement each other and are an example of how we combine different manager skill sets to create the overall performance profile we desire for a specific fund.

High growth rates could bode well for the future

As developed economies wrestle with sluggish growth, emerging economies continue to live up to their reputations for delivering more robust economic growth. Emerging-market and developing economies now account for close to 80% of global economic growth, almost double their share from two decades ago, according to the International Monetary Fund (IMF). The IMF also notes that emerging markets account for close to 85% of the growth in global consumption, more than double their share in the 1990s.

The IMF World Economic Outlook Update forecasts growth of 4.6% for emerging-market and developing economies in 2017. This growth tends to be cyclical and investors should be prepared for the volatility that this entails. Meanwhile, advanced economies are expected to average just 2% growth.

Growth prospects in emerging markets are even more impressive when you break them down by country. The two most populous countries in the world, China and India, are forging ahead with expected GDP growth of 6.6% and 7.2%, respectively, forecast by the IMF in 2017. Core inflation has also remained largely stable in emerging economies as well, with some, such as Brazil and Russia, even showing big drops in inflation. Solid growth and low inflation are a recipe for sustained economic expansion.

The IMF says commodity importers like China and India have driven growth. But, more importantly, stronger growth reflects gradually improving conditions in large commodity exporters, like Russia, Nigeria and Venezuela, that suffered recessions in 2015–2016, which in many cases were caused or worsened by falling prices for key commodities like oil.

FundSpotlight

Innovation is becoming a major emerging-market growth driver

It might surprise many investors that technology has become the biggest sector in the benchmark MSCI Emerging Markets Index. The 2017 MIT Technology Review of the 50 smartest companies includes 13 from emerging markets, with China taking seven spots. Technology’s weighting in emerging-markets is also larger than in the U.S. as a percentage of market capitalization. In China, about 50% of the index is technology, up from just 5% 15 years ago.

Many Chinese tech companies are getting close to becoming household names outside China. Some of these more familiar names include e-commerce giant Alibaba Group Holding Ltd. and internet search firm Baidu Inc. But there are many more companies, especially in areas linked to online shopping, smartphones, online gaming and mobile payments.

Complementary investment strategies: Comgest and GMO

Our international and emerging-market investments are managed by our investment team in Ottawa, led by Mark Fairbairn, Senior Investment Analyst. We complement our expertise with external advisors such as Comgest and GMO for our dedicated MDPIM Emerging Markets Equity Pool, which is available exclusively to MD Private Investment Counsel clients.

Comgest applies strict quality criteria

The managers at Comgest believe that, over the long-term, superior returns are generated by the stock price appreciation of companies that can sustain above-average earnings growth for an extended period of time. To find these companies, Comgest applies strict quality criteria, which include earnings visibility, exceptional business franchises, low cyclicality, high returns on equity, sustainable profit margins and self-financing capabilities. Comgest’s disciplined process seeks to identify companies that can achieve above-average returns at below-average levels of risk over the long-term.

Five growth trends

Comgest is accessing five growth trends in emerging-markets through investments in good quality growing companies:

  • market share gainers
  • market leaders
  • growth of the middle class
  • large-scale infrastructure build-out
  • innovators

Comgest portfolio manager Charles Biderman points to Localiza, a Brazilian car rental company that fits three of our five growth trends. “It is gaining market share, it’s a market leader and it’s benefiting from the growth of the middle class,” Biderman says. “We see continued strong growth for Localiza.” The company has grown in part by consolidating its market share by purchasing smaller competitors. Its success hasn’t gone unnoticed. On August 31, Hertz formally entered into a long term strategic partnership agreement with Localiza.

“Power Grid of India is another interesting name. It’s an example of the large-scale infrastructure build-out that we are seeing across so many emerging markets. Power Grid of India faces little competition from the private sector because of government support it gets for obtaining land,” Biderman said.

It operates the largest transmission network in India, carrying 55% of the power generated and 90% of inter-regional transmissions. Its returns are guaranteed by contracts and demand is surging as India’s economy continues to expand.

Another of Comgest’s favored industries is insurance. It holds companies such as the Hong Kong-listed China Life Insurance and Brazil’s BB Seguridade. As the middle class grows across emerging markets, it will continue to push demand for financial services like insurance.

GMO takes a top-down approach

GMO uses top-down quantitative analysis and bottom-up fundamental analysis to identify undervalued companies that will produce superior long term results primarily within the emerging markets equity universe. GMO will invest across the market capitalization spectrum and may invest in developed-market companies with a substantial percentage of revenues that depend on the emerging-market economies. In contrast to Comgest’s quality-growth approach, GMO offers a more contrarian valuation-based process, which tends to focus on out-of-favour countries and sectors where the market has become overly pessimistic, thereby deeply discounting those areas of the market.

“One of the dominant themes driving GMO’s approach is rising domestic demand. Rising incomes and favourable demographics are creating a sweet spot for companies focused on meeting this demand,” says Binu George, a portfolio strategist for GMO based in San Francisco. George and his team are finding good opportunities in Taiwanese IT, Korean consumer discretionary and financial stocks, and Chinese telecom providers. 

“Investors have potentially much to gain if they ignore the noise of short-term volatility in emerging markets and focus instead on the secular forces driving domestic demand,” George says.

Emerging-markets outlook: More dynamism ahead

Emerging markets are likely to remain the most dynamic part of the global economy, but they come with greater volatility. Following a five- to six-year down cycle, the environment appears to be stabilizing, while company sales and earnings should recover from a low base. Companies that adjusted to tough times are now beginning to perform better than expected. This suggests that even if there is just a modest pickup in revenue, the impact on earnings could be significant. Earnings growth in emerging markets could also continue to exceed that of developed markets in the coming years.

The key for investors will be to find the right investment managers to unearth these opportunities. The MD emerging-market mandate encompasses a broad range of opportunities with a distinct set of attributes and therefore risks. Not all emerging markets are created equal. Companies in China are different from India or Mexico, for instance.

The ability of portfolio managers to understand the nuances of those markets and to manage a fund to address that is particularly important in emerging markets. This is why MD Financial Management has created an effective approach to managing our emerging-market mandates exclusively for MD clients. 

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