Value Idea: Emerging Markets

I was working on this post all of last week but Barron's today has published a similar idea you can find it here: "Emerging Markets are cheap and they're the future". It is nice to get a verification of the idea.

Emerging markets (EM) equities and debt look very appealing, debt in particular. Emerging markets index has declined more than 33% this year, while EM debt spread have soared to 300 basis points over treasuries, its spread was 170 BPS in 2007.

Investors over the past few months have scaled down their holdings in emerging market equities and debt considerably. Capital flight from these markets was due to the credit issues faced by the developed world. Investors feared that credit issues will spread eventually to the Emerging Markets. EM funds have seen an outflow of $26 billion, compared with an inflow of $100 billion in the previous five years (source: Financial times, Economist).

I think the changed perception of EM risk is an opportunity. I see that a good risk/ reward proposition is in EM, debt in particular. Although perception of risk has changed, the fundamentals do not support the increased risk due to the following:

1. future growth is much more solid in emerging markets with less structural issues and headwinds to limit its progress.
2. emerging markets currencies will appreciate against the potential collapse in US currency due to current and trade accounts deficits.
3. Developed economies are facing recession and credit risks while EM are facing one headwind in global recession. EM hold surplus foreign reserves as a result their credit situation is
   much better than the US and Europe. Its ability to fulfill its debt
   obligation is not impaired
   

For sure emerging markets will slow down as a result of the rescission in the US; there is no decoupling ever and I am not arguing this. But the upward growth trend is not broken by the current credit crises.

First, Emerging markets economies are growing 4 times as fast as developed nation economies according to IMF. They no longer depend on foreigner to make capital investment; now they are capable of doing that on their own to spur growth.

Second, Emerging markets do not produce only cheap goods, but they have produced multinational companies that compete on the same level with developing nations companies. These companies will expand into developing economies to add markets and spurring growth. This will translate into higher job creation at home and higher wages.

Third, by the numbers emerging markets account for 80% world's population and 50% of GDP growth but only 8% of stock markets capitalization. The imbalance have to be corrected by owning more of the world's assets and occupying more in market capitalization.

Fourth, EM are cash rich and own a large portion in basic resources. As a group, they are in far better shape than ever before.
Many are commodity exporters and many commodities are at record highs.
Recently, crude oil is around $100 a barrel while
other commodities prices have also been increasing, although they came off their recent highs lately. Moreover, over the
past five years, many emerging market governments have taken steps to
insulate themselves from the effects of a global financial crisis.

EM governments are cash rich with reserves at record level. They are sitting at 75% of global cash reserves. Those reserves will support their currencies against the euro and dollar. Although currency appreciation is not the outcome those couturiers want to happen, there is no escaping it. The US dollar faces lots of head winds: ballooning trade deficits and ever increasing debt load. Treasury and the fed are continuing to pump dollars in the system debasing its value; it is astonishing that the dollar has not fell off cliff thus far.

This brings me to what will Sovereign Wealth Funds (SWFs) and cash rich countries do with this capital. The recent credit issues of US have given SWFs and cash rich countries pause and hesitance to invest in the US. These parties want to diversify away from the US to reduce their exposure. EM assets allows them to do just that, particularly EM debt.

My strategy is to be a buyer of EM debt and patient accumulator of equity, as it is highly correlated with global equity markets. I do not know when markets will recover therefore EM equities may languish a bit so I will cost average over the next little while. This strategy will provide me with the following:

1. income as EM debt spread is high for no fundamental reason
2. hedge against US dollar decline
3. appreciation once investors come back to the market
4. improve my asset allocation by increasing debt portion in my portfolio.
   

Valuation
Now, emerging markets are trading once more at a significant discount. There
are some good reasons for this. The turmoil in states bordering Russia
suggests a rise in political risk. For example, stocks in the Ukraine
doubled in barely 18 months, but since January they have halved.

A lot of emerging markets are in the low double digit PE. Falling to single digit PE would provide very attractive entry point.The chart to the left displays that EM equities on PE basis are trading at a discount of 50% to the S&P, while debt has a spread of more than 300 basis points to treasuries. (Charts courtesy of Financial Times)

Next post I will discuss the risk associated with investing in EM also what type of instruments to use to monetize the idea.