Should you strike while the EMs are cool?

Julian Mayo, co-chief investment officer at Charlemagne Capital (UK), still sees opportunities in emerging markets, despite recent outflows.

Emerging markets have suffered outflows this year as investors recycled money into Western regions – but the longer-term case for the East remains intact. While we see the market perception of this selloff as exaggerated, emerging equities have underperformed during the six months to the end of March, with areas such as Turkey worst hit.

This correction was down to two major factors: a recovering US presenting beneficial asset allocation opportunities; and lingering inflation fears in emerging countries. Inflation concerns are justified, with a recent 9% level in Indian wholesale prices for example, but we feel pressures are now peaking in line with tighter fiscal policies and higher food prices beginning to come off.

A good entry point

Meanwhile, various indicators, such as the long-term debt downgrade by S&P, suggest the recent growth spurt from the US is dissipating. Events in North Africa and the Middle East show political risk remains in emerging markets but we see the recent corrections as providing a good entry point. This year’s outflows have at least stopped commentators suggesting a bubble in these equities – an argument we never saw as valid.

For 2010, the region traded on a price/earnings multiple of just under 14 times, falling to 11 for this year and ten for 2012. There have been several instances over the years where emerging markets have traded above 20 times earnings, and current levels are well below such peaks. While emerging equities remain broadly attractive, there are some more expensive areas such as Chinese A-shares on 16 times and India on 17 to 18 – but even these are not excessive.

We like the A shares of Ping An, the insurer, which trade at a discount to the company’s Hong Kong listed H shares. In addition, a recent visit to India confirmed that Mahindra & Mahindra, the nation’s top producer of agricultural vehicles and pick-ups, remains attractively valued at 15 times 2012 earnings, given its strong fundamentals and structural growth story.

The end of Western dominance

Among many changes in the world post-credit crunch, the most important for us is an apparent end to Western dominance of the global economy. Emerging market growth has long been a powerful macro story but we are now in a position where these countries are largely free of debt – in contrast to the years of deleveraging facing the West.

After blow-ups in the 1990s, emerging markets have taken a far more conservative balance sheet position and borrowing – at personal, corporate and government levels – is much lower than in developed nations. Beyond low debt levels, the region also has the capacity to pay off this borrowing through future economic growth, underpinned by several powerful demographic forces.

This argument sets, for example, ageing populations in the West against a growing Eastern middle class of working age. One way of profiting from this is via banks. We currently invest in Bank of China – which we think will benefit as policy eases, and which trades at a price to book ratio of only 1.4 for this year – and Kasikornbank in Thailand.