Issue #52 – Update on Emerging Markets

As many of you know, for the past three years I have been a proponent of investing in Emerging Markets such as India, China, Indonesia, Poland & Columbia.  Our initial allocation was in November of 2014 for reasons discussed at length in IMI#30 – Emerging Markets Dividends, followed by a significant “double-down” in many portfolios when we moved to the fee-for-service model earlier this year.

Our target allocation, the RBC Emerging Markets Equity fund, is up 18.20% year-to-date, prompting us to complete an in-depth review of the position to determine its long-term prospects for future returns. In this month’s IMI, we present you our updated thesis on the overweight allocation to emerging markets in our model portfolio.

 

Our investment allocation process for growth stocks is based on the following core principles which are necessary for stock prices to rise:
- Economic fundamentals must be strong and growing.
- Stock market valuations must be fair and not over-inflated.

This investment philosophy is known as “GARP”, or Growth at a Reasonable Price.  Let’s start by focusing on the economic fundamentals of emerging markets as a whole and breakdown our preferred allocations.

Emerging Markets Statistics¹

• 80% of the world’s population
• 1/3 of the world’s Gross Domestic Product (GDP)
• 1/2 of the world’s growth
• 30% of the world’s stock market capitalization (value)
• 5% growth rates compared to 2% in developed markets

Given that buying stocks is about the future and not the past, an economy’s prospects are more important than its achievements.  The health of the middle class is of particular interest as it is overwhelmingly responsible for the growth of the economy. 

According to Sammy Simnegar of Fidelity, “10 years ago, there were about 50 million households in China with disposable income of $10,000 or more.  Today China has about 250 million households and the U.S. has about 120 million.”  As such, over 200 million households (!) in China have crossed the $10,000 threshold and can now participate in the transformation of China’s economy from a low-wage manufacturer to a service and consumer-led economy.  This marks a transformative shift for these countries as they diversify away from their dependence on foreign markets to economic powerhouses in their own rights.  The Chinese governments’ stated focus on technology, education, environmental protection, and the national consumer market is logical and likely to bear fruit in the near and long term.

In India, Prime Minister Narendra Modi has undertaken a colossal modernization of his country, particularly for basic modern necessities such as indoor toilets and bank accounts.  More than 200 million bank accounts were opened since his inauguration.  Along with facilitating transfers to the poor, this increase in bank accounts will help broaden the tax-base of the Indian government by moving the country away from its cash-based economy.  It is hoped that these new tax dollars will find their way into desperately needed infrastructure projects, which overwhelmingly benefit the lower and middle classes.

Economic growth rates in these countries are expected to average between 6% and 7% over the next decade, almost three times the expected rate for developed economies.

Home-Bias

Despite these strong economic fundamentals, Canadians continue to favour investing at home.  Vanguard released an excellent study in 2015, “Home Bias and the Canadian Investor”, that breaks down the lack of diversification present in the average Canadian portfolio.  Simply put, Canada comprises only 3%² of the world’s stock market.  The 10 largest stocks in Canada make up 37%² of the Toronto Stock Exchange (TSX), which is far from a diversified index. More than 1/3² of the TSX are financial stocks, 1/5² are energy stocks and 1/10² are materials and mining stocks.  In other words, only 3 of the 12 major sectors make up more than 60%² of the market, leaving important sectors like technology, consumer goods, health care, and industrials grossly under-allocated. 

The result is a bad combination of more risk and less return for the typical Canadian investor whose average stock exposure consists of 60%² Canadian stocks.  This tendency is known as a Home-Bias  and can have dire consequences during periods of economic turmoil due to insufficient diversification.

Canadians aren’t the only investors suffering from Home-Bias.  Low interest rates and high corporate profits in the US encouraged investors to borrow to invest, which in turn pushed stock valuations to eye-watering highs.  As noted in IMI#47 – “The Return of Irrational Exuberance”, the price-to-earnings (P/E) ratio, the benchmark for determining stock market valuations, is flashing warning signs of a bubble in the US. 

Valuations

Historical research shows fair market value when the P/E ratio average for stock indexes is between 16 & 20, while a bubble is usually considered anything above 24.  According to StarCapital’s research, as of June 30^th, 2017 Canada’s market was floating just above 20³ while the US reached an average adjusted P/E ratio of 28³. 

Comparatively, China was trading at 15.4 times earnings, or almost half the price per share.  This ratio tells us that despite its excellent profits and growth potential, the home bias of the rich world’s economies are pushing up stock markets without regard for their actual growth prospects.

Our thesis is that eventually investors will turn their gaze outward and realize that they are missing out on a truly big piece of the pie – and one of the only ones whose growth is rising faster than inflation!  According to Morningstar’s “Canadian Balanced Portfolio”, the average Canadian invests less than 0.2% of their total holdings in emerging markets.  Should that exposure increase to its fair share of the world markets, we would see an almost 10-fold increase in investment dollars into those markets. 

The Risks

Undoubtedly, this allocation is not without risks and certainly not for the faint of heart.  Substantial risks are presents in these markets, including an all-out trade war between Russia and the US, nuclear Armageddon in South Korea, bribery scandals in Brazil, and the real-world Game of Thrones at China’s Communist Party Summit in November.  It would not be surprising for this allocation to lose 30-40% in a bad market.  For these reasons, we continue to tread lightly and recommend no more than a 10% allocation to these markets. 

In an effort to combat some of these risks, we chose active management in this sector over a low-fee exchange traded fund (ETFs).  Our research shows that many of the low-fee ETFs in the market are simply buying up the biggest companies.  In many emerging markets, the biggest companies are state-owned enterprises and the furthest thing from what we want to buy up!  Rosneft, Petrobras, and Sinopec are owned by the Russian, Brazilian, and Chinese government and are the antithesis of why we buy emerging market stocks, yet feature prominently atop many ETFs in the sector.  According to Copley Research⁴, this trend may partly explain why managed funds outperformed ETFs in Emerging Markets over the past decade, ⁴.

Our Pick

In a precarious market it is best to be nimble.  Following our research of the sector, we began recommending Phillipe Langham’s Emerging Markets fund, operated by RBC.  His team focuses on identifying exceptionally well managed businesses that are based in emerging markets and across a variety of sectors to maximize diversification.  This strategy has paid off in spades as the fund outperformed its index and peers over the near and long-term⁵, as presented in Barron’s article with Langham.

Summary

There is no doubt that our recommended overweight allocation to Emerging Markets increases a portfolio’s risk.  That being said, the added diversification, strong economics, and attractive valuations of these markets combine to make a more compelling case than stocks anywhere else in the world.  Furthermore, the potential for future dollars to flow into these positions should home-bias be overcome would provide significant rates of returns for those who are already invested. 

In the words of Wayne Gretzky, “skate to where to puck is going, not to where it has been”.  By investing in Emerging Markets early and a willingness to live through its ups and downs, we are doing precisely that.  

Jean-François Démoré

CIM, CFP, MBA, HBCCS

 

Sources:
1- It’s not too late to catch emerging markets’ updraft. Globe & Mail – August 22^nd, 2017 https://www.theglobeandmail.com/globe-investor/globe-advisor/its-not-too-late-to-catch-emerging-markets-updraft/article36026922/
2- Home Bias & the Canadian Investor.  Vanguard – 2015.  https://www.vanguardcanada.ca/documents/home-bias-adv.pdf
3- Global Overview of Fundamental Valuation Ratios – June 30^th, 2017.  http://www.starcapital.de/research/stockmarketvaluation
4- Evidence Supports Active Equities in Emerging Markets – June 15^th, 2017.  https://blog.abglobal.com/post/en/2017/06/evidence-supports-active-equities-in-em
5- Long Term Winners for Emerging Markets.  Barrons – April 29^th, 2017.  http://www.barrons.com/articles/long-term-winners-for-emerging-markets-1493438622

 

The information contained herein was obtained from sources believed to be reliable, however, we cannot represent that it is accurate or complete. This report is provided as a general source of information and should not be considered personal investment advice or solicitation to buy or sell any securities mentioned. The views expressed are those of the author and not necessarily those of ACPI.