Monday, 20 May 2013

Emerging Disappointments

I was 6 years old when Emma Taylor broke my heart. It was a classmate's birthday party, and the back garden had been decked out with all the main attractions of a playground. Much amusement was had by all but, despite the other guests’ best efforts; it was I that had demonstrated superiority on both the climbing frame and the swing. As the day came to a close, however, events moved in a much more complex direction. Each reveller was given a balloon to take home and in what was fast becoming tradition, provided you were brave enough, that balloon would be gifted to the target of your affections. A lack of preparation on my part on how to affect this potentially life changing moment, resulted in delay. This in turn created a window of opportunity for the much adored Paul Bush to pounce. It was a perfectly executed handover; gentle and selfless. The moment had passed and with it my first opportunity for love.

It was a harsh lesson for a young boy, but from that day I vowed never again to be caught off guard at the end of a party. Socially it may have resulted in some rather over ambitious efforts, but in the work place it has fared me much better.

The latest party to come to an end is in the realm of emerging market fund selection, with the two perennial outperformers (Aberdeen & First State) both making soft-closure announcements this year. For the ill prepared this presents two major problems. Not only do two other strong candidates need to be sourced but the case for replacing them with the next best 'similar' strategy is starting to look challenged. The issue stems from both First State and Aberdeen having a quality bias which, as a result, has steered them toward the more defensive growth areas such as consumption. These sectors have enjoyed a substantial rerating versus the more cyclical (economically sensitive) and 'cheaper' parts of the market, and now look optically expensive.

But before we explore this further, let’s take a look at the valuation case for emerging markets as a whole, using the P/E ratio*.
Source: Bloomberg
This chart highlights that the average valuation of emerging market companies is slightly below fair value, which appears encouraging. But then did you hear the one about the man who had his head in the oven and his feet in the freezer? On average his temperature was fine.

I think a very similar situation exists in emerging markets. The following chart measures the P/E ratios* of a basket of emerging market growth (and arguably cyclical) sectors** versus a basket of emerging market growth (and arguably defensive) sectors*** - using current market weightings.

Source: Bloomberg
The above chart highlights the extremity in valuations between the cyclical and defensive sectors, and goes some way to explain the staggering levels of out performance delivered by Aberdeen and First State.

A key driver behind this move has been the continued uncertainty in regard to economic growth and a resulting flight to quality. However, this is purely a cyclical issue - fundamentals suggest there are structural drivers at play too. In fact, even if global growth picks up, given these structural issues are so deeply entrenched, describing the cyclical sectors as 'cheap' perhaps misses the point.

The cyclical areas of the market are dominated by energy and materials companies that, in the main, are tools of state. Management focus, therefore, is typically geared toward helping government achieve full employment, rather than maximising profits for shareholders. The same can also be said for many financial companies (though to a lesser extent), often instructing credit expansion to help achieve growth targets and, frequently, with scant regard for the viability of the project. (Further elaboration on some of the structural headwinds facing emerging markets were discussed in the recent blog Go Jonny Go.)

As a result of these issues, we cannot envisage cyclical companies forming part of a buy and hold strategy and, instead, more likely represent trading opportunities. This approach, however, comes with a higher degree of risk and is something we are less comfortable with our managers executing upon. Instead, we would prefer fund managers to maintain a bias to the higher quality companies and, in that regard, our core emerging market fund replacements, continue on the path trodden by Aberdeen and First State.

I must also add that whilst the party may be over for fund pickers, clients can maintain existing holdings and can continue to benefit from the strength of the Aberdeen and First State propositions. What is more, whilst Aberdeen has already soft-closed, First State will not do so until 7th September 2013.

Ben Gutteridge
Divisional Director - Research



*Current Price divided by trailing 12 month earnings
**Cyclicals: Energy, Financials, IT, Materials, Industrials
*** Defensives: Consumer Staples, Consumer Discretionary, Telecoms, Healthcare, Utilities

The above categorisation is certainly up for debate, but we would argue that EM consumption is a structural growth story and, therefore, both staple and discretionary sectors can be considered defensive.

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