Emerging markets defy the pessimists, but widely divergent returns will reward shrewd stock-pickers

After strong relative performance and massive fund in-flows in 2009, many experts were predicting that emerging market equities would have a poor year in 2010. We were more sanguine, expecting modest outperformance as a result of low valuations, strong earnings growth and economic fundamentals that were still attractive relative to developed markets.

That forecast is working well, but markets have rewarded shrewd rather than indiscriminate investors. The major markets are struggling, with China down and India the only BRIC country that is outperforming. Instead, the best performances have come from south east Asia, Chile and Colombia. The Frontier Index, dominated by the Middle East, has been disappointing overall, but it contains some outstanding performances: Sri Lanka (following the end of the civil war), Ukraine (despite the drought) and Mongolia have all more than doubled while Argentina and (uninvestable) Iran have also soared.

Large and mega-capitalisation stocks, especially those listed overseas, have disappointed, but small and midcaps have done much better. The Brazilian investor who avoided giants Vale and Petrobras has done well, as have investors everywhere who focused on consumer goods and services companies. This means that while the performance of some emerging funds has been pedestrian, others have beaten their country, regional or global benchmarks by huge margins.

This trend is likely to continue, with emerging markets doing well, but followers of the herd being trounced by careful stock-pickers, those prepared to be contrarian in their country selection and those committed to careful research rather than buying the obvious. Emerging markets now account for 12,6% of the MSCI Global Index and nearly 14% if Hong Kong and Singapore are included, compared with below 9% for the UK and Japan. Very few private or professional investors have weightings this high, so are likely to be buyers on any setback. Such a setback was provided in 2008 when emerging markets fell by 30% relative to developed markets but, of course, most investors missed it and emerging markets made back the lost ground in 2009. Since 2001, emerging markets have more than trebled relative to developed markets and this shows no sign of reversing.

The fundamentals show why. Emerging market indices trade on 13 times 2010 earnings and 11 times 2011, an 8,3% discount to the MSCI Global Index. Forecast 2010 earnings growth is, at 33%, less than for the global index but 2011, at 24%, is higher and earnings were flat in 2009. Over the three years, earnings growth is expected to be 63%, 10% higher than for the global index. Moreover, few doubt that economic growth in emerging economies will continue to significantly outpace that in developed economies while they were much less impacted by the credit crisis and their national finances are better. This means that growth in corporate earnings is likely to significantly outpace that in developed markets in the medium and long term.

However, they are not without problems. Competitive devaluation and ultra-low interest rates in developed economies mean that currencies are often stronger than their governments would wish (notably in Brazil and South Africa) and high interest rates to fight inflation, notably in India, threaten to worsen the problem. As is normal in emerging economies, current accounts and government finances are often in deficit, but these deficits are worryingly high in some of Eastern Europe. Corporate governance, though improving, is variable, with companies like Gazprom more focused on the economic agenda of its majority shareholder, the Russian government, than on investor returns to the minority. From Iran to Burma and Venezuela, there are many basket cases; these are of tiny significance to emerging market investors, but there is notable political and social deterioration in Mexico and South Africa (though Thailand is improving) which are much more significant.

Fund flows continue to be strong into emerging markets, but that reflects their demand for capital to finance growth and high returns rather than an investor mania, though a mania could develop which pushes valuations to absurd levels. Investors have also started to focus on corporate bonds and local currency government bonds (as we have been urging for two years) where there is also a risk of an avalanche of cash creating a bubble. At present, both corporate and government bond yields are still very attractive relative to developed markets while most currencies remain undervalued but, as for equities, the upward path of returns could be volatile. There are also individual opportunities to unearth value in an investment field where most investors are still wary of even calculated risk.

The outlook from emerging market equities is for more of the same. Returns between sectors, countries and companies are likely to vary enormously, so equity investors may want to consider seeking a broad spread via funds, mostly global or regional ones rather than single country ones. Investing in developed market stocks with high emerging market exposure has proved to be no substitute for the real thing and this is unlikely to change.

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