Emerging markets in Asia experienced another bout of turbulence in the first half of 1998, following their steep decline in 1997. Although investors can expect further volatility in these markets, there is no doubt the severity of these declines has opened up enormous opportunities for those seeking value in emerging markets as a whole.
True, a number of potentially negative events still lurk on the horizon in Asia, where most value-oriented investors are now focused, including a possible devaluation of the Chinese renminbi. Social strife also may ensue as unemployment rises and living standards fall in much of Asia. The restructuring of public and private debt owed to foreign banks and corporations promises to be a long and complex process.
Yet in the next three years, some of the Asian emerging markets hold attractive prospects for investors, especially those countries that seriously embrace the International Monetary Fund stabilization programs. Adhering to the IMF programs is generally expected to lead to a quicker restoration of global investor confidence and also might improve the potential for economic recovery over this period.
Overall, Asia's recent cyclical downturn is likely to bring about positive changes in the region's political and financial institutions. While the shock administered by a flight of capital from the region might not mitigate the rampant "crony-capitalism" in many emerging market economies, Asia's financial markets as a whole should, over the long term, become more investor-friendly and transparent in their operations.
LOOK AT FUNDAMENTALS
In the heat of market turmoil, it is easy to overlook the fundamental economic factors that attract long-term investors to emerging markets. Consider the following:
* The percentage of the world population embracing free market reforms has more than doubled in the past decade, from 40% to more than 90%, according to the U.S. Bureau of Census, international database. This has been a key contributor to higher global economic growth rates.
* In the coming decade, young populations, low per-capita income and underdeveloped economies should enable the emerging market countries to have substantially higher gross domestic product growth rates than the developed market countries.
* Emerging markets as a percentage of global equity market capitalization have more than tripled to 11% since 1986. They are expected to reach 25% by 2006, by our estimates.
In structuring a portfolio to take advantage of emerging markets -- particularly at this time -- institutional investors should think carefully about the philosophy, style and process they choose to adopt. The ultimate objective should be to build and maintain a portfolio of securities that has substantial upside potential and minimal downside risk.
THE RIGHT PHILOSOPHY
Four basic precepts are critical to developing a successful emerging markets investment strategy.
* First, macroeconomic and liquidity factors strongly influence the prices of stocks.
The prosperity of companies in these markets is closely linked to the development of their national economies, because they generally are not multinational in scope, do not possess globally competitive technology, and do not have high barriers to entry in their businesses. Consequently, emerging market stock prices generally are strongly correlated with the overall business cycles of their domiciles.
This is not the case in developed markets, where companies are more multinational and their operations more diverse. Further, government fiscal and monetary policies are less erratic in the developed world and the business cycle tends to be less extreme.
The importance of a top-down approach to emerging markets investing is illustrated in Table 1, which shows that an investment in the worst performing stocks in the best markets over a 12-year period would have produced an average gain of 91%. The best stocks in the worst markets would have produced a 28% loss. By contrast, a similar analysis of developed markets shows average gains of 15% by owning the worst stocks in the best markets and 27% by owning the best stocks in the worst markets.
* A second precept is there is little correlation between an emerging market's size, in terms of capitalization, and its return potential. Using a capitalization-weighted index to invest in these markets is illogical because it will overweight countries that have performed well, reducing the upside potential and increasing the downside of a portfolio. An equal-weighted approach toward country selection, on the other hand, forces investors to rebalance their portfolios periodically by taking profits in rising markets and deploying the proceeds in weaker ones that are poised to recover.
* Third, the inefficiencies of emerging markets offer an opportunity to achieve strong returns. The annualized standard deviation of three-year U.S. dollar returns in developed markets varies between about 10% in the United States and 20% in Italy as of Dec. 31, 1997. In emerging markets, the variation is considerably larger, both in absolute and comparative terms, ranging from more than 30% in Korea to more than 50% in Russia and Turkey as of Dec. 31, based on Morgan Stanley Capital International indexes.
* Fourth, diversification among emerging markets enables the investor to mitigate risk and reduce overall portfolio volatility. These markets offer a universe of 40 countries (of which 28 are investible by institutional standards) compared with 22 in the developed world.
A VALUE APPROACH
A value-oriented, contrarian investment style is ideally suited to emerging markets, keeping in mind the goal of maximizing upside and minimizing downside potential. A process that combines a top-down and bottom-up approach is essential, beginning with asset allocation by country and by global industry sector. Quantitative factors determining country allocation should include both domestic and exogenous elements such as the level and trend of GDP growth, export growth, inflation, interest rates, trade and current account balances, money supply, credit, liquidity and global capital flows. Resultant weightings can then be modified, based on a judgment of qualitative factors such as political and social risks.
To select stocks, institutional investors should begin with a quantitative screening of the total emerging market universe, including a liquidity screen that reduces this universe to perhaps one-fourth of its original size. Further evaluation should involve estimating an upside target price based on a positive set of operating assumptions, using reasonable valuation multiples, as well as a possible downside target, assuming that fundamentals and multiples on the stock will deteriorate. The objective is to buy stocks trading at low multiples (of revenue, cash flow, net asset value, book value and, to a lesser degree, earnings) and whose operating margins are at the low end of their range through the economic cycle.
Of course, it is difficult to time peaks and troughs consistently in emerging markets, just as it is in any asset class. But, the 18- to 24-month period following severe market corrections in emerging markets historically has been an exciting time, where investors often have had an opportunity to realize extraordinary returns, as shown in Table 2. While past performance offers no guarantee of future results, it is hard to refute the argument that, for the long-term strategic investor, these markets in general, and Asia in particular, might be too tempting to ignore.
