Over the last 12 months since the advent of talk about U.S. tapering, global emerging markets equity feels like the asset class strategists have loved to hate. While some think there might be the occasional "dead cat bounce," the region remains, in the opinion of many, a dead cat.
As a result of that, and despite the long-term growth fundamentals of emerging markets, the GEM equity asset class is often viewed as a somewhat binary risk-on risk-off call: "if the dollar is strengthening, EM will underperform," alternatively "if global yields are rising, you don’t want to be in EM." Recent flows bear this out — most of them have been into index ETFs.
While it is certainly true that rising global yields and tapering are a headwind to many emerging market economies, treating the region as an amorphous "blob" masks some tremendous changes and opportunities that are happening at the corporate level. There are simply more under-researched, "undiscovered" companies in GEM which provide compelling investment opportunities, and a manager who can consistently unearth them is bringing something special to the table.
To reduce one's view on the region to a binary call misses the point that within emerging market equities, the dispersion of stock returns is very high relative to developed markets. This means that the difference in returns from holding the right stocks vs. the wrong ones in emerging markets is greater — in short, it's an area where active management has the potential to add the most value. Investing purely at the index level misses many of those opportunities, yet in practice this is what often happens. There has been a continuous wave of outflows from GEM equity through the first quarter of 2014, but since this finally began to turn positive again in the spring and summer more than 90% of the inflows have been into passive ETFs, leaving lots of potential money making opportunity on the table.
One reason for the greater dispersion of returns in GEM is that the region spans such broad territory and is relatively under-researched. With strong resources and an appropriate investment approach, it's possible to find and make investments in companies that are followed very sparsely, if at all, by the big bulge-bracket firms but where the potential for positive change and stock price outperformance is large.
During 2013, for instance, the share price of VIP Shop (a Chinese online flash-marketing company used by clothing retailers to dispose of their unsold inventory) rose more than 360%. At the beginning of that year, there were only a couple of major brokers covering the stock; today there are 22. That familiarization process by the market (plus great execution by management in a massive growth market) helps explain the stock's re-rating and meteoric rise. Finding these opportunities early in their lifecycle can yield great returns, and is genuinely possible with well-focused investment resources.
A second reason why dispersion of returns is higher is that the benchmark contains a high number of large, inefficient state-owned enterprises. SOEs account for almost one-third of the MSCI Emerging Markets market cap and during the three years to March 2014, the average SOE underperformed non-SOEs by more than 40 percentage points, according to analysis by UBS. Over time, avoiding these companies (unless they are becoming more efficient — in which case they can make great investments) in favor of better-run, faster-growing businesses can add a lot of value.
A third factor is the "shoot first, ask questions later" nature of GEM, driven by flows and the volatility of macro and political news flow. Following a surprise election result in Georgia at the end of 2012, stocks with exposure to the country sold off in panic. As it turned out, however, the new government followed broadly similar economic policies to its predecessor, allowing a well-run company like Bank of Georgia to continue to press its competitive advantages and deliver great returns for shareholders as it grew its customers and balance sheet. Being proactive in taking the opportunities the macro and political volatility provides is an important factor in generating good returns. With more than 20 countries in the region there will always be macro volatility, but this creates excellent opportunities to pick up great businesses at attractive prices. Bank of Georgia has since returned around 150%.
On the surface GEM may seem to be "all about the macro" and thus to some extent a binary call — but the macro can mask great changes taking place within industries and companies. During 2013, for instance, there was relatively little that was positive to say about Chinese macro and the Chinese market as a whole did poorly. But within that, companies like Haitian (a manufacturer of plastic injection molding machines), Minth (a fast-growing auto supplier) and Rexlot (a lottery business) each returned more than 70% during the course of the year. Once again, this shows that stock picking can add significant value, even when the region as a whole is performing anemically or even negatively.
The medium and long-term structural arguments remain compelling for GEM equities. While there are well-flagged headwinds from tapering and the necessary economic fine-tuning this mandates in the various EM countries, the barrage of negativity has been overdone. The question at the macro level is not whether rising yields raise the cost of capital for emerging economies or tend to migrate flows towards developed markets (they do and have). Rather, the key question is whether these factors are now well understood and priced into markets, something that looks increasingly the case.
Regardless of that debate, investing in emerging market equities should be about more than a binary call, a function of one's view on U.S. Treasuries. It can (and we think should) be about exploiting the under-researched nature of these markets and the dispersion of returns they offer. This is done by focusing on the stock-picking alpha which is available through rigorous company contact and analysis; it's what active fund management should be all about, and EM is prime soil for it.
Mark Vincent is the investment director and manager of the Standard Life Investments Global Emerging Markets Equity Income Fund.