Investors returning to emerging companies find them more innovative
MORE stable commodity prices and better corporate earnings have whetted investors’ interest to take a peak into emerging markets.
However, returning investors may find the companies of today’s emerging markets are very different from what they were in the past.
The landscape of emerging-market corporations in general has undergone a significant transformation from the often plain-vanilla business models of the past that tended to focus on infrastructure, telecommunications, classic banking models or commodity-related businesses, to a new generation of more innovative companies that are tech-savvy and have higher value-added production processes.
Franklin Templeton has started to see the establishment of some very strong globally represented brands which originate from emerging-market countries.
Back in the late 1990s, technology-oriented companies made up only 3% of the emerging market, as represented by the MSCI Emerging Markets (EM) Index.
Much has changed since then. Today, around a quarter of the MSCI EM Index is in the IT sector, which includes hardware, software, components and suppliers.
And while much of this activity originates from Asia, similar developments in Latin America, Central and Eastern Europe and even Africa are happening.
In terms of valuations, as at May 25, the MSCI EM Index had a price-to-earnings ratio (P/E) of 15.37 times and a price-to-book value (P/B) of 1.66x, compared with a P/E of 21.53x and a P/B of 2.33x for the MSCI World index.
Frankling Templeton executive vice-president and the director of global emerging markets/small cap strategies for the Templeton Emerging Markets Group, Chetan Sehgal tells StarBizWeek why he remains positive on emerging market.
Prior to joining Franklin Templeton, Sehgal was a senior ratings analyst for the Credit Rating Information Services of India Ltd.
Sehgal earned a Mechanical Engineering degree from the University of Bombay and a post-graduate diploma in management from the Indian Institute of Management in Bangalore, where he specialised in finance and business policy and graduated as an institute scholar. Sehgal speaks English and Hindi and is a Chartered Financial Analyst holder.
SBW: What is the main thing which has changed in emerging markets today?
Sehgal: Technology is now a much a larger part of the indice, and this was not the case earlier. Ten years back, when people were trading in emerging markets, they used to look at commodity prices, energy and material prices.
With the growth in technology (and technology itself is a secular trend in emerging markets), emerging markets today have become much more widely owned and not just dependent on money flows any more.
Remember that emerging markets then were merely outsourcing stories for the West.
It’s still happening, but now it’s not just for the West, because China has become an importer and demand driver. China is demanding a lot of goods. As a result of this, the dependence on Western policies has actually come down quite a bit.
Have emerging markets become less dependent on Western policies as a result of China’s rise?
Emerging markets have become far more diversified. It is much larger too. Its dependency on any one single factor has come down quite a bit.
Those are the two big changes that have happened over the last 10 years.
In our analysis of investing, you play emerging markets for the secular trends, hence the rise of technology and structural things like demographics, these are things that don’t change over one decade. It takes a long time to change. So structural and secular themes are there.
Third is that industrial consolidation has taken place. For example, if you go back 15 years, we used to have many companies entering the tech space, trying to make D-RAMs for phones and PCs.
Now the number of companies doing this has come down as the technology has improved. You will notice there are now more dominant players and as a result of this, these dominant players have pricing power. Thus, the price of D-RAMs has gone up quite significantly.
Another important fact is that China is also trying to consolidate some of its supply side, for example in its cement, coal and steel industries. China is initiating supply side reforms, and this augurs well for shareholder return over the long term.
Are you saying that emerging markets are also trendsetters since they no longer depend on Western policies?
Yes, that is definitely the case. Every emerging market is different and all their models are changing quite a lot. There isn’t a right or wrong mode.
And in terms of new technology, another trend that I want to highlight is that 15 years ago, the number of patents application from emerging companies were probably 25% of the global patents.
Now it is about 40%. That is a big change.
So, this changes all the perceptions of emerging markets. Because in the old days, we worry that should the Fed raise interest rates, will emerging markets start to fall. All these perceptions have been there and ingrained over a period of time but we need to appreciate the fact that emerging markets are evolving.
The emerging markets of today are not what it was yesterday.
Having said all that, is there any particular sector within emerging markets that you like?
On the big cap side, we are very much overweight on the technology side. We invest in platforms such as Tencent, Alibaba and Naspers. We also invest in semiconductor companies such as Samsung and TSMC. And we are also invested in some of the services companies. We like products, platform and services.
On the small cap side, it is very distinct from large caps.
Here are some differences. For example in the large caps, you have companies in the banking, energy and materials sector. Those are large industries.
But in the small cap, you find companies run by local entrepreneurs, which are catering to local demand. Most of them are in the consumer sector. Their growth rates are also non-cyclical compared to the larger caps. Historically we found that their earnings are less cyclical.
The stock market is probably equally sensitive because people tend to rush in and rush out of small caps. Nonetheless, volatility in small cap earnings is not inferior to the volatility of big caps on an agregate basis.
We like consumer discretionary companies. For example we have one in India, they are doing the autos and the two wheelers. We also like the healthcare sector, Some Korean companies which have become very good in the pharmaceutical sector, have now started licencing their products to the global majors.
Is there any sector you like which is not a favourite just yet?
Apart from secular trends we also play cyclical themes. Two years back when the Brazilian currency was beaten down, we invested a lot in Brazil, because the currency was very devalued. Last year we invested in Mexico, where the currency also came down quite abit.
Despite the recent turmoil in Brazil, we still like it.
We do notice that there is an overwhelming demand from the people in emerging markets for better transparency and more governance.
In India, for example, when its current Prime Minister Narendra Modi came into power, it was on the back of kicking out corruption. This overwhelming trend in emerging markets is very positive.
So is it now a good time to put more money in emerging markets?
Yes, the days of tactically investing in emerging markets are probably over. At that point in time, we used to just look at what the Fed was doing. But now, we need to be strategically invested in emerging markets. Because the fact remains that this is the largest landmark, this is the largest population, the hotbed of entrepreneurship.
Political reforms have taken place. They are leapfrogging on technology.
That is very positive characteristic. The GDP growth is there, and penetration for certain things are still nascent. You can create a new brand, you can grow it. Whereas in the West, while some of these opportunities still exist, it could be saturated.
It is far more difficult to establish something new in the West because most people already have access to such products.
Most big funds are still underweight on emerging markets at the moment?
It depends on how people define it. In our assessment, people are still underweight on emerging markets because of the home country bias.
Also, we find that emerging market companies are not inferior to those in the West. We have done a lot of studies on this. The rate of return on equity for these companies are not inferior to those in the West. These are all the more reasons to buy into emerging market companies.
You told us about the things you like. What about the things you don’t like about emerging markets?
We have stayed away from companies and countries where the government has extremely strong influence on shareholder returns, We have typically avoided the utilites, where the governments don’t want them to make a lot of money.
We also try to stay away from companies where the corporate governance is bad, So for us, the number one health-check is really the corporate governance. It should be good, or on the way to improving further.
Are you positive on the energy sector at current oil prices of around US$50?
We are neutral on energy. We used to be underweight, but now we have turned neutral. And its all about specific companies. Its not about the price of oil. We think its going to be range-bound. But we are not trying to predict that. We are trying to look for companies that are in the best position to generate cashflow for shareholders. Not those that would benefit significantly from an increase in oil prices.
What is the impact of the Fed raising interest rate, since you said that emerging markets are now less dependent on policies of the West?
Again it comes down to individual countries. Some countries have very high interest rates and is in fact embarking on a cutting cycle. Like for example Brazil. In general, investors are over obsessed with the Fed raising rates and how that will impact emerging markets, rather than how the Fed rate hike will impact the US economy.
If the Fed is raising interest rates because the US is becoming much stronger than what they thought, then it is ok. This is because demand drivers are in place.
Nonetheless I feel that the Fed raising interest rates have more or less been discounted by emerging markets. The US economy is also appearing stronger.
Should the US be more concentrated on bringing back jobs and investments to the US, how does this affect emerging markets?
From an emerging market point of view, China has filled in a great void. It has become a very important demand driver and source of investment. It is not being led by the funds, but by the government and the banks. And we see that that is not slowing down. We are seeing more and more commitment to fulfil the void that is being left by the West.
What is your opinion on the One Belt One Road policy?
I think its a very positive initiative because it opens up the historic trade links, will improve productivity across the region and create greater opportunities. We will see greater people to people contact. And its good because the traditional Western model was to have a flow of funds toward these economies, but now, these are investments into the ground. So its a slightly different kind of approach, and you see the tangible benefits on the ground.
As you said that there are tangible benefits on the ground, is this the start of earnings in emerging markets coming up?
There has been an expectation of improving earnings. The manufacturing goods and trading has improved significantly. Commodity prices have improved a little bit. And as currencies have come down, there is also a lower cost base from what it was previously. We are seeing people revising their earnings expectations upwards.
Yes we think this is a good time although the market has gone up quite a bit from last year. In fact the MSCI EM index has done exceptionally well. So we think its still the initial phase. From now on, there could be more volatility as the big move has happened. Thus, markets will now be more discerning than what it was previously.
So you are still positive on finding value in emerging markets?
They aren’t as cheap as they were a year back, but we still find opportunities. Our central belief is that in every market you will find good opportunities. We are looking at over 25,000 listed companies in emerging markets. Many are still undiscovered gems. We can always find new gems in every markets.
There could be more volatility going forward, but we still think its good for the long term. We have seen cyclical recoveries in many markets. But secular trends don’t change overnight. They are still there. The structural trends are also in your favour.
Many say that the US economy is on the verge of a recession because its had quite a good run. Thats not a good reason to predict a recession, but still, what do you think?
I feel that many of the companies in the US have become very global. So now you have the Apple iPhone in everybody’s hands. And if you look at the constituents of the companies in the US indices, they are driven by the companies that have become far more global. These companies are deriving their earnings from the world, not just the US, so this is good. The US is dependent on the globe, China too is dependent on the globe, so aggregate-wise, we think earnings will be revised upwards.
Do you see the US going into recession?
In our estimate, that is not really happening. There will be some slowdown, but we are not making a base case that the US will have a recession. In fact, the rise in oil prices and shale have come back quite a bit. And as shale has come back, more and more jobs are being created in that sector. Also, the theory of the US going into recession is not consistent with the Fed wanting to raise interest rates.
If the Dow does fall, we will also suffer? It’s still a perception thing to follow the US lead?
The Dow did fall last week right? And after that, Brazil actually fell 9% in dollar terms. But the Hong Kong companies, espeically on that day, actually rallied. For example Tencent released its results, which were good, and the stocks there moved up.
So this perception that the Dow coming down will actually have an influence on emerging markets has reduced a lot. It used to be much more, but now its not the case.
In the past, all brokers in their morning notes, were always very focused on what happened overnight in the US. Everyone expected that the next day would start based on what happened the previous night.
I think people are not so focused on that anymore. They are now more focused on individual countries and companies. And in fact, trade relationships with China have become so important. Because if you see how the Korean stock market reacted based on their relationship with China, it seems to suggest that China is the more important factor.
What are the things you don’t like about emerging markets.
Number one, corporate governance needs to improve a lot, especially on the shareholder and dividend return policy. Secondly, shareholders need to have a greater voice in trying to ensure that whatever they feel the company should do, should happen.
And this has historically been the reason why people flocked to the US, because shareholders have a greater say there.
Political interference needs to come down, and there should be stable policies so that companies can develop on their own and compete. There is some chance that protectionism may come up, but our feeling is that China is actually trying to open up, and that is a very positive signal.
Historically, reactions of governments tended to be to isolate and insulate. The commitment to remain open is a very important commitment. That allows for markets to grow faster.
Any particular country you like?
In the small cap side, we like India. We think India has a lot of positives in the sense that policy making is clearer, it has become a lot more transparent. It is still embarking on the reform journey, and is still far behind in terms of per capita income. There is a real move towards change. So we have been overweight especially on the banks.
Apart from the financial aspect, what else do you look at in choosing your companies?
Our analysts generally do the research. However, the thought process is to look at the people behind the companies. The management and their commitment, their vision and what is the scale of opportunity they are going after. How flexible they are.
We want to buy into companies that are run by entrepreneurs, willing to take risks and where the corporate governance is good.
What is your opinion on Malaysia now?
We run a lot of mandates for the local funds. Historically we don’t have a high rating on Malaysia. Given the fact that the currency has come down quite a lot, there must be good opportunities. So, we have been telling our analysts to look out for new ideas here since we feel there is quite a bit of value now.
We are looking for good companies to invest in, in the hope that we will never have to sell them!