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As the United States, Japan, and Western Europe struggle to get their fiscal house in order, international equity investors who have been able to identify dynamic growth and value companies in emerging markets in all kinds of economic conditions have had plenty to write home about.
In fact, between 1988 and 2012, a period marked by several major financial crises, emerging markets generated greater long-term returns than a diversified portfolio of developed market stocks (see Chart 1). For a while, BRICS grabbed most of the attention, as if they were some monolithic growth engine, which of course they weren't. Now that BRICS have cooled off, Turkey, Philippines, Poland, and even former Latin America trouble spots such as Mexico and Colombia have stepped into the limelight (see Table 1).
(Based on $100 invested in the MSCI Emerging Markets Index1 and MSCI World Index2 on December 31, 1987)
Source: FactSet; data as of December 31, 2012.
Past performance is no guarantee of future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investments.
Investments in emerging markets may be considered speculative and generally are riskier than investments in more developed markets because they tend to develop unevenly and may never fully develop.
Ranked by performance
Source: Bloomberg, The Economist poll or Economist Intelligence Unit estimate/forecasts, and the CIA World Factbook.
* The emerging markets listed here were chosen to show the contrast between the best-performing indexes in 2012 (ranked highest- to lowest-performing indexes) versus the largest developing economies, as represented by the BRICS, and developed markets in the United States, euro area, Japan, and Britain. Past performance is no guarantee of future results. Investments in emerging markets may be considered speculative and generally are riskier than investments in more developed markets because they tend to develop unevenly and may never fully develop.
For illustrative purposes only and does not depict the performance of any Lord Abbett product or any particular investment.
Indexes are unmanaged, do not reflect deduction of fees or expense, and are not available for direct investment.
† Philippines government forecast.
No matter what acronym you use to describe them, emerging markets have been one of the great equity investment opportunities of the last several decades, and what’s striking is the number of countries that overcame significant structural issues to become top performers. Of course, volatility has fluctuated greatly, but the frontier continues to expand.
Up and Down the BRICS Road
With an average of 19.9 years in the financial industry, Lord Abbett's 12-person international equity team has developed extensive knowledge of emerging markets in northern and Southeast Asia, Latin America, Central and Eastern Europe, the Middle East, and Africa.
In assessing the prospects of various emerging markets, the emphasis has been on the company as well as country, as one would expect of a time-tested research approach that spans the globe for optimal risk-adjusted returns across all sectors, especially when the performance and business climate of BRICS varied widely.
Brazil, for example, was by far the weakest among BRICS last year, hampered by declining exports, lower commodity prices, higher inflation, and government policies that impeded growth, all of which held its major stock index to a measly 0.8% gain in 2012. South Africa was racked by poverty, 25.5% unemployment (through the third quarter) and violent strikes, as exports plunged, inflation picked up, and three credit rating agencies downgraded South Africa's rating. Yet the stock market showed a healthy 19% gain in dollar terms3 (see sidebar, "Alpha Beta Soup," below). Russia, on the other hand, despite a long history of corporate governance issues and dependence on vast natural resources and the eurozone, seemed so undervalued that Lord Abbett's international team invested in a major gas producer, as well as a railcar transportation company tied to that country's huge energy and materials sector. And in India, after considerable political instability and a significant slowdown in growth of gross domestic product (GDP), the hard-hit financial sector created an opportunity to invest in a large, well-managed bank with considerable upside potential.
Of course, the international team have been quite selective about China. Although the world's most populous nation is renowned for its long history of double-digit growth, the Hang Seng China Enterprise Index4 is down more than 18% over the five-year period ended December 31, 2012, with property, financial, and manufacturing companies particularly hard hit.5
In recent months, however, Lord Abbett's international core equity strategy has been adding to its positions in China, particularly in the property sector, where housing demand continues to be robust, prices appear to have bottomed, and stock valuations appear attractive. Lord Abbett's international small cap core strategy also has been adding to its China position by buying shares in a Chinese truck manufacturer, a department store company, and two different property companies that appeared poised for recovery. (For the full country breakdown of each portfolio, please see the "Portfolio" tab on lordabbett.com.)
Why invest in a Chinese property company when some experts claim the market is overbuilt? Some of those fears are exaggerated. In fact, property prices in certain markets have stabilized and margins of certain companies in the sector have started to improve. One company we decided to buy was selling at 40–50% discounts to net asset value (i.e., the value of the company's assets minus the value of its liabilities) and had good top-line and bottom-line growth and relatively cheap multiples of 7–8 times earnings versus 2011, and the upside potential appeared attractive.
Among emerging markets in Asia, the biggest gainers were Thailand, an amalgam of six spectacularly diverse regions, and the Philippines, an archipelago of 7,107 islands—both nations' growth driven by expanding economies and a rising and increasingly prosperous middle class that is likely to drive consumption in 2013.
One common denominator in those countries is the greater availability of credit, especially in the Philippines, where property prices are still below where they were during the 1997 Asian financial crisis. Now that banks have delevered, deposits have rebounded, and interest rates are low, those institutions can lend at attractive terms—all of which has benefited investments in property companies and banks.
Keep in mind that the emerging market story is about the democratization of credit. Like the explosive growth of the United States in the 1950s, it's about helping young workers with sufficient jobs and income to buy their first motor scooter, first car, or first house. They do that by getting credit and saving enough to afford other installment purchases.
"Emerging market economies did so well in the past decade, that for the first time they spent more time in expansions and had smaller downturns than advanced economies," the International Monetary Fund said in a recent report.6 "In the 1970s and 1980s, emerging market and developing economies spent more than a third of their time in downturns. In the 2000s, however, they spent more than 80% of their time in expansion. In contrast, the advanced economies have spent less time in expansion over the decades, and in the 2000s, they were in downturns more than a fifth of the time," the report continued.
Given such dynamics, emerging-market growth should be a major story for the next several decades as rapidly rising incomes and better technology, machinery, and skills help young and growing populations consume more goods and services. According to an October 2012 report by HSBC Global Research, nearly three billion people—more than 40% of today's population—will join the middle class by 2050, almost all of them in emerging markets. If so, emerging market consumption could comprise almost two-thirds of global consumption by that time, compared with about one-third today, said HSBC.7
"Countries such as the Philippines, India, Pakistan, Egypt, and Saudi Arabia all have populations today with a median age of 25 or under," HSBC added. "These young people, with growing incomes, are getting ready to shop, in stark contrast to aging populations in [developed] countries such as Italy, Germany, and Japan."8
Of course, the outlook for emerging markets may be clouded by energy, environmental, political, and currency factors, but the proliferation of consumers there could go a long way toward addressing global cyclical and structural challenges. As HSBC concluded, "The world became far too dependent on the U.S. consumer in the 1990s and early 2000s and ended up paying a heavy price because of the imbalances that dependence brought with it. Luckily, major new sources of demand are emerging in the East and South."
While some emerging markets have demographic challenges of their own—Brazil, China, and Mexico also have rapidly aging populations—emerging markets may be better positioned than developed economies to weather the shocks if the global recovery stalls, said Kate Moore, global equity strategist of Bank of America/Merrill Lynch Global Research. For one thing, government debt in developing countries averages about 33% of GDP versus 78% of GDP in the developed world, Moore said. In the event of another global recession, emerging markets would be in a better position than heavily indebted developed countries to cut interest rates and increase stimulus programs, she added.9
Of course, emerging market performance may fluctuate widely. As Ruchir Sharma, author of Breakout Nations: In Pursuit of the Next Economic Miracles, put it recently, only Malaysia, Singapore, South Korea, Taiwan, Thailand, and Hong Kong have been able to grow at an annual rate of 5% or more for four decades. So even before BRICS stumbled, the chances of Brazil experiencing a full decade of growth above 5%, or Russia, its second in a row, were slim.10 "Although the world can expect more breakout nations to emerge from the bottom income tier, at the top and the middle, the new global economic order will probably look more like the old one than most observers predict," Sharma concluded. "The rest may continue to rise, but they likely will rise more slowly and unevenly than many experts are anticipating. And precious few will ever reach the income levels of the developed world."11
The bottom line is that while emerging markets have generated greater long-term returns than a diversified portfolio of developed market stocks, they also have become riskier, according to a recent study by Ernst & Young.12 This is all the more reason to rely on active managers with extensive experience in navigating volatility as investment opportunities and competitive advantages cycle around the world.
Emerging markets are consuming, producing, and contributing to the global economy at a rapidly increasing rate. Here's how they compare with the rest of the world:
Source: Bank of America Merrill Lynch Global Equity Strategy (February 2012), BP, CIA World Factbook, IMF World Economic Outlook, MSCI, and the McKinsey Global Institute.
1 McKinsey Global Institute's base-case scenario, derived from consensus GDP growth forecasts using 2010 exchange rates.
Edward Allinson is a Portfolio Manager of the international small cap core equity strategy and also contributes as a Research Analyst to the international core and international dividend equity strategies. Mr. Allinson joined Lord Abbett in 2005. He received a BA and MBA from the University of Pennsylvania. He also is the holder of a Chartered Financial Analyst designation, and has been in the investment business since 1985.
Don't let the outsized growth of emerging markets fool you (see Chart 1). While catchy acronyms like BRICS, BELLs, and MIST3 may appeal to media headline writers, they often cloud the fact that there is no correlation between a country's GDP growth rate and its equity prices. "In fact, the long-term correlation is negative, so an investment strategy based on following GDP growth trends is a losing trend," said Vincent McBride, Lord Abbett Partner & Director of International Equity.
Ranked by performance
Sources: International Monetary Fund (IMF), World Economic Outlook database, World Bank World Development Indicators database, Penn World Tables 7.0, and IMF staff calculations. Data as of October 2012.
AE = advanced economy; EMDE = emerging market and developing economy.
Supporting that assertion are a number of recent studies which examined the theory that over long time frames, earnings growth should track economic expansion and equity returns should reflect that earnings growth. Over shorter time frames, researchers found, these relationships can break down.
Take, for example, a 2012 study by Credit Suisse that found little correlation between real GDP growth and equity market returns in 21 different emerging markets between 2002 and 2011 (see Chart 2). Why? One reason may be that the generally low correlation may have reflected equity markets anticipating future GDP growth and pricing that in, sometimes overoptimistically.4 Another reason "may lie in the use of U.S. dollar returns and real GDP," Credit Suisse said. "A large part of what an equity investor is trying to capture is an amalgam of real GDP growth, inflation, and nominal currency appreciation."
How GDP growth and stock price performance compared between 2002 and 2011
Source: MSCI and the International Monetary Fund.
Past performance is no guarantee of future results.
* R2 (R-squared) is a statistical term that expresses how good one term is at predicting another. If R-squared is 1.0, then given the value of one term, one can predict the value of another term with a high degree of certainty. Generally speaking, the higher the value of R-squared, the better one is able to predict one term from another.
Of course, country selection is important, but not nearly as important as bottom-up stock selection. When, for example, Alex Redman, Credit Suisse's chief emerging markets strategist, analyzed the returns of the MSCI Emerging Markets Free Index5 between January 1996 and January 2012, he found that country selection contributed considerably less to returns than company selection. That trend was even more pronounced over the last two years of that study, with country selection accounting for 17.7% of the returns versus 51.6% for company selection and 30.7% for sector selection.6
1 Alpha refers to the return of a portfolio that is attributable to the efforts of an active manager. In many cases, alpha may be negative.
2 Beta is a measure of an investment's relative volatility. The higher the beta, the more sharply the value of the investment can be expected to fluctuate in relation to a market index.
3 In the beginning, there was BRIC, a moniker used by Goldman Sachs economist Jim O'Neill to describe the fast-growing but quite diverse economies of Brazil, Russia, India, and China, which in Goldman's view would pace the transformation of global capitalism. That was in 2001. Four years later, Goldman identified the "Next 11" largest populations that could greatly impact the global economy, which ranged from Korea to Nigeria to the Philippines. In 2009, as the world emerged from the great recession, the Economist Intelligence Unit heralded the young growing populations of CIVETS (Colombia, Indonesia, Vietnam, Egypt, Turkey, and South Africa). In 2012, Goldman would proclaim a steady MIST—the rising economies of Mexico, Indonesia, South Africa, and (leftover) Turkey, to be exact—which precipitated even more acronyms to describe other top performers. Among the other emerging market acronyms used to describe either top-performing or dramatically transformed countries in 2012 were SHIMP (South Africa, Hong Kong, India, Mexico, and Poland). Had Russia done better, that could have easily morphed into SHRIMP. Then there was CAPPT, which stands for Chile, Argentina, Peru, Philippines, and Thailand, followed by BELL, a reference to the once-beleaguered economies of Bulgaria, Estonia, Latvia, and Lithuania. And in a recent critique of microeconomic meddling in BRIC, Financial Times contributing editor Sebastian Mallaby concluded ROCK (Rwanda, Oman, Colombia, and Kazakhstan) could teach BRIC how to regain momentum.
4 Credit Suisse Global Investment Returns Yearbook, Credit Suisse Research Institute, February 2010.
5 The MSCI Emerging Markets Free Index is a free-float-adjusted market capitalization index designed to measure equity-market performance in the global emerging markets.
6 Bunt Ghosh, Andrew Garthwaite, Paul Fage, Mark Richards, "Emerging Markets: Developing a Structured Approach to Country Allocation," Credit Suisse, June 2012.
Risks to Consider: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Investing in small and mid-sized companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity. Investing in international companies generally poses greater risk than investing in domestic securities, including greater price fluctuations and higher transaction costs. Special risks are inherent to international investing, including those related to currency fluctuations and foreign, political, and economic events. The securities markets of emerging countries tend to be less liquid, to be especially subject to greater price volatility, to have a smaller market capitalization, and to have less government regulation, and may not be subject to as extensive and frequent accounting, financial, and other reporting requirements as securities issued in more developed countries. Further, investing in the securities of issuers located in certain emerging countries may present a greater risk of loss resulting from problems in security registration and custody or substantial economic or political disruptions. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential, as well as their volatility, can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. No investing strategy can overcome all market volatility or guarantee future results.
Neither diversification nor asset allocation can guarantee a profit or protect against loss in declining markets.
Indexes are unmanaged, do not reflect deduction of fees or expenses, and are not available for direct investment.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.