A P: Emerging markets: On the winning track

Emerging markets remain the place to be in for serious investors.

Emerging markets (MSCI EM Index) outperformed developed markets (MSCI World Index) in each of the last four years, and are currently on track to do so again in 2005.

So far this year emerging markets are about 700 basis points ahead of the developed markets, positioning them for their fifth consecutive year of outperformance.

This outperformance has been delivered in both bull markets and bear markets, with the emerging markets' universe delivering smaller negative returns (than MSCI World) in 2001and 2002 and much stronger positive returns in 2003 and 2004.

The extent of outperformance was also quite extensive, with the EM universe having a performance edge of at least 10-15 per cent per annum.

After such an extended period of out-performance, the inevitable questions get asked again. Can this last? Have we not already reached a stage of euphoria? When will the next crisis erupt? Should one not cut back on EM exposure?

When trying to think through the answers to the above questions, it really all boils down to one's view of how secular the change in the riskiness of the asset class is, and how over-extended the sentiment is.

If one believes that the emerging markets are simply highly leveraged bets on global growth, excess liquidity, or commodities, then clearly a case can be made to trim one's holdings.

In that case, relative performance has probably hit a cyclical high, and things can only revert back to the mean from here onwards.

To continue to hold an overweight position in the asset class from here requires fundamental belief in the improved micro and macro fundamentals of the asset class.

One has to fundamentally believe that these economies have made huge strides in reducing their dependence on foreign portfolio and debt flows, dramatically reducing their susceptibility to external shocks.

One has also to believe that the vastly improved returns delivered by the EM corporate sector (RoE of 16.5 per cent, the highest of any region in the world) are not just due to high commodity prices but serious restructuring and changed micro level behaviour.

The resilience and strength of these economies are demonstrated in their ability to weather the oil price shock, with as yet no serious macro imbalances developing.

In prior periods, oil at $60 would have been enough to knock many an emerging country into serious macro imbalance.

The external indicators of most of the countries in the EM universe are also significantly better than their peers in the OECD.

Further testament to the improved EM risk profile is the sustained decline in equity volatility to the 15 per cent range over the past 12 months, a level comparable to the long-term average volatility of Europe or the US.

The easy money in the emerging markets in that sense has already been made; now is the time when one's conviction will be tested and you will have to decide as to how much of the secular story you really believe.

If you do not believe that there has been a fundamental improvement in the quantum, quality and sustainability of growth in the emerging markets universe, then now is as good a time as any to take your money off the table.

As for how over-extended the cycle is already, one can look at valuations and flows.

As far as valuations go, there still seems to be little reason to worry. The EM universe still trades at a 34 per cent P/E discount and 23 per cent P/B discount to MSCI World (source: Morgan Stanley), despite having the highest RoEs in the world at 16.5 per cent.

Along with the highest RoEs, the EM universe also has faster earnings growth and one could argue less external vulnerability.

While these valuation discounts have narrowed quite significantly from the doom and gloom days of 1997-98, they still are a far cry from the premium valuation multiples these markets exhibited in 1993-94 (the last time global investors fell in love with the asset class).

With strong relative earnings growth prospects, leading RoEs and arguably less external vulnerability than most of the OECD economies, valuation discounts have scope to narrow further from here, and do not seem to be in any zone of irrational exuberance.

As to those who argue that profit margins and RoEs in the EM universe are overstated due to high commodity prices, the fact is that margins are at all-time highs globally and not just in the EM universe.

As far as flows are concerned, once again things do not seem to have gone to extremes. According to the MSCI hedge fund indices (through end of May), emerging markets were tied with Europe as the best performing geography for hedge funds (up 2.6 per cent, compared to -.3 per cent for the overall indices).

Among mutual funds, Latin America and Asia-Pacific funds are also leading the pack globally up 7-9 per cent YTD.

With new flows invariably chasing performance, the implication of the above performance numbers is that significant new chunks of money are likely to be allocated to the EM asset class over the coming months and quarters.

There is also substantial scope for additional flows as even today EM funds account for less than 1 per cent of US equity mutual fund assets, despite these markets having a 6 per cent weighting in global equity benchmarks.

Allocations even today remain below the 1994 peak, when these markets accounted for 1.05 per cent of all US equity mutual fund assets.

Today the figure stands at .97 per cent (source: Morgan Stanley). Simply going back to the last peak would imply a further additional inflow of 9 per cent of all current EM assets, a significant number.

Also there is absolutely no reason why flows cannot exceed the previous peak, as the accessibility and understanding of these markets have improved dramatically over the past decade.

New vehicles such as ETFs (exchange traded funds), which have opened up access to the EM universe for a whole new class of investors, did not exist for these markets in 1993-94.

The institutional returns gap between the financial returns pension funds/endowments need and can expect with a conventional asset allocation strategy continues to expand.

This will continue to drive higher allocations towards notionally higher risk/higher return assets like EM equities.

The flood of money into emerging markets from this pool will continue.

Now is the time when one's conviction and belief in the emerging markets will really be tested. The temptation will be to trim the EM asset class on the first signs of market weakness, and while that may be the right thing to do from a short-term viewpoint as weak holders get shaken off, I still remain a believer in the long-term prospects of these markets.

Short-term underperformance aside, these markets remain the place to be in for most serious long-term investors.

Most global investors still do not comprehend the extent of change, quality of micro-level opportunities and long-term shift in the balance of economic power in the emerging markets.