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Invest in Emerging, Not Submerging, Economies

Schroders' Allan Conway questions why one would want to invest in the 'submerging' developed economies when emerging economies offer such opportunity

Holly Cook 7 December, 2010 | 9:53AM

Holly Cook: For Morningstar, I am Holly Cook. Joining me today is Allan Conway. He is Head of Global Emerging Market Equities at Schroders.

Allan, thanks for joining me.

Allan Conway: Pleasure. Thanks.

Cook: So, Schroders' emerging markets team manages $26 billion of assets in the region. You've got funds in emerging markets, in BRICs, you are about to launch a frontier markets fund, can you explain terminology-wise, what are the differences between ‘developing’ markets, ‘emerging’ markets and ‘frontier’ markets?

Conway: Sure. Yeah. There is actually no accepted definition, but the starting point tends to be on GDP per capita. So, very simply, economies with a GDP per capita above about $11,000 would be developed, between roughly $1,500 and $11,000 would be emerging, and underneath that that would be frontier. Having said that, there are lots of exceptions and that comes down to openness of markets, the ease of moving money in and out and other regulatory requirements. So, it is not an easy answer, but broadly speaking it's based on degree of development.

Cook: So, I guess the key question is, why would investors want to invest in emerging markets at all?

Conway: I'd almost turn the question the other way, why on earth would you want to invest in what are now called developed markets? I'd rather – they are really the dinosaurs of the economic world. I think you could call the world today as split between emerging and, if you like, ‘submerging’.

The developed world is now hindered by a massive degree of debt—the ball and chain around the necks of these economies is going to take them years to get out of that. They have got adverse demographics. Japan, as we know, is shrinking in population. Europe, the U.S. are looking quite similar. They really are yesterday's story. In a good year you might see these economies jump for joy if they are growing at 2.5%, more likely it's going to be less than that.

Today emerging markets account for something like 65% to 70% of growth in the world. Economic power is clearly shifting eastwards. The arrival of China and India, 2.5 billion people, that's dramatically changed the economic landscape and the strong economies today, the economies that dominate global growth, are the emerging economies. So I think the question is why on earth would you want to invest anywhere other than these economies?

Cook: Given the dichotomy that you described, emerging markets were actually already a fairly popular destination for investors' assets, and increasingly so recently, which has obviously led to talk of overheating. What's you take on that?

Conway: There are some issues there—people are getting concerned about inflation in emerging, but we are way, way off a bubble. One of the things I have just put together in my presentation is a little cartoon of this strong body-building fellow blowing up a balloon and the balloon is starting to inflate, but it’s a long, long way from bursting. In fact, as he is blowing up this balloon, it probably won't burst until about 2012. It is going to take at least a year to get this balloon blown up enough to bursting point.

I have got opposite him this wizened old man, who just hasn't any air in his lungs at all to remotely blow the balloon up. There are various arrows coming in at these balloons; the little old man, not only is his balloon not blowing up, but if he were to get any air in it, it will be burst pretty quickly because these arrows—marked by double dip and euro crisis and massive debt—are going to ensure there is no air that gets into that balloon.

There are some balloons [arrows] heading towards the emerging, this big strapping fellow, most of them are going to miss—things like double dip and debt, these are issues coming from the submerging world, as I call it. The only one issue in the emerging world that people are concerned about is inflation—we think those [concerns] are overdone. But today emerging markets are on a prospective P/E of 11.5 times—that’s nowhere near bubble territory. Ultimately, it's quite likely we'll end up in a bubble; there's massive liquidity coming into emerging, investors really now deciding that you've got to have strategic exposure, not just tactical exposure to emerging. So I think in the end we'll see a bubble, but I think that's a story probably for 2012. When you see a prospective P/E of 17 times, 18 times and various other indicators where you've got excessive overvaluations, that's the time to get out. Between now and then, there's a lot more to go for.

Cook: So, the Schroder Global Emerging Markets fund is a flagship fund of the emerging market team. The latest top 10 holdings where all based in BRICs, plus I think a holding each in Korea and Taiwan. Are there any specific economies within emerging markets where you see particular opportunity or perhaps somewhere you would actually avoid because of political risk or so forth?

Conway: Yeah, I mean the countries that we are over weighted in the EMEA region, our key overweights there are Russia...Russia, obviously has problems, we all know that. There are corporate governance issues, but it's on a prospective P/E of just 6 times, almost half the level of emerging generally.

Whilst a discount is required for Russia because of the problems, that discount is way too big at the moment. So we think Russia looks very attractive. Obviously, it's helped enormously by the oil price and the oil price continues to be pretty strong. The underlying fundamentals in Russia are quite good. It's got its problems, but at 6 times they are already discounted in the price.

If we're looking at Asia, a key overweight there is Korea, South Korea and of course you mentioned politics and we've recently had the problems with North Korea, but periodically you're going to get those problems. It was interesting to note the stock market didn't particularly get affected by that.

I think you've got to remember in the world of emerging markets, the benchmark you hold them to needs to be slightly different. Just think earlier in the year, in Thailand you had the whole business district occupied and closed down, rioters on the streets, buildings being burnt down. You could imagine what the markets would have done if that had been in London or New York.

Actually Bangkok, despite that happening, Thailand was one of the strongest markets throughout the crisis and so far this year has been extremely strong. So I am not minimising political risk, but I am simply saying there isn't a uniform standard of political risk, but overall we like Korea in Asia, Brazil, and Russia are the sort of three key markets.

Cook: Now, I can't let you talk about Russia without talking about the World Cup. Russia has obviously just won the 2018 bid to host the World Cup. Is that going to have an impact on investment there or is it actually a phenomenon that plays out or just something that we prefer talk about?

Conway: It does. There is a World Cup effect and obviously with the sort of increased spending in infrastructure that's going to have a beneficial effect in the economy. The nice thing there is they are not going to have to massively run up debt to finance the infrastructure spending, they've got the reserves.

So yes, there will be an impact on the economy as the infrastructure spending increases. Typically, in the year or so before the event, stock markets usually sort of do fairly well, but we're talking about quite a few years down the road.

Cook: So, in your team, you have 34 investment professionals. How do you go about selecting the equities that are going to be the holdings within your funds?

Conway: Well, we take what is probably a slightly unusual approach. Most emerging managers focus purely on stock selection. If you look at emerging market performance in the past, it's absolutely clear that anything from 50% to 70% of the returns that you've achieved in the past have come from country selection. So, under our process, we aim to get 50% of our returns from country selection and 50% from the stock selection.

For countries, we use a quantitative model as our key guide and that's got a very strong track record. For stock selection, we have analysts in the field, throughout Asia, Latin America, Middle East, and Europe close to the companies, so the analysts are doing detailed fundamental research, talking to the companies and building models.

Cook: So, to sum up, you've described the developed markets as the ‘dinosaurs’ really, and you seem to very much see the emerging markets as a positive alternative for investors who wish to avoid the doldrums that we find ourselves in on this side of the world. Is that fair to say?

Conway: Well, I think that's absolutely right. As I mentioned earlier, emerging already accounting for 65% to 70% of global growth and that will simply continue. Economic power has clearly shifted eastwards and will continue to do so. I think economic historians, in years to come will view this period we're living through now as the peaking of U.S. and if you like G7 power, the moving of that power to what we call today emerging countries, led by China and India. And the great thing that's different today about investing in emerging markets in the past is that, historically, when you were putting money in emerging they were growing strongly but you had extra economic risk.

Today, the economic risk lies with the developed. If you look at where the strength is, in terms of foreign currency reserves, current account, fiscal account, on any measure, emerging today is stronger. Indeed one of the charts I've got in my latest pack is a sort of country X and country Y showing pretty awful profile. And if you looked at that slide 20 years ago, you'd said, okay, those are clearly emerging countries.

Today, it's the U.S. and it’s what Brazil used to look like. The U.S. today looks like everybody's idea of emerging markets 15 or 20 years ago. So when you invest in emerging today, you're not just getting strong growth, you're actually getting stronger fundamentals and less risk not more.

Cook: Well, thank you very much Allan, a very interesting perspective on global investing and emerging markets in general. Thanks for joining me.

Conway: It's pleasure. Thank you.

Cook: For Morningstar, I'm Holly Cook. Thanks for watching.

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About Author Holly Cook

Holly Cook  is Managing Editor of Morningstar.co.uk