For Emerging Markets It’s How, Not When 2
church or iglesias rosario dos pretos in pelourinho area in the beautiful city of salvador in bahia state brazil

This summer, emerging market stocks are experiencing a revival that’s nothing short of stunning. Spurred by yet more rate cuts in the developed world after Brexit, investors starved of yield—and tantalized by the sight of Brazilian stocks up 60% in dollar terms—are piling back in.

Investors poured more than $9 billion into emerging market (EM) equity funds in the six weeks ended Aug 10, 2016, the largest inflow over such a period in three years. The MSCI Emerging Market Index was returning 13.86%, year-to-date, compared with a return of around 5% for the MSCI World Index and 6.7% on the Dow Jones Industrial Average.

Is it time to join the throng? That’s the wrong question, says Ashutosh Sinha, lead portfolio manager of Morgan Stanley Investment Management’s Emerging Markets Leaders strategy.

Trying to get the timing right in a volatile asset class like this is nearly impossible,” he says. Instead, investors comfortable with the higher risks of emerging markets versus developed markets, should consider strategies that seek to generate more consistent returns, while staying invested during the asset class’s ups and downs.

“Investors have to stop thinking about EM in terms of piling in when it’s rallying and rushing out again when things go bad,” Sinha argues.

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His team’s analysis of MSCI EM index returns since 1988 suggests that a $10,000 investment made back then would now be valued at about $80,000. On the other hand, investors who hopped in and out of the market wouldn’t have seen anywhere near that return for the same time period.

Returns of the MSCI EM Index

 emerging markets

Past performance is not a guarantee of future results. The index performance is for illustrative purposes only and is not intended to predict the performance of any specific investment. Indices are unmanaged and their returns do not include sales charges or fees, which would lower performance. It is not possible to invest directly in an index. See disclosures for more information. Source: FactSet, MSIM EM Research as of July 2016.

Sinha is not suggesting that EM stocks need to be held for 28 years. Rather, the analysis of the index’s returns over time demonstrates that even missing out on upside a few months every year can defeat the purpose of buying EM stocks for return potential.

Investors also need to think about how they get exposure. Sinha benchmarks the performance of his strategy to the MSCI EM Index, but not slavishly so, because a broad, passive exposure might not work as well as it used to.

“Whatever you thought you knew about emerging market stocks, throw it out and start again,” says Sinha. “We are in a dramatically different world today than where we were when EM stocks last had a bull run [in 2003-2007]. Before 2008, the China-fueled boom in commodity prices was a tide that lifted all boats, but those days are gone.”

Today, the tide is out, and the troubles of some countries’ economies have been laid bare. “Growth is now lower, harder to find and uneven,” says Sinha.

Managing emerging market equity risk is part and parcel of Sinha’s aim to persistently outperform the index over a three- to five-year investment horizon, and is built in to every part of his stock selection process.

“We avoid companies in sectors with volatile earnings streams, like copper and steel stocks,” he says, as an example. He also skirts around large parts of the MSCI EM, like “old-China” sectors that boomed in the past—financials and industrials—but he believes hold little promise for future growth. Instead, he looks for sectors with long-term secular growth trends and, within them, companies offering long-term pricing power that can support growing profitability.

He prefers consumer staples, healthcare, drug manufacturers and global services—even financials in certain countries with favorable credit trends. “We like financials in Peru because debt-to-GDP is 40% and has a lot of room to grow. But you wouldn’t buy financials in China, where it’s 230%.

Bad Seeds

Once he finds those companies, he’ll scrutinize the management, to ensure that it has the shareholders’ interests top-of-mind. “In the emerging markets, you could find an interesting growth sector and a company that’s making money, but the management is siphoning off the profits for another business,” says Sinha.

And all bets are off if the stock is in a country that’s unstable. “EM is not like developed markets, where you can say, ‘I like this company, it’s cheap, let’s start buying.’ When there are riots in the street, the whole picture changes.”

When all of these hurdles are cleared, the stock’s price, the most crucial risk-mitigating and return-generating factor of all, is taken into account.

“We strive to build in what we consider to be a “margin of safety” by making sure that we’re not buying a stock that’s rallying because of market momentum. It has to be cheap enough to give us good return, as well as an additional buffer against market volatility.”

It’s a grueling selection process, but if done right, Sinha believes it’s possible to generate more consistent competitive returns from emerging market stocks over time—and without the stress of timing the markets.

Ashutosh Sinha is a Portfolio Manager on the Global Emerging Markets team, focusing on the Emerging Markets Leaders strategy.

As originally appears

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