Developed markets are “tapped out” and saddled with “the biggest debt burden that they’ve had since 1929,” said Lee Partridge, CIO of Salient Partners, in relation to developed markets.
With China, too, showing signs of slowdown, this makes emerging markets “a very powerful story,” and explains why investors are increasingly seeking growth in previously untapped markets, according to Partridge.
But, as Donald Lindsey, CIO at George Washington University pointed out, “it’s important not to confuse growth with profitability,” as high GDP growth doesn’t necessarily imply high profitability and high equity returns.
The complexity of navigating emerging markets can produce a variety of views, even from Institutional Investor’s award-winning Money Masters, who gathered the morning after the award ceremony for a wide-ranging roundtable discussion. (Our Money Masters also talked at length about J.P. Morgan's trading losses.)
With Institutional Investor Editor Michael Peltz and Senior Writer Frances Denmark steering the conversation, Partridge and Lindsey were joined by Robert Manilla, CIO, Kresge Foundation; Lawrence Schloss, CIO of the New York City Employees Retirement System; and Sean Gissal, CIO at Marquette University.
What follows are excerpts of the portion of their discussion related to emerging markets.
Lee Partridge: The whole idea of public equity markets being the mainstay of a portfolio is a very recent phenomenon. That is not how money has been invested for thousands of years. That is a product of the 20th century and one very loudly-spoken Wharton professor, who advertised that stocks were the only way to get to the returns that you needed as an investor. That simply isn’t true. The reality is this is definitely a tale of two cities. Seventeen percent of the world’s population lives in developed markets. They are tapped out. They have the biggest debt burden that they’ve had since 1929, and they’re going to be working that off for a long period of time.
Robert Manilla: We think that there are interesting opportunities in emerging markets, but the opportunities are dramatically changing from four to five years ago. You’re beginning to see different types of assets become investible that weren’t investible a few years ago. Since we have more emerging market exposure than just about any foundation in the country, we tend to look at things from a GDP-weighted benchmark, but we do that for growth assets, not across the portfolio. We think for hedge funds, for example, you’d only do that if you think there’s an interesting idea in hedge funds, and that’s a big chunk of our portfolio. In the fixed income space, we don’t necessarily view that as the same opportunity set, because they’re not as developed, so we don’t split that one. But all of our growth assets -- that’s our benchmark -- are GDP-weighted around the world, as opposed to using the MSCI World [Index]. We’ve been doing that for six years now.
Larry Schloss: Can I ask one emerging market question? When you look at emerging markets, is Nestle an emerging market company?
Lee Partridge: It is. I think you have to be aware of that. Because is PetroChina in an emerging market country that’s exporting principally to developed markets? That’s a big question. I think the domicile of the country versus the consumption base that’s driving the growth of that company are two different things, and you have to be very aware of that.
Schloss: I would say it’s a more efficient way to get to country markets.
Partridge: Small cap emerging is very different — it plays on emerging consumer demand directly.
Donald Lindsey: I think there is a difference between companies that derive a bulk of their revenue and income in some emerging markets and companies that are positioned in the emerging markets. What we try to do within our portfolio is have regionally based managers. So our Latin America manager is in Rio. We have Asian managers in Singapore. There are a lot of factors — cultural, social, political. Consumer preferences vary dramatically from region to region, even within countries. Depending on where you are, consumer preferences can be very different. So having somebody on the ground is important, but that’s tough to do. It’s exponentially more difficult to find those managers, but I think it’s the right way to go about it, as opposed to having somebody in Boston or New York or Chicago managing the emerging markets portfolio.
Manilla: We’ve taken it one step further, we don’t even do regional. We just do country. So there’s a China guy, a Brazil guy, etcetera.
How do you decide where you want to be in emerging markets?
Manilla: On the margin, we’d rather be in emerging markets than elsewhere, so that’s step one. We looked at the development of their capital markets, and it naturally led you to China and Brazil before India, for example. You can play Eastern Europe a little bit simpler, there are other ways than actually having to find a manager in some of those markets. So we start in China and Brazil and it took us a long time to find good, active managers in India. I think China was pretty easy. The typical modus operandi for a Chinese manager was somebody born in China, educated in the U.S., worked in the U.S. and then went back to China, and those were the guys that we tended to find across asset classes that have done well.
Are there places you’re avoiding such as Russia?
Manilla: We used to play in Russia in the public markets with a manager in Russia. We think there’s actually much better opportunities in the private markets in Russia so we do some private stuff in Russia. The public markets are not an interesting way to play Russia at all.
Lindsey: I think Russia is tough. They’re a resource play but given the structure and the corruption and the legal system it’s difficult.
Manilla: The private market in China is getting difficult because of the rising renminbi funds, so you have to pull your head out of the sand. The guy investing dollars in China today is at a huge disadvantage to the local renminbi funds. You need to think through if you still want to be a private investor in China.
Schloss: I’d be very careful of privates in emerging markets. You need a rule of law in private assets. And you talk about liquidity: that’s illiquid, plain and simple. If you listen to private equity investors, they’ll all tell you horror stories about investing in emerging markets. Because besides the political risk, I think you’ve compounded the exit risk and the timing for this to the point that if you add risk premiums for that you’ll convince yourself not to invest there. By the time you get in -- if it’s an emerging market it has booms and busts -- you can’t get out: you missed it.
Lindsey: Right now I think public markets are so attractively priced that it’s harder, particularly in emerging markets, to identify the right premium that justifies the greater risk. I’m sure there’s opportunities out there but I just see the best opportunities in the public markets. We’ve looked recently and will continue to look at Africa. The capital markets are small there but they’re growing. And you also have a lot of African multinationals that are listed on European exchanges, not necessarily in exchanges within Africa.
Schloss: When you try to add the illiquidity premium to it you price yourself out of local private equity markets. The people who are in charge in the emerging market country are playing an inside game that you’re not playing. You add a couple of risks, you add a currency risk, you add a governmental risk, and before you know it you could lose basis points of return and the market is trading under that. So you lose bids all the time. I think it’s very difficult.
When you invest in emerging markets, is that primarily a growth story or in this kind of market are there distressed opportunities as well that are equally attractive?
Sean Gissal: One of the things we’ve done over the last couple of years is, as we’ve added to emerging markets, we’ve tried to look at the world from some of the variables that have been mentioned today such as GDP being a key indicator. We’ve tried to say we believe that long term asset prices will go up. Where do we get that portion? So we wanted to invest in emerging markets. But then we also said to ourselves, “Volatility isn’t a good thing.” So for Marquette having to make its annual payout and not wanting to reduce scholarships, how do we give ourselves the smoothest ride? When we broke the world apart we saw some of the debt ratios. The more debt that a country is going to have, the more volatility that we would assume would go along with that.
Partridge: Echoing what Sean said, I think all emerging markets have a growth story embedded in them. They’re infused with growth. That’s one of the reasons that we’re attracted to them. If you look at China and India, you have two and a half million people that are future consumers with a much more positive demographic pyramid than what the developed markets experience. That’s a very powerful story. Now China’s population pyramid is going to turn over in 10 years and it’s going to look entirely different but for now you’ve got a lot of consumers that are driving consumption patterns much like the baby boomers did here for a long time. We don’t have that as a tailwind any more. The baby boomers are all exiting the consumption pool. Latin American and Eastern Europe are also natural resource stories that not only had internal demographics that are positive, but also support growth in Asia.
One of the things we’ve noted is, when you look at all these great returns on a local basis and you control for the currency, the currency explains a tremendous amount of the relative country returns that have been received. And one really easy way to get emerging market exposure without having to worry about the idiosyncratic risk in the companies is to just have exposure to the currency. So you could have the S&P 500 denominated in reals or renminbi and experience an S&P return that has a full currency effect of another growing country, which is an interesting position to have. I think the currencies are oftentimes a better way to play the growth directly than trying to pick the companies.
Manilla: We just did a small investment in China in non-performing loans and special situations, which didn’t exist six, seven years ago. It’s a group I’ve been following for four and a half years. It’s a small investment. But that was my point -- these markets now are moving past just being able to sell their equity or their sovereign debt, in the case that they have sovereign debt. We’re beginning to see some opportunities come up in markets that weren’t there three or four or five years ago.
Lindsey: I think it’s important not to confuse growth with profitability. We have high GDP growth that doesn’t necessarily imply that high profitability and high equity returns will be there. I think the story is the growth in discretionary spending per capita. Many emerging market countries are now at a tipping point where there’s a developing middle class that’s spending dramatically in different patterns than what they did when they made much less money. Diets are changing, demand for consumer goods like toothpaste and things that we take for granted — look at cell phone penetration in emerging market economies. The developing middle class is the key driver.
