If Exxon Mobil shares seem a little pricey at a multiple of 22, how about Yukos Oil instead at a P/E of 7?
By Charles Keenan
July 2002
Institutional Investor Magazine
There aren’t a lot of bright spots in equities these days, but emerging markets have regained some of their former luster. As measured by the S&P/IFCI composite index, these fledgling bourses gained 9 percent through mid-June, against a 12 percent loss for the Standard & Poor’s 500 index. Anyone with a sense of history, however, would add this sobering statistic: The S&P/IFCI index remains 16 percent below its 1996 high.
Despite the chronic volatility of emerging-markets stocks -- and setting aside disaster zones like Argentina, where local shares have dropped 70 percent this year -- many portfolio managers believe the recent outperformance is sustainable. As always, they are lured to these markets by attractive valuations and fast-growing economies. Today there’s an added inducement: a suddenly suspect U.S. dollar, whose weakness benefits U.S. shareholders venturing overseas.
Money managers’ recent shift into emerging markets differs from previous forays. They are not focusing exclusively on leading exporters (with oil selling at $26 a barrel, Russian petroleum producers are an important exception). Instead, investors are betting that maturing consumer markets in developing nations will lessen dependence on exports, increase economic stability and fuel growth, boosting corporate profits and share prices.
“Emerging markets are finally delivering on their promise of diversification, and consumer demand is one of the key components of that,” says Sam Wilderman, a portfolio manager at $1.8 billion-in-assets GMO Emerging Markets Fund, which had risen 19 percent as of mid-June. “The growth picture going forward is much stronger than in the developed world.”
Where are the best prospects? China, Russia and South Korea are among the favorites of emerging-markets specialists. Growth in all three is strong -- GDP is projected to increase this year by 8.3 percent in China, 20 percent in Russia and 5.7 percent in South Korea, according to DRI-WEFA, an economics consulting firm in Lexington, Massachusetts. The firm expects consumer spending to grow even faster: 11 percent in China, 25 percent in Russia and 7.7 percent in South Korea.
South Korean stocks were up 32 percent through mid-June, and Chinese shares had gained 2.2 percent. The still-raw Russian stock market had risen 46 percent, as investors bet on the country’s continued economic and political stability.
Less than four years after the collapse of the ruble, Russian President Vladimir Putin has taken steps to reform the financial system. In March he replaced central bank governor Viktor Geraschenko with Sergei Ignatyev, the respected former deputy to the finance minister. Foreign investors viewed the move as a tentative endorsement of economic liberalization.
In Russia’s case, strong oil prices represent a clear boon for one of the world’s largest petroleum exporters. That’s one reason Brian Wolahan, a senior portfolio manager at $41 million-in-assets UAM Acadian Emerging Markets Portfolio (up 17 percent through mid-June), finds Russian stocks attractively priced at just seven times estimated 2002 earnings, even after the run-up they’ve had.
“The stocks are still pretty cheap,” says Wolahan, who keeps 8.5 percent of his assets in Russian equities, versus 6 percent for the S&P/IFCI index.
Not surprisingly, he has loaded up on petroleum producers. His fund started purchasing American depositary receipts of Yukos Oil in February at $98, eventually building a position representing 5 percent of his portfolio at an average cost of $117 a share. In mid-June the stock was trading at $152. Even so, Yukos shares are still inexpensive relative to U.S. oil companies, trading at seven times projected 2002 earnings, versus 22 for Exxon Mobil Corp. Acadian has owned Lukoil Holding since February 1998, buying at an average price of $37 a share. It is Russia’s largest vertically integrated oil producer, with estimated reserves of 14.2 billion barrels. After treading water for a time, Lukoil shares bottomed out at $36.76 last October, but then moved steadily up through May when Acadian sold shares -- representing 1.2 percent of its portfolio -- at $66.13. Although Wolahan has sold off 55 percent of his Lukoil position, the shares still make up about 1 percent of his portfolio.
“It shows that patience is often needed in emerging-markets investing,” Wolahan says.
Other managers are equally bullish on Russian energy producers. “You have some wonderfully run companies selling at a massive discount to global valuations because of perceived riskiness,” says GMO’s Wilderman.
He’s betting on natural gas giant Gazprom, which represents about 1.3 percent of his fund’s holdings, judging that it will continue to grow faster than its global rivals. Gazprom holds 22 percent of the world’s known gas reserves, delivers 23 percent of global gas production and supplies 30 percent of Europe’s demand. Wilderman has had a position since May 2001. His average price: 51 cents a share, versus a recent $1.03.
Telecommunications companies in emerging markets present another area of opportunity. Certainly, many of these wireless companies look considerably more appealing than their beaten-up Western rivals.
When Russia’s Mobile TeleSystems sold ADRs at $22 a share in a June 2000 IPO on Nasdaq, Frank Chiang, a portfolio manager at $138 million-in-assets Montgomery Emerging Markets Fund, initiated a position that now makes up 1 percent of his portfolio. The company, using technology from major stakeholder Deutsche Telekom, claims a 33 percent share of the national market and 60 percent of the Moscow region. Granted, only 5 percent of Russian households own a cell phone, but that’s projected to jump to 40 percent by 2006 -- an obvious bonanza for Mobile TeleSystems. As a result, its shares recently traded at 30, off their January high of 40, but still way up from the IPO. “Mobile TeleSystems is about to explode,” says Chiang, whose fund was up 5 percent through mid-June.
The bullish case for China: Beijing will continue to remove barriers to foreign investment, a condition of its World Trade Organization membership. “China is what we call growth at a reasonable price,” says Wolahan. While GDP gained an annualized 7.6 percent in the first quarter over the same period a year ago, inflation is a tame 0.6 percent.
Wolahan has done well with China Mobile, which averaged 65 percent annual growth over the past four years as one of only two players in the Chinese cellular phone market (the other is China Unicom).
Other emerging-markets funds have turned to nontech names, including Chinese consumer companies such as Giordano, a casual wear retailer that makes its own jeans and T-shirts. Liu-Er Chen, portfolio manager at $200 million-in-assets Evergreen Emerging Markets Growth Fund, which had gained 12 percent through mid-June, likes the company’s low cost structure and the quality of its manufacturing operations. Evergreen bought shares in January at HK$3.90 ($0.50), and the stock reached its target price faster than expected, prompting Chen to take profits on a 37 percent gain.
Selectively, the Evergreen fund is also purchasing shares of Chinese exporters. It owns Techtronic Industries Co., a low-cost maker of power drills that supplies such major American retailers as Home Depot. The fund bought shares in June 2001 at an average price of HK$2.89; they recently traded at HK$6.50.
South Korea inspires some of the most intense bullishness. Managers cite strong consumer demand sparked by low interest rates and recent reforms that effectively cleaned up the country’s beleaguered banking industry. Unlike their Japanese counterparts, South Korean banks have been quick to write off loans and tighten lending practices, paving the way for greater economic growth.
“Korea is beginning to have a domestic sector,” says Aaron Low, a Singapore-based emerging-markets specialist for Pacific Investment Management Co.
In September Montgomery’s Chiang and his colleagues noticed consumer demand had taken off in South Korea. Looking for solid retail names, the fund that month bought Shinsegae Co., a department store retailer that had traditionally catered to the upper class but was now going after middle-class suburbanites. The fund purchased shares at 80,000 won ($66.72); they recently traded at W200,000.
The fund also paid an average W15,000 a share for a stake in Hyundai Motor Co.; the stock recently traded at W45,000. The automaker has benefited from a surge in sales -- up 18 percent for the month of May year over year.
Gains like these are a far cry from the dark days of 1997 when the Asian financial crisis pummeled emerging markets. “These asset classes are coming back to life,” notes Acadian’s Wolahan. Quite simply, he says, they offer good value. “If you are looking at multiples, these stocks can be really cheap when you compare them to U.S. or European stocks in the same sector.” After all, a barrel of oil from Yukos sells on the open market for the same price as a barrel of oil from Exxon Mobil.
