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Finding Safe Stocks in Battered Emerging Markets
The key to finding value in fragile economies is to pick stocks whose performance is independent of their domestic currencies.
Many emerging markets have had a rough start to 2014, owing to a toxic combination of continued tapering by the U.S. Federal Reserve and political crises at home. The MSCI emerging-markets index has fallen to its lowest level since June 2013.
Members of what has become known as the fragile five have suffered the largest declines: Brazil, Turkey, South Africa, India and Indonesia. International investors have exited these markets in recent months in large part because of high current-account deficits, funded by foreign capital that may disappear as the Fed reduces liquidity it pumps into the U.S. economy. For example, Turkeys Borsa Istanbul 100 index is down more than 18 percent on the year.
Despite the attention paid to the fragile five, it is hard to find emerging markets that have performed well. Russia has a persistent current-account surplus, worth $33 billion in 2013, but the RTS index of 50 Moscow Exchange stocks has tumbled 17 percent over the year, including an 8 percent fall in January alone hit, say analysts, by a general retreat from a wide range of emerging markets in response to the Fed and continued fears about the countrys underlying economic growth.
Some believe, however, that investors ultra-sensitive reaction to the Fed taper allows nuggets of gold to emerge. In many cases, these nuggets are all the more attractive because they have been caught up in the general sell-off, regardless of their individual quality. Emerging markets around the world are universally hated, creating great opportunities for bottom-up stock pickers, says Alper Ince, managing director and sector specialist in long-short equity and event-driven equity at Pacific Alternative Asset Management Co. (Paamco), an Irvine, Californiabased fund of hedge funds firm with $9 billion in assets under management.
One potentially rewarding strategy is to pick stocks within sectors driven by trends that have little to do with the vagaries of the individual emerging markets economic performance.
Sam Mahtani, director of emerging-market equities at F&C Asset Management, a London-based asset manager with £82 billion ($136.8 billion) in assets under management, sees opportunities for share appreciation of large retailers in emerging markets with fragmented market share. This fragmentation will, he says, allow them to gain more ground on local mom-and-pop stores, which find it difficult to compete on price and service.
One such group is supermarket chain Magnit, Russias largest retailer. Mahtani remains optimistic about Magnit, despite downbeat forecasts about Russias gross domestic product. The Russian government predicts annual growth of only 2.5 percent until 2030. Were not so concerned about a recovery in Russian GDP growth, says Mahtani. Magnit can grow by increasing penetration across the country and taking market share from others.
Companies as large as Magnit can fall prey, however, to a particular danger. They are big enough to attract the attention of flighty international equity investors, who are far more prone than domestic investors to bail out at any sign of trouble. Magnit fell 8 percent in January as international equity investors pulled more money out of Russia, though it is still up 47 percent on the year. Such declines could present opportunities for bargain hunters. But they could be also a precursor of further falls.
Another strategy is to pick well-managed companies that have fallen out of the global limelight. Mahtani also recommends Mandaluyong City, Philippinesheadquartered supermarket chain Puregold Price Club for many of the same reasons as Magnit: a consolidation play in a fragmented national market. With a market capitalization of only 106 billion Filipino pesos ($2.38 billion), however, Puregold is too small to make a blip on international equity traders radar screens.
An alternative strategy for less risk-averse investors is to go down the opposite road: buying companies caught up in emerging-markets turmoil that have suffered sharp price declines despite strong fundamentals. George Birch Reynardson, frontier-markets investment analyst at London-based Somerset Capital Management, with $3.8 billion in assets under management, cites as an example Bolsa de Valores de Colombia, the South American nations monopoly stock exchange. Hit by a sharp decline in foreign interest in Colombias equity market and the 2012 collapse of Interbolsa, the countrys largest brokerage, Bolsa de Valores de Colombia has experienced a 35 percent drop in price over the past 52 weeks, to a low of 20.60 Colombian pesos, worth negligibly more than one U.S. cent. The stock closed at 21 pesos on February 19. A year ago we wouldnt have been interested in the stock because it was too expensive, he says. Now that the price has come down, however, there is some sort of upside. Birch Reynardson believes that recent reductions in commissions will help restore trading volume.
A final strategy adopted by some emerging-markets investors has been to find stocks with very little exposure to their troubled home countries. Paamcos Ince cites stocks based in two fragile five economies.
One is national flag carrier Turkish Airlines. Its stock is trading at a bargain-basement 7.4 times forward earnings, says Ince, because of investor fears about Turkey. Yet, says the Turkish-born Ince, I dont see it as a domestic play but as a transit play on growing air traffic as Istanbuls Atatürk Airport positions itself as an international hub. In particular, Turkish Airlines has bulked up its service to sub-Saharan Africa, including direct service from Istanbul to Ouagadougou (in Burkina Faso) and Douala and Yaoundé (Cameroon).
The second is Mondi, a paper and packaging maker headquartered in Johannesburg. It holds a double attraction for Ince. Globally, the paper and packaging industry has been consolidating, increasing manufacturers pricing power. In addition, 60 percent of Mondis profits stems from outside emerging markets, with only 10 percent from South Africa.
Mondi is particularly strong in Europe, which accounts for 50 percent of its sales. Investors should look at Mondi as a European recovery play, which we see becoming a consensus trade, says Ince.
Inces recommendation of a stock precisely because of its heavy European sales and relatively low emerging-markets exposure suggests how far the markets have come over the past year. At the beginning of 2013, many investors would have wanted precisely the opposite.
But whereas there are attractive individual emerging-markets stocks, their high performance in local currency terms means nothing if those currencies continue to suffer. The Turkish lira, for example, has lost more than 20 percent against the U.S. dollar during the past year.
But Mahtani believes emerging-markets currencies will stabilize. Currency rises and falls can overshoot in the very short term, he says. However, as investors we are taking a longer view than this.