31 Oct 2014

Waiting For Growth No Longer, Emerging Markets Take Action

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Waiting for Growth No Longer, Emerging Markets Take Action
by Mihail Dobrinov, CFA , Portfolio Manager

Waiting for the healing power of high growth in this post-crisis world has sometimes felt like waiting for Godot – endless and futile. For emerging-market investors this has become painfully obvious – exports to developed markets are still weak, margins have declined, and our markets have underperformed
since 2010. The derating of emerging equities has been rational: average ROE has declined to the level of developed markets and, for the first time in decades, they no longer command a premium. Emerging markets have been slow to adjust to the new environment, but are starting to do so. Let us
review the problem – neither a spending binge from U.S. consumers nor a massive investment program from the Chinese government is a likelihood any time soon; real interest rates globally are close to zero, so central banks have limited new help to offer; the markets for goods, services, and capital are
now truly global and competition is fierce; and finally, income levels and wages in emerging markets have risen tremendously over the past decade, eroding relative competitiveness. So how are emerging countries to prosper, and emerging stocks to regain their edge and outperformance in this new

The answer lies in applying a large dose of self-help; not just waiting for growth to happen along, but taking steps to create it. That means boosting productivity growth, reducing operating and capital costs, improving profitability, and returning more capital to shareholders. At the country level, this
means structural reforms; at the firm level it requires prioritizing return on capital, rather than growth at any cost. These changes are necessary, but neither of them will be easy or popular, and some attempts will stumble.

We find it encouraging that some of these shifts are already taking place. Last year, we saw sweeping reforms in Mexico, unthinkable just a few years ago, which over time should boost growth by more than one percentage point. Indian voters just handed Prime Minister Narendra Modi the strongest
reform mandate any Indian government has ever had, because the priorities for the rising middle class are jobs and growth, not subsidies and protectionism. Chinese leaders have also embarked on painful, but necessary, reforms of the economy and are cleaning up and restructuring the notoriously inefficient state-owned enterprises.

Capital spending as percent of sales in emerging markets is expected to decline by more than two percentage points this year – the first since 2009. Profit margins have stabilized and are expanding slowly. These are good first steps towards improving returns on invested capital. Taiwanese corporates
have substantially increased their dividend payouts over the past few years and have been rewarded with higher valuation multiples. Korea may be next, if the government adopts a proposed law that penalizes capital hoarding and encourages higher dividend payments.

Importantly, this is good news for stock pickers, because stock-specific factors will increasingly determine relative performance in the future. Over time, countries and companies will fall in one of the two categories – those that get it and do the right thing and those that don’t. Stock selection has worked well in emerging markets. During the heady growth years, however, a large beta tilt could deliver outperformance. In this new lower-growth environment, alpha will assert its primacy.


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