This article is part of the Morningstar's Guide to What the Experts Say. Click here for our edit on what the professional investors think about economics, equities, bonds, financial advice and portfolio construction.
Emerging markets are not the place for investors to be for the long term – the fundamentals trotted out by most fund managers are false.
Controversially, this is the opinion on one leading emerging market fund manager, BlackRock’s Sam Vecht, who says for the first time in a long time he is positive on his asset class – but investors should proceed with caution.
“Most emerging market managers trot out four reasons why investors should buy into their fund,” he said.
“That emerging economies are growing, that they have little debt, that stocks are cheap and that you are buying into the consumer of the future. All four of these reasons are either misleading or untrue – or both.”
In fact, emerging markets have been flat for the past eight years, returning nothing to investors – with some academics from the London Business School claiming that emerging markets have underperformed for more than 100 years, since 1900.
Add to this, the fact that most managers tend to underperform this lacklustre benchmark – around 85% of active funds underperform the composite index – and you can see Vecht’s point.
Speaking at the recent Morningstar Investment Conference, Vecht said that corporates in emerging markets are not run for shareholders, but for the state, the family and “Mr Big”.
“Government, management and sentiment are all more important when it comes to emerging market investing,” he said. “Even in a good year at some point you will lose 20% at some point as all investors want in or out of the sector at the same time.”
Unlike with developed markets, Vecht claims that asset diversification in emerging markets is pointless.
“Diversifying in emerging markets has no benefit. In the developed world there is a negative correlation between bonds and equities. In emerging markets they are massively correlated,” he said.
“That is very important to remember. When markets are so linked to the macro environment or the government what happens is equities go down 10%, and bonds lose 20% – and you’ve lost 33% after fees.”
Vecht dispelled the ardently held view that thematics drive emerging market returns. The consumer story is oft cited as the reason to have exposure to emerging markets, the growing middle class and their capabilities for consumption should mean that consumer staple stocks have increased revenue streams, and a buoyant share price.
“Thematics do not work. The message actually translate as ‘The consumer has just started consuming and you can get exposure with these already expensive companies that are not growing.’,” he said.
“I mean, if all of China eats another orange what does that mean for Florida?”
The assumption of past growth does not deliver future returns either – in fact more US companies have managed a 10% annual growth figure over the decade to October 2013, than emerging market stocks.
“Perception and reality in emerging markets are often meaningfully at variance with each other, creating significant alpha opportunities both top-down and bottom up,” said Vecht. “How do you profit? Buy cheap equities and cheap currencies that are not getting worse.”
Vecht said valuations matter – and that investors must learn the difference between what makes a good company and what makes a good stock.
“Fancy websites do not matter when it comes to investing – all you should be asking yourself is can you make a return? Look at a company’s cashflow. That is what shareholders get paid out of, not earnings which is a figure made up by an accountant,” he said.
A stock picking approach can be successful, but investors must learn to view emerging markets as not homogenous. Vecht named and shamed those markets he called the “real fragile five”. In November last year, Emily Whiting, of JP Morgan's Emerging Markets Equities team said that there were five markets in particular that have grown in an environment of cheap and easy money - and are therefore most at risk. The currencies of Turkey, Brazil, India, Indonesia and South Africa all suffered the most at tapering rumours.
But Vecht said the real fragile five were to be found in sub-Saharan Africa, where there is extreme illiquidity and lots of debt.
“There are only three stocks that trade several million dollars,” he said. “There are millions people in Africa that will get richer over time, but the question is will you get rich with them?”
