Despite suffering heavy falls in 2018 to date, emerging market stocks are not yet cheap enough to buy, according to Saracen’s Graham Campbell and David Keir.
Geopolitical risks, trade tensions, rising US interest rates and a stronger US dollar have all combined to weigh on sentiment towards the emerging world.
In the year to 26 November, the MSCI Emerging Market index has declined three times as much as its MSCI World counterpart, at -15.7% and -5% respectively.
At the end of the third quarter of 2018 – before markets, led by the US, began to re-price – that difference was even more pronounced. The MSCI EM index was down 9.5% at that point, with the MSCI World up 3.8%.
In their market commentary for the third quarter, Campbell and Keir, co-managers of the TB Saracen Global Income and Growth fund, said they would start to focus their research on looking for undervalued opportunities in emerging markets.
At the time, they said: “Having largely avoided the underperformance in emerging markets, we are now seeing selective opportunities in this area.”
However, after two months of searching far and wide in the universe, the duo told Morningstar.co.uk this week that they had not found a single stock cheap enough to buy.
“Emerging markets have had a terrible time and we thought we’d find loads of things, but we haven’t,” Campbell said. “We haven’t found many names that have been cheap enough, or the debt has been quite high.”
That second point is also important because a lot of that debt is dollar-denominated. The greenback has been strong this year, with most emerging market currencies being weak. As a result, said debt has become much more expensive and harder to service.
Emerging Market Exposure
The team name a couple of brewers that they have been looking at – Thailand’s Thai Beverage (Y92) and Brazilian AmBev (ABEV3). But, on around 18 times earnings, “they’re still quite dear with a lot of debt”.
In fact, Keir notes that the stocks that do screen as cheap in emerging markets are the big tech names, both on the hardware and software side, and the e-commerce giants.
These firms have found the going even tougher thanks to regulatory crackdowns and the squeeze on their supply chains via trade tariffs. Examples include Korea’s smartphone maker Samsung (005930), Taiwanese chip maker TSMC (2330) and Chinese conglomerates Baidu (BIDU), Alibaba (BABA) and Tencent (00700).
All of the above are fund manager favourites, meaning they are areas Campbell and Keir are likely to stay away from. “Folk simply buy those to say, ‘I’ve got X% in emerging markets’,” explains Keir.
“We look at it a completely different way; we’re trying to say ‘right, what are the cheapest shares?’ We don’t care where they’re listed, just try to find cheap shares as opposed to making points and becoming more growthy. It just becomes pointless.”
There are two portfolio holdings, out of 41, listed in emerging markets, namely Singaporean bank DBS (D05) and Chinese sportswear manufacturer Anta Sports (02020). But, despite the negligible weighting to the asset class by domicile, by sales the fund has around 10% in emerging countries.
Companies like US cigarette maker Philip Morris (PM); Cadbury and Oreo maker Mondelez (MDLZ); and German buildings material producer Heidelberg Cement (HEI) are all big emerging market plays. “A lot of our purchases all have massive emerging market growth in them, but they’re all listed in developed markets,” adds Keir.
October Correction Creates Opportunities
Elsewhere, the managers say they were unusually busy during October, as they took advantage of the stock market correction to add new positions, or top up existing holdings, that had become cheap.
“The way that we make most money for our clients with the lowest risk is, occasionally, finding a really good business that, for some reason, has gone out of favour,” explains Campbell.
One of those that popped up on their radar in October was French tyre maker Michelin (ML), which other fund managers have told us they bought during the month, having fallen 28% in the year to 24 October. It’s bounced 9% since then to trade at €93.50 at the time of writing.
Automotive companies have struggled this year, particularly in Europe. The diesel scandal a few years ago has led to a new emissions test that new vehicles must pass, which has prompted a sharp decline in new car sales worldwide.
US President Donald Trump's tariffs and the apparently imminent take-off of demand for electric vehicles have not helped sentiment, either.
As a result, car makers have been “walloped”. And the firms that services those car makers, like Michelin, have also been caught up, whether that is justified or not.
“You don’t say, ‘I’m going to buy some tyres today because I saw a special offer’. You buy tyres when a guy says, ‘you’re going to fail your MOT, Sir, you have to buy new tyres,” Campbell asserts.
“And typically the cost of you buying tyres is much more profitable for Michelin that in is when Ford buy tyres because they get special deals.”
While in general it’s a “stable, low growth business”, some parts of the business are growing much faster than others. For example, it sells tyres for mining trucks, which companies had been de-stocking, but are now re-investing in.
Meanwhile, even if demand for tyres used for new cars drops off, demand for replacement tyres will continue to trend upwards. And electric vehicles won’t pose that much of a threat: “They still need tyres. And they’ll need different – tall and thin – tyres, which should be higher margin, so good for the guys like Pirelli (PIRC) and Michelin.”
