Playing Defense In Emerging Markets

Why should emerging-market investors exercise caution in a rising market? With big unresolved challenges, we think it’s prudent to target companies with solid fundamentals and stable business models to overcome macroeconomic uncertainty and build a resilient portfolio for the long-term.

Emerging-market stocks have bounced back in 2019. After dropping more than 14 percent in 2018, the MSCI Emerging Markets Index was up 12.2 percent through the end of April. And then after falling more than 4 percent in early May, many investors are trying to determine whether the upward trend will resume.

However, instead of trying to predict the market’s next move, we think investors should look for the companies with the best chance of beating the 8.4 percent annual returns that the MSCI Emerging Markets has achieved on average over the past 20 years.

 The Case For Not Timing the Market

Despite the strong performance of emerging market stocks this year, there are still plenty of reasons for caution.

Emerging-market stocks have risen and fallen based on two unpredictable factors of late. The first is the prospect for resolution of the US-China trade war, which like many geopolitical events is inherently difficult to predict.

Central bank action, which influences global interest rates, is the second and equally unpredictable factor. Our research shows that emerging-market equities tend to do well when interest rates are rising in emerging markets relative to those in developed markets. However, the path of relative interest rates doesn’t predict performance–the two merely coincide.

There’s also the fact that growth in emerging economies (and in many developed economies) is slowing, making further negative earnings revisions likely. And while emerging-market stocks are somewhat cheap relative to the 23-year average of 14.9 times earnings, our research shows that valuation alone is not a reliable predictor of how they will perform over the next year.

Playing Defense Without Sacrificing Potential Performance

Our research shows that when you tune out the day-to-day noise in the market, dividends and earnings tend to drive total returns in both developed and emerging markets. And the companies with healthy earnings and dividend payouts tend to have strong, predictable cash flows underpinned by resilient business models and shareholder-friendly management decisions.

Where to find those qualities in emerging markets? Try traditionally defensive sectors such as utilities, infrastructure, and consumer staples. There are many examples of companies in these sectors that handily topped the MSCI Emerging Markets’ 8.9 percent annual returns over the past 10 years.

That might surprise those who think of utilities and infrastructure companies as low-risk, low-return investments. However, their services are in high demand, thanks to the ongoing need in many emerging-markets to build critical infrastructure, including airports, gas pipelines, and electrical and water supply systems. Utility and infrastructure revenues also tend to be relatively resilient to ups and downs in the broader economy, a clear advantage during a downturn.

The key to finding companies that produce above-average returns over time is to seek out those that focus on creating value for shareholders, as opposed to public-service companies, which provide services for the benefit of a country without as much regard for the interests of shareholders. Public-service companies are often at least partly owned by the state, but public ownership doesn’t tell investors everything they need to know about whether a company is a good steward of capital. Investors must carefully analyze the management team’s strategy, the wider regulatory environment and the influence of stakeholders such as the government.

Consumer Staples Can Also Be A Defensive Outperformer

The consumer-staples industry also has safe and steady companies that nevertheless drive strong dividend and earnings growth. Sometimes, that’s because there are high barriers to entry. We believe CP All, a Thai company with an exclusive license to operate the 7-Eleven convenience store chain within the country, is an example of a high-quality company that benefits from a wide moat that keeps would-be competitors at bay.

Companies that have built strong brands and loyal adherents have a similar advantage. Kweichow Moutai, a distiller that makes the most popular brand of the Chinese spirit baijiu, has a market capitalization of USD$149 billion, more than McDonald’s and roughly equal to British oil giant BP. That too is a moat of sorts.

Local players aren’t the only ones with formidable brands, however. Global giants such as Nestlé and Unilever have invested over many years to create labels that resonate in the emerging world. They include Nescafé coffee products and Maggi instant noodles and seasonings for Nestlé, and Dove soaps, Sunsilk hair products, and Cif cleaning products for Hindustan Unilever, the conglomerate’s Indian subsidiary.

Steady Isn’t Just About Sectors

Not all safe-and-steady outperformers fall under the umbrella of consumer staples, infrastructure or utilities. Companies in a variety of sectors have generated strong earnings and dividend growth by executing their strategies effectively. Tata Consultancy Services, for example, has leveraged India’s abundant supply of talented, relatively low-cost IT engineers to excel not only at traditional IT, but also to help corporate clients adapt to the technologies of a new digital reality, including cloud computing, automation, and analytics.

Dependable companies may not have the sex appeal of fast-growing Chinese internet giants, nor the high-octane upside potential of more cyclical businesses such as autos, real estate and commodities. But their stable business profiles can help deliver long-term, above-market earnings. In a market characterized by volatility, that’s an undervalued attribute.

Photo: Murad Sezer/Reuters