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Selective opportunities as emerging markets change

Added 23rd March 2015

Long-term structural growth and low valuations make emerging markets appealing relative to developed markets, according to Capital Group, but stock-picking skills will be critical.

Selective opportunities as emerging markets change

Consumer discretionary and pharmaceutical companies specifically offer prime opportunities for capital growth, the firm said.

China, for example, is laying the foundation for more sustainable long-term growth by cooling down an overheated property market, reining in unbridled lending, and curbing unprofitable infrastructure projects, Capital Group said.

“Rising living standards alter consumption patterns [and are] driving demand for higher value goods and services.”

The ageing population in China and other emerging markets is another driver. 

“The initial beneficiaries of this ageing trend were the large-cap global pharmaceutical companies,” said Noriko Chen, portfolio manager. 

“But we are now moving into the second stage, where people have even more disposable income and are willing to pay for services like private healthcare and diagnostics. Service providers, particularly hospital operators listed in Asia, have very positive tailwinds.

“I would be much more willing to buy a Chinese healthcare–related or services company rather than a luxury brand,” Chen said.

Shift in dividend culture

Management views on paying dividends also appear to be changing, and investors are starting to view emerging markets not just for growth but for income as well.

“There is a growing appreciation among managements of emerging market companies that dividends do not send a bad signal to markets, and in many cases they send a very positive message,” said Chapman Taylor, portfolio manager.

The average dividend yield of the MSCI Emerging Markets Index was 2.95% on 31 December and around one-third of emerging market stocks had a dividend yield greater than 3%. 

Benchmark lags active managers

However, there are limitations. China’s growth is in a sustained slowdown, and that has implications for other emerging market countries. 
Even if EM companies show an earnings recovery, double-digit market growth is not on the horizon, argue Morgan Harting, portfolio manager in emerging markets and Sammy Suzuki, portfolio manager of emerging markets strategic core equities at AB.
"Many things have changed in recent years that make a repeat of the explosive equity gains in emerging markets unlikely," they wrote in a recent blogpost. 
"As a result, we think that buying the benchmark isn't the right way to go."
The emerging market index track record is poor versus active managers. 
"Last year, the MSCI Emerging Markets benchmark ranked in the 69th percentile of active managers. It hasn't done much better for most of the past decade. In other words, a median-performing emerging-markets manager would have consistently beaten the benchmark over the past 10 years.
"Political risk is rising in Russia, Brazil and Turkey, while China is facing a deceleration of economic growth. Passive exposure to emerging markets will force investors to take big positions in regions facing significant headwinds."

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