“Emerging markets underperformed materially for the past 4-5 years,” said Secker at a recent FSA roundtable with Asia fund selectors. “Every other asset class gained except EM equities during that period.”
Secker, who works with the team investing in EM value stocks, believes inefficiencies in EM corporations drove five years of profitability decline. “Asset turnover -- sales over assets -- have drifted down. The mindset in many emerging market companies is that they still need to grow.”
That view prompted Michael Christo, managing director and head of IPS portfolio specialists at UBS in Hong Kong to ask: “If I could tell clients one key reason they need to buy EM equities now, what would it be? I struggle to do it.”
Emerging markets present a valuation argument, Secker said. “It’s investing in an asset that everyone else has applied bad news to. Great companies have been sold off because whole sectors tend to go down together, like the oil sector, where everything oil-related sold off by nearly the same amount. When everything moves together, it’s a great opportunity to cherry pick and we’re getting that in EM today."
Although EM equities remains a contrarian view, Secker believes EM corporates have become more shareholder-friendly over the last few years. Companies are cutting back on capital expenditure and management pay is increasingly linked to share price, he said.
“More management teams are being paid on profit targets rather than growth targets. Their interests are becoming more aligned with ours as EM companies generate profits rather than just growth.”
Moreover, the risk of loan defaults has decreased over the last five years, when a large number of EM corporates tended to have US dollar-denominated debt. “That’s not the case today because very few have dollar pegs,” Secker said.
Untouchable Chinese banks
Value investing in emerging markets is sharply different than in developed markets, he said.
“In China, for example, you can’t rely on mean reversion. Many companies have terrible management practices and that’s why a cheap company will remain a cheap company. That value comes with a value trap.”
As an example, he cited Chinese banks, which are paying relatively high dividends and have low valuations. However, post-2008, the banks were directed by the state to give loans to old economy businesses, which then built capacity to take part in infrastructure projects. Supply increased while demand decreased, eroding profitability.
“Chinese banks are underpinned by the government and they were forced to lend to companies that shouldn’t be operating, keeping alive `zombie businesses’. It may not finish in a meltdown, but a big rise in bad debts is likely and there is [inadequate] provisioning for bad debts. So banks are untouchable and very cheap for a good reason.”
Still Secker believes selective undervalued EM equities are a good bet. The US market, by comparison, has been on a five-year run.
“Do you want to buy into the US equities markets, which is up 100% over the past five years or this market that’s done nothing? You sell where everyone is buying and buy where everyone is selling.”