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Global Top Cat

Navigating The Road Ahead

By Yiannis G. Mostrous, on Jun. 11, 2013

When it comes to emerging markets, investors are selling in May and going away. Disappointed by the steady stream of earnings downgrades and lowered expectations for economic growth, investors have been pulling money from these formerly high-flying markets. According to EPFR Global, emerging-markets funds suffered outflows of US$8 billion in capital. Asia-focused funds were hit particularly hard.

Nevertheless, we continue regard Asia’s emerging markets as the best structural growth story for investors with a longer time horizon.

Given the underperformance of the MSCI Asia ex-Japan Index of late, it’s easy to overlook the solid returns posted by equities in smaller market such as Indonesia, Thailand, Singapore and the Philippines.

Within this pocket of strength, the MSCI Philippines Index has been the star performer, following a 44 percent gain in 2012 with a 13 percent return thus far in 2013. Much of this outperformance reflects a domestic economy that’s firing on all cylinders; in the first quarter, the Philippines grew its real gross domestic product by 7.8 percent on a year-over-year basis. Although the island nation’s growth story appears to have legs, stock valuations have become slightly frothy after the recent run-up.

What can investors learn from the outperformance of Philippine equities relative to other emerging markets in the Asia-Pacific region?

First and foremost, investors shouldn’t view the market in absolutes. Yes, emerging markets have struggled in recent years–but dismissing a particular market as bereft of profitable opportunities can be a costly mistake. Successful investors dig behind the headlines and develop a more nuanced understanding of potential risks and rewards.

Moreover, few market observers have an optimistic outlook for emerging markets in general and Asia in particular. Much of the commentary these days emphasizes what can go wrong while overlooking what could go right. When investors have a unified outlook, the markets oftentimes confound these expectations.

Asia’s emerging markets could outperform developed markets in the back half of the year; in particular, US equities appear to be discounting solid economic growth and haven’t priced in any potential mishaps.

In contrast, the MSCI Asia ex-Japan Index trades at only 1.5 times book value–a lower multiple than when these markets troughed in September and November 2011 and May and August 2012.

Source: Bloomberg

The MSCI Emerging Markets Index, which trades at 1.47 times book value, also appears inexpensive for investors with a longer time horizon.

Source: Bloomberg

Although the global economic recovery isn’t the strongest on record nor does it include every country and sector, the EU is doing a better job managing its sovereign-debt crisis. And on the other side of the pond, the US economy continues to strengthen.

We expect the Federal Reserve to maintain its accommodative monetary policy through the end of 2013; next year, the central bank will likely contemplate tapering these supportive measures. Once the Federal Reserve begins to tighten, expect market volatility to increase.

Investors with a longer time horizon should take advantage of periodic weakness to build positions in inexpensive markets that offer real upside potential. Asia’s emerging markets fit the bill on both accounts.

We would focus on India, where economic reforms are gradually taking place and the investment cycle is slowly picking up. Investors will also benefit from exposure to the economic recovery in China. Meanwhile, South Korean equities offer leverage to the global economy, while Malaysia’s stock market has benefited from the reduced political uncertainty after the recent elections.

In regards to sectors, consider energy the energy patch and companies in the consumer discretionary, financial, technology and industrial sectors that have also been out of favor. Focus on names with positive earnings momentum and low leverage—-e.g., net debt that’s less than two times earnings before interest, taxes, depreciation and amortization. Finally, investors should favor companies with larger market capitalizations. 

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