Industry Voice: Emerging market shares have been hampered by negative investor sentiment in 2018 and are currently trading at a significant discount to developed markets; the widest it has been for a decade.
Yet historically emerging market equities purchased at today's valuation levels have gone on to return on average between 40%-50% over the subsequent five years. This is reflected in the asset class's current price/book ratio which is currently at 1.5x-1.6x, a level that in the past has been supportive of investors generating strong returns in subsequent years.
In many instances this is because companies are maintaining their robust underlying economic fundamentals in spite of negative headlines surrounding the region. Thus, we believe the combined effect of heightened risk aversion and the resulting falls in valuations has led to emerging markets as an asset class looking more attractive in the second half of the year and as we approach 2019.
This is particularly the case when it comes to small and mid-cap stocks. This is a familiar space for us given our benchmark agnostic approach to investing in the region, and our investment philosophy which looks for ‘positive change' in emerging market companies.
Mid-caps are an interesting space to look for ideas because they tend to feature companies that have reached a significant size (we focus on those companies which have reached a market cap of $2bn or more), and are often well established in their respective sectors. Yet these companies are also still small enough to be able to generate a significant amount of earnings revenue and growth.
In addition, many small and mid-cap companies are large players in the sectors or markets in which they operate. In Taiwan, for example, we are invested in a company, Ginko, that manufactures and sells contact lenses in China. Although it is a small-cap company, it owns one-third of the Chinese contact lens market.
Another example of small and mid-cap company with similar potential is Kenya Commercial Bank (KCB). The company is by all classifications a small-cap company, yet it has a strong heritage - it started life 100 years ago - and is the leading banking franchise in Kenya. KCB also benefits from long-term structural growth tailwinds in the form of increasing financial inclusion and technology enabling rapid positive change. For example, the bank is the key partner for M-Pesa, Kenya's largest mobile payments platform, and the rise of mobile banking has been a catalyst for growth in Sub-Saharan Africa and KCB is at the forefront of this change.
Frontier exposure
Frontier stocks such as KCB account for a number of our high conviction ideas in the small and mid-cap space. With much better structural demand drivers and ongoing change in specific countries helping to drive significant profit growth, company fundamentals have remained strong in frontier markets in spite of the negative sentiment surrounding wider emerging markets.
In addition frontier markets are often overlooked, with little third party research conducted on individual companies. This allows us an opportunity to gain an information advantage on many stocks in the region. It has helped us identify a number of financial stocks we believe have significant growth potential.
Alongside KCB we also own Nigeria's Guaranty Trust Bank (GTBank) and Bank of Georgia. One thing that all of these stocks have in common is they are leading banking franchises in the individual markets in which they operate, with customers trusting and valuing the retail banking systems they offer. With strong deposit franchises in place the banks are able to operate with a low cost of funding, and can generate large profit margins by lending money to corporates or investing it in government bonds. This has seen the companies consistently generate a high return on equity in a relatively low-risk way.
Meanwhile, from a growth perspective, frontier markets have a young demographic with a low penetration of financial products meaning there are multiple structural drivers for individual stock growth. As an added source of help, these drivers are quite idiosyncratic in nature and helps us diversify away from the very significant influence of China within the emerging markets.
Emerging outlook
Whilst we cannot generalise about emerging markets, it is an asset class that has gained much more macroeconomic credibility over the years. Policy makers in both emerging and frontier markets have lived through multiple periods of market disruption and they continue to learn from previous episodes of stress, be it the global financial crisis of 2008 or the Asian financial crisis before that. We now see many emerging economies acting in a much more conservative manner than they have done in the past, with central banks regularly prioritising real interest rate levels to ensure they are able to support their currencies for example.
Of course, political headwinds remain and trade tensions will likely remain elevated for some time among emerging economies. However, when you combine strong company fundamentals with the fact earnings growth in a number of countries is still significantly positive - the average emerging market company delivered earnings figures in the high teens year to date in 2018 - it leads us to believe the outlook for emerging markets at an underlying company level remains positive as we move towards 2019.
This document is intended for investment professionals and is not for the use or benefit of other persons, including retail investors. This document is for informational purposes only and is not investment advice. Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the authors at the time of writing, are not necessarily those of Jupiter as a whole and may be subject to change. This is particularly true during periods of rapidly changing market circumstances. Every effort is made to ensure the accuracy of any information provided but no assurances or warranties are given. Company examples are for illustrative purposes only and are not a recommendation to buy or sell. Quoted yields are not guaranteed and may change in the future. Jupiter Unit Trust Managers Limited (JUTM) and Jupiter Asset Management Limited (JAM), registered address: The Zig Zag Building, 70 Victoria Street, London, SW1E 6SQ are authorised and regulated by the Financial Conduct Authority. No part of this document may be reproduced in any manner without the prior permission of JUTM or JAM.
