Grabbing the emerging action

The performance of emerging markets has made some investors twitchy, but that just means they might have to think more laterally to get into those regions, as David Burrows explains

While it"s fair to say that western stock markets are a little "bouncy" at the moment - buffeted by general economic news and a (so far) minor tech fallout - they do seem to be relatively stable and trading in a consistent range. The picture has not been quite so rosy in emerging markets, however, and hasn"t been helped by economic slowdowns in China and India, and recent tensions in Ukraine. While intrepid investors may be willing to take a risk with emerging markets, others are nervous.

This lack of confidence is supported by figures from the Investment Management Association (IMA), which showed outflows of £69 million from Global Emerging Market funds for December 2013. This compares to inflows of £252 million in December 2012 when the sector topped the retail sales chart.

This represents a rapid fall from grace in anyone"s book, but is the exodus justified? After all, emerging markets are often seen as a white-knuckle but potentially profitable ride for investors over the long term. Why go short term and bail at the first sign of trouble?

Keith Barrett, Head of Research at Ingenious Asset Management, suggests that investors too often buy into a theme when it"s at its height then lose their nerve when the picture darkens, preferring to crystallise a loss rather than sit tight and wait for recovery. By mistiming their entry and exit, the investor"s experience may be so unpleasant they never dip their toes into emerging markets again.

However, there"s a danger of overplaying the fall from grace of emerging markets. For instance, if you go back to 2008, annual net retail sales to the end of December were £331.4 million; by comparison the figure for the year to end of December 2013 was a far more healthy £889.3 million.

Martin Bamford, Chartered Financial Planner with Informed Choice, agrees that emerging market equities currently fall into the "unloved" category, primarily because investors are rotating to more developed markets where sustainable economic growth is reappearing following a global recession.

However, he insists, as a long-term investment, some allocation to emerging market economies continues to make sense. “This has always been a higher-risk asset class, so investors should be rewarded for the additional volatility in time. Investors should not be taking short-term positions or reacting to short-term market volatility,” he explains.

Different strokes

For people wanting to invest directly in emerging markets, there are two real options - individual shares or collective funds. Individual emerging market shares require a bolder approach, and as Barrett explains, in such cases the principle of "buyer beware" comes into play. “If you want exposure to nickel and iron ore markets then you can invest directly in companies such as Vale in Brazil, but stocks like this are extremely volatile due to metal price fluctuations and if demand from countries like China falls.”

Simon Finch, Asian Equities Fund Manager at Ashburton, agrees that direct investment is not always feasible or prudent. “Some emerging markets have their own barriers to investment, such as in India, where individual foreign investors are precluded from holding Indian equities directly,” he explains. “One must also consider the costs of investing here are typically higher than in developed markets. Other factors to consider include liquidity of the markets, as well as the lack of available information on certain stocks.”

Finch says an effective way to circumvent these hurdles is to access these equities through a diversified, collective fund. And there are plenty out there - according to the IMA, there are currently 72 funds and 10 investment trusts available to retail investors.

But for some people, the preferred emerging market play is to invest in western companies gaining a foothold in high-growth emerging market countries such as China, Russia and India, rather than in companies based and listed in the countries themselves.

Justin Oliver, Investment Director at Canaccord Genuity Wealth Management, explains why this approach is gaining traction. “If you look at the FTSE 100, around 85 per cent of revenues come from outside of the UK, and for many of these companies, emerging markets are the key driver,” he says.

Oliver name-checks BMW, WPP, SABMiller, and Procter & Gamble as western companies with high levels of business with the east. “BMW enjoys very large sales to China - there are now more BMW 5 Series sold in China than in Germany. SABMiller is well placed to benefit from increased disposable income in emerging markets with a preference for international beers over home brands.”

As for specific sectors ideally positioned to benefit from the long-term growth potential of emerging markets, Oliver picks out healthcare. “There"s a correlation between countries getting richer and what they spend on healthcare. Given this, a good way to play emerging markets is through western healthcare stocks such as Procter & Gamble.”

Barrett echoes Oliver"s sentiments on healthcare, pointing to names such as Sanofi, with a third of its business in emerging markets, and Colgate-Palmolive, where half of its revenues come from the developing world.

Western way in

These companies are not in emerging markets on the back of a potential longer-term growth story - the potential is already being realised and is reflected in the profit breakdown. “It"s not just about growing sales volumes, companies are already making good profits out of the east - for instance 44 per cent of [drinks manufacturer] Diageo"s operating profits come from emerging markets,” Barrett explains.

He adds that, as with the healthcare sector, consumer-focused stocks such as Diageo and Unilever are key beneficiaries of the growing spending power in countries like China and India. “You realise the global presence of companies like Unilever by the fact that 160 million products, from mayonnaise to tea bags, are sold each day in 170 countries.”

So if your preference is to invest in emerging markets via the west, what options are available? Oliver says a small proportion of people take the DIY option and invest directly in those large-cap companies with the bulk of their business in emerging markets, but most investors prefer to spread the risk and access these names via "global brand funds" - the Morgan Stanley Global Brands fund being a case in point.

Barrett picks out Fundsmith, a global equity fund run by Terry Smith, as a good way to access the east via the west. “His underlying exposure to emerging markets is around the 40 per cent mark, which is pretty high compared to his peers.”

The fund is well exposed to global mega-caps such as Unilever, Nestle and Imperial Tobacco, as well as stocks like Intercontinental Hotels which has 40 per cent of its business in emerging markets, with China a stand-out region for the company"s growth.

Playing the east via the west is a perfectly reasonable investment strategy, but investors need to be aware of their "global brand" investments and how they sit with other mainstream UK or US funds they might also hold. As Finch points out: “People who hold investments in, say, Coca-Cola or McDonalds, may not be aware that both these companies have more than 40 per cent of their revenues generated in emerging markets.”

Investors may think their broader investment portfolio has low or medium exposure to the vagaries of the emerging markets when the reality is very different.