Emerging markets may be stormier these days, but they’re still brimming with opportunities. You just need to know how to find them. That’s going to take some skillful piloting—and highly sensitive downside-risk radar.
The developing world’s economic growth engine is losing steam. Commodity prices have collapsed, and some of the largest nations are facing structural and political struggles. Demand in the developed world has been persistently weak, and the prospect of rising US interest rates is adding uncertainty to the outlook. In this environment, simply buying an index isn’t likely to generate the easy outsized returns it had for most of the past decade.
Investors may be tempted to bail. But writing off the developing world altogether means missing out on many of the world’s most dynamic, fast-growing economies and companies. The secret to success, then, is being able to identify pockets of strength—even in weak economies—and to catch nascent trends before they become obvious to others. In our view, that means investing actively, taking the long view and adopting preemptive tactics for riding out stormy times.
It Pays to Deviate
Generally speaking, we are indifferent to the benchmark. The reasons for this are clear: it pays to deviate liberally from the crowd. Emerging equity markets are less transparent than developed ones, and news tends to travel more slowly than it does in the developed world. As a result, developing-market stocks are more prone to overreactions and mispricings—but also far richer in opportunities for attentive stock pickers to exploit. That’s the beauty of emerging-market investing.
Being active means leaning into reliable, long-term sources of equity outperformance. In other words, simply follow the basic tenets of good stock-picking: Buy stocks when they are cheap, when they are delivering stronger-than-average and/or more consistent profitability, or are more likely to score positive earnings surprises. Because emerging-market indices are so inefficient, the payback potential from such a back-to-basics strategy is high.
Buffett’s Rule #1: Don’t Lose Money
In storm-prone emerging markets, defense counts more than offense. So we’re especially vigilant about avoiding excess volatility. For years, the conventional thinking was that volatility was part and parcel of being an emerging-market investor. Since those risks were fully understood and accepted, active emerging-market managers didn’t have to control for it. Many professional investors merely track the ups and downs of a benchmark and call that risk control.
We see things differently. In our view, the key to success in emerging stocks is to hold onto as much of your gains as possible over a full market cycle. That means being proactive and thoughtful about absolute—not relative—risk. One way to do that is by maintaining a consistent tilt toward companies with stable cash flows, good capital stewardship and/or lower sensitivity to the business cycle. Another way is to be ever watchful for looming macro risks. We rely more heavily on our country-specific economic insights for avoiding risk than for selecting stocks or return potential. This risk-aware approach is akin to constantly buying downside protection, in our view.
Hunt for Durable Trends
In times of increased economic turbulence, earnings quality and consistency become paramount. Some examples of companies with these attributes include South Korean biopharmaceutical company Medytox, which is getting a lift from the surging demand for an improved, next-generation botulinum toxin (commonly known as botox), an affordable form of eternal youth. When they travel abroad, Chinese vacation-goers are snapping up expensive skincare products from South Korean luxury cosmetics company Amorepacific. And emerging-Asian yarn spinners, fabric mills and sneaker makers are riding the phenomenal growth of “athleisure” sportswear. All of these companies are beneficiaries of enduring lifestyle trends.
While generally shunning commodity-centric countries, we see further growth potential for many of the low-cost manufacturing centers. For example, Mexico, Vietnam, Poland, Hungary and the Czech Republic should all continue to gain from China’s waning status as a source for low-cost labor.
Winning investments can be found even in sectors with uncertain or dismal outlooks. For example, global demand for electronic devices appears to have reached saturation, from personal computers to laptops to tablets and smartphones. Yet certain niche players in the sector, such as camera lens makers and flexible printed circuit-board makers in South Korea and Taiwan, look headed for strong revenue growth as smartphone makers rush to add desirable features and slimmer designs.
In the face of the likely economic squalls ahead, we believe that combining active, high-conviction investing with a greater sensitivity to risk is the best strategy. To get the most out of emerging-market equities, there’s no contradiction between finding returns and reducing risk.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.