SPONSORED FEATURE: The emerging opportunity

Firas-MallahA recent sovereign bond issue from Saudi Arabia underlines the appeal of emerging market investing. What must investors consider when allocating to this asset class? Firas Mallah of BMO Global Asset Management shares his views. How significant was the issuance of $17.5 billion of Saudi government bonds this year?
Apart from being the largest ever issue in emerging markets, the bond issuance is a strong signal of change in regional finances, where budget deficits will no longer be handled with cost cuts and using sovereign reserves but also by restructuring government finances to include a significant amount of debt. How do Saudi Arabia and the other Gulf states compare with emerging markets in other parts of the world?
The main difference with most of the other emerging markets is the source of government income and the breakdown of GDP. Apart from the UAE and Bahrain to an extent, the GCC is mainly reliant on oil income and on investment income from the sovereign reserves. This makes their income sensitive to oil price change while on the other hand being resilient to dollar value fluctuations thanks to the currency peg. Emerging markets, on the other hand, have generally a different source of income and an export-reliant economy, making them more sensitive to dollar value fluctuations. Do emerging markets still merit inclusion in an investor’s strategic allocation?
Emerging markets continue to offer long-term investors significant opportunities and really do merit inclusion in a diversified portfolio. Despite some consolidation of growth rates, on aggregate these economies are still growing at a premium compared with developed markets. There are also clear and visible long-term trends at play in many of the countries such as young and growing workforces, urbanisation, technological innovation, a wealthier consumer base and as such a wider pool of potential customers for many businesses and service providers. Could you expand on some of the reasons mentioned above in terms of the secular attraction of emerging markets?
It is worth noting that the term ‘emerging market’ is broad and encompasses many different economies, cultures and demographics. As such, it requires deeper thought, but some reasons include:
  • Higher growth – the fastest-growing global economies, such as India, Indonesia and China are in the emerging market space.
  • Demographics – emerging markets tend to have young and growing populations, in contrast to many mature economies where the balance between young and old has turned negative. As education levels improve in emerging markets, so too does productivity and it can be expected that this will lead to increased per capita GDP, higher demand for many goods and services and innovation in many industries.
  • Urbanisation – while this is a global trend, it is much more significant in emerging markets. We know from mature markets that concentrating populations in urban areas leads to an improvement in economic activity, trade and opportunity.
  • Diversification – in a world where loose policy has compressed risk premia in many asset classes (particularly fixed income), adding an allocation to high-quality emerging market companies, which are exploiting or have built a competitive advantage, can offer upside that is less correlated to global factors.
 How do you think an investor can best exploit this opportunity set?
The best way to exploit the exciting themes in emerging markets is to find truly great companies that you can trust and invest with them for the long term. Focusing on high-quality companies with sustainable business models generating substantial excess returns over their cost of capital through the cycle and taking a long-term view are positive approaches. This leads to asset-light business models with modest capital needs, robust balance sheets and proven management teams with disciplined capital management. We believe an investor should also look for clear and fair alignment between majority and minority shareholders. Can you comment on the risks of investing in emerging markets? 
Any investment comes with a level of risk, be it in developed or emerging markets. As investors we must analyse these risks and decide if the upside potential adequately compensates us for the risk we take. As we discussed, emerging markets offer long-term investors a wealth of opportunity in many diverse markets and sectors. However, in emerging markets we must also recognise that many of these companies operate in less developed financial markets where corporate governance may not be as robust as we are accustomed to in the developed world. As such, portfolio managers must take great care to understand the companies they invest in and build a level of trust that a particular company is being managed in the best possible way and in the best interests of shareholders. They should consider cash flow generative businesses, where a company has a sustainable business model, capital expenditure discipline and low debt. We believe that if you build a portfolio of really high-quality companies based on a disciplined and consistent investment process without overpaying, you are in the best position to participate in the upside potential of these markets without taking excessive risk. Is it true that macro or top-down factors have a significant impact on the market? Can you also comment on which markets you think are most attractive?
Macro factors can have a material impact on short-term market performance. However, if you are a long-term, bottom-up investor you do not need to make investment decisions based on a particular view of a country or sector.  With this approach to investment selection, it is possible to find dominant companies in less developed parts of the emerging markets spectrum. Not only are penetration rates low for many goods and services, but challenging infrastructure in many of these countries also raises the entry barriers substantially, allowing many of the dominant companies to generate high margins, high returns and a strong free cash flow. Typically, these companies are found in the less developed parts of emerging markets such as India, Indonesia, the Philippines, Vietnam and Egypt.  In general, what should investors be aware of when they’re investing in emerging markets?
Emerging markets offer long-term investors great opportunities to invest with many high-quality companies. However, we must also realise that some of these companies operate in markets that have additional risks compared with traditional developed markets. These challenges include lower corporate governance standards, low liquidity and currency risks. When constructing a portfolio it is vital to take a long-term view, remove as many ‘known’ risks as possible by investing in high-quality companies, and be consistent and disciplined. Emerging markets can be susceptible to volatility. At these times, it is essential to remain true to your investment philosophy and prevent a dilution of your process, which ultimately leads to value dilution. ©2016 funds global mena


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