Emerging Markets: From Discovery to Distinction

October 2015
Emerging Markets:
From Discovery to Distinction
Emerging-market equities are at an interesting crossroads. In this
wide-ranging interview, Portfolio Manager Gaurav Patankar talks
to Senior Portfolio Strategist William J. Adams about opportunities
Gaurav Patankar
Managing Director,
Portfolio Manager
William J. Adams
Managing Director,
Senior Portfolio Strategist
in the asset class and where he’s finding potential winners.
Emerging Markets: From Discovery to Distinction
As an asset class, emerging-market equities are at an interesting
crossroads, with a debate raging between those who believe
it will experience a “lost decade” and those who advocate for
greater exposure amid recent underperformance. We believe
that there are still plenty of opportunities to make money in
emerging markets, but the approach to investing will have to
be very different than it has been for the past 20 years.
■■ Being nimble to take advantage of special situations/
dislocations in a post-quantitative-easing world, where
all moves are amplified.
First, the emerging-markets asset class has evolved from a
“discovery” phase to a “distinction” phase. The discovery
phase broadly occurred after the Asian financial crisis
and continued through 2010 with the rise of the BRIC
economies and particularly China’s industrialization. This
phase resulted in unprecedented demand for commodities,
robust sovereign balance sheets resulting from deleveraging,
cheap currencies, stable inflation, falling real interest rates
and obviously robust absolute returns for those who
allocated to emerging-market equities. Optically, we also saw
significant productivity improvements in most emergingmarket countries, including commodity exporters, but what
remained masked was capital misallocation into the state
sector, minuscule structural reforms and the “underbelly”
of a weak national infrastructure, in some cases.
This approach is embraced by Gaurav Patankar, who
manages the Global Research Emerging Markets Equity
strategy at The Boston Company. His portfolio is fairly
concentrated, with wide parameters around country and
sector relative positioning. Holdings are largely determined
by Global Research sector experts, although the portfolio
manager can add value through opportunistic/macrooriented investment ideas. Gaurav recently sat down with
Senior Portfolio Strategist Bill Adams to discuss his views on
emerging markets as well as the related impact of developing
trends.
All of this has contributed to a shrinking growth differential
versus the developed markets, as shown in Exhibit 1, and
to a stall – and ultimately a reversal – in emerging-market
returns.
Exhibit 1: Where the GDP Growth Is
8
6
US$tn
4
2
0
(2)
(4)
2009
2010
Advanced economies
2011
2012
2013
2014
Emerging & developing economies
We believe that over the next decade, investors cannot
generate alpha by being simply “long” emerging markets
as an allocation decision or taking small relative bets versus
the index. Instead, the winning approach will likely combine
these three key tenets:
■■ Focusing capital on countries with the highest potential
for and traction in structural change.
Bill: With the current backdrop, what is so attractive about
emerging markets today? Over a five-year period, the S&P
500 gained more than 13%, while the MSCI Emerging
Markets Index is down roughly 3% in U.S. dollar terms, as
of this September.
Gaurav: It’s hard to ignore the unrelenting stream of
emerging-markets headlines, which can make it difficult to
maintain a balanced view. Over the next 18 to 24 months, I
believe emerging markets are heading into one of the most
turbulent times in history, with corporate defaults, significant
currency devaluation and forced selling. All of this sounds
ominous, but I see a significant opportunity to make money.
First, for U.S. investors, emerging markets have always been
and will always be about “growth differential.” If the growth
engine is broken or a path to its sustainable resuscitation
doesn’t look good, investors will stay away.
Not all emerging markets are created equal. This asset class
encompasses more than 20 different countries that are
geographically, politically and financially diverse. We loosely
define the group as one, but I believe we are in the early
phase of a multi-year regime change that will drive vastly
different outcomes for individual markets. QE in developed
economies and China’s structural move to a lighter and slower
growth trajectory have translated into lower commodity
demand, out-of-sync monetary and fiscal policies for most
emerging markets, poor terms of trade, weaker currencies
and higher dollar debt.
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Source: CLSA, IMF. Annual increase in world nominal GDP in US dollar.
■■ Focusing much more on owning fundamentally sound
companies with strong governance standards and a
sustainable moat.
I would broadly classify emerging markets into three
categories of countries:
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Emerging Markets: From Discovery to Distinction
■■ Proactive Reformers: Markets that can and will
take advantage of this regime change to make tough
structural reforms and follow a path to strong relative
growth momentum. India, Mexico, China, Colombia
and the Philippines are well ahead of the curve. South
Korea and Indonesia can also be loosely classified as
such.
dispersion in stock prices. Plus, many dislocations arising
from recent volatile moves in foreign-exchange rate curves
and commodity prices are creating tailwinds for specialsituations investing in emerging markets. So the opportunity
set for active investing is actually quite robust, given a longerterm view.
Bill: Coming down a level from country selection, how
does an investor identify winning and losing stocks and
themes? What traits do you look for? What is interesting
for the next three years?
■■ Forced Followers: These countries have the structure
and construct to make change, but will not do so until
the markets force their hands from time to time. These
include Brazil, Turkey, Malaysia, Chile and Peru.
Gaurav: I have always looked for three key characteristics in a
winning business: strong corporate governance, a sustainable
moat and a tight circumference around core competence.
More thematically, looking out 24 to 36 months, I find the
following four themes particularly exciting:
■■ Willful Laggards: Such countries choose to limp along,
showing minimal if any positive growth differential vs.
the developed world. They have neither the capacity to
create true structural reform nor any visible catalysts to
force their hands. Russia and South Africa certainly fall
into this category.
1. Exporters with a moat. Despite significant currency
weakening already, I expect the dollar to continue
strengthening in the medium term, which will be a nice
tailwind for exporters. I am not talking about commodity
or low-end manufactured-goods exporters, but more
export-oriented names with a “moat,” meaning that these
companies have a differentiated/specialized product or are
embedded in a key supply chain, which serves as a buffer
against competition or having to pass on the currency
tailwind to the buyer. Some examples might include handsetcomponent makers and precision auto-parts manufacturers.
These companies are poised to benefit from multiple factors,
including a currency advantage, lower labor costs, better
trade dynamics and thus improving margins. Another pocket
of opportunity is anything connected to travel and leisure,
especially as inbound foreign leisure travel picks up.
So, to make money, fundamental allocation in combination
with theme decisions will matter more in the first category,
tactical macro and sector bets in the second, and pure stockpicking in the third.
Stock dispersion, though, is quite high overall. Among
emerging-market stocks, a far greater number of winners
and losers emerge, as evidenced by the consistently wider
performance dispersion in the MSCI Emerging Markets
Index vs. the S&P 500, creating more attractive stock-picking
opportunities. (See Exhibit 2.)
Furthermore, the most widely followed indexes capture only
a fraction of emerging-market listed stocks, which feeds
Exhibit 2: Heightened Dispersion in Emerging Markets
350%
250%
200%
150%
100%
50%
0%
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
MSCI EM
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
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Quintile % Return Spread (USD)
300%
S&P 500
Source: Thomson Quantitative Analytics, MSCI, TBCAM. MSCI EM v. S&P 500: 12/31/95 - 12/31/14. Top - Bottom quintile % Return Spread.
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Emerging Markets: From Discovery to Distinction
2. Acquisition targets. There are two angles here. First,
Western corporations with a large base of offshore cash
will have a greater desire to acquire long-term growth
opportunities in emerging markets and also play defense by
right-shoring their manufacturing base into countries with
competitive currencies. Among companies in the S&P 500
for example, more than 46% of sales were produced outside
the U.S. in 2013, almost flat with the two preceding years.1 A
strengthening dollar makes these companies less competitive
on a global scale, and they certainly have the balance sheets
and cash on hand to snap up emerging-market firms that can
help them regain some advantage.
Second, emerging-market companies with a large burden
of U.S. dollar-denominated debt and slowing revenues will
recognize the need to partner. It will be difficult to pick
winners, but I see some interesting opportunities within this
theme in the Industrials and Consumer sectors.
3. Power passed down to millennials in family-owned
companies. A significant number of Western-educated
millennial heirs (especially in Asia) are assuming command
of their family empires. This generation is much more
capital-disciplined, anti-conglomerate and metrics-focused.
While this is a generalization, thematically many companies
are ripe for significant value-unlocking, especially with some
engaged ownership.
4. Forced sell-downs in less-liquid quality franchises:
Active emerging-market inflows into managers over the past
four to five years have been very concentrated. Given my
expectations of systematic capital withdrawal by allocators
from the space, I see forced sell-downs in some highquality but less liquid names; this opportunity set is getting
progressively interesting.
Exhibit 3: Buying Picks Up Within India
Bill: India stood out last year as a consensus buy for many
in the investment community. Why do you still like it? What
are you watching there?
Gaurav: The easy money has been made in India, but there’s
a very long runway ahead. I see India as the best-performing
market with a 3-, 5- and 10-year view. India’s monetary
policy is in a good place, as Raghuram Rajan, governor of
the Reserve Bank of India, has worked decisively against
inflation and has brought considerable stability to the
currency markets. This, in conjunction with the government’s
fiscal restraint, has made the economy much less vulnerable
to external shocks. As shown by Exhibit 3, domestic Indian
investors are warming up to Prime Minister Narendra Modi’s
agenda.
The commodity cycle is a strong fiscal tailwind, and
the government has evolved strategies for state-ownedenterprise (SOE) banks, improved bureaucratic efficiency,
enhanced transparency in auctions, and cracked down on
black-market proceeds. That said, there is more heavy lifting
to be done. What I am most keenly watching right now are
the Goods and Service Tax Bill, the bankruptcy code and
the land bill. The upcoming Bihar state elections this fall will
be a significant binary event. A strong win by the Bharatiya
Janata Party (BJP) should shift the pace of structural reforms
into overdrive, but a loss can quickly change the political
momentum. I put the odds of a BJP win at 50/50, with a
slight positive tilt.
From a valuation perspective, the markets are not expensive,
especially as corporate profitability is currently at cycle
lows with utilization far below capacity. Depreciation of
the currency is already driving earnings in export-oriented
sectors, which when combined with a cyclical upturn in
economic activity, should provide substantial tailwinds for
earnings growth.
India domestic mutual funds monthly net buying of Indian equities
2.0
1.5
US$bn
0.5
0.0
(0.5)
(1.0)
(1.5)
(2.0)
Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 Jul 14 Jan 15 Jul 15
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1.0
Source: CLSA, Bloomberg, as of 9/14/15.
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Emerging Markets: From Discovery to Distinction
At a macro level, the markets have never been so bipolar,
disproportionately benefiting sectors/companies with clean
balance sheets, high return on capital employed, profit
growth and visibility while punishing those that are more
cyclical, highly regulated and closely tied to the investment
cycle. As India’s political landscape changes and a structural
recovery takes hold, I believe the investment universe will
expand considerably. As the state strengthens and the policy
environment improves, SOEs and companies related to the
infrastructure/investment cycle value chain should become
interesting. The one landmine to avoid is family-owned
companies that enjoyed disproportionately high returns on
equity due to political patronage. I see the best risk-reward in
SOE banks, as explained further in the sidebar.
The Case for Public-Sector Banks
India’s public-sector banks, which account for more than
70% of outstanding loans, are facing a capital shortfall.2
However, we see four reasons for optimism on the sector:
1. The extraordinarily cheap valuations of these banks seem
to question their status as a going concern. The government,
which is a majority owner, recently announced plans for
capital deployment/efficiency at the SOEs, and it probably
would not raise capital at way below book value and dilute
itself.
2. Significant synergies would come through sector
consolidation, which is likely to happen slowly but surely
over the next 36 to 48 months as the government starves
some of the poor utilizers of capital.
3. With a keen focus on eliminating directed lending
and meritocratizing these institutions with new CEOs,
incremental problem-loan creation will slow, if not stop.
In conclusion, we believe the potential upside substantially
trumps the downside in at least five or six of these banks.
Gaurav: In evaluating a country’s investment potential, I
look at three competencies: efficiency, productivity delta,
and innovation possibilities. For most Middle Eastern
countries, you can’t check the box on more than one of
those attributes. But one country may have a chance – over
the very long term -- to fire on all three cylinders.
If you are really prepared to think with a 10-year horizon,
consider Iran. I believe the nuclear deal, in which economic
sanctions are going to be lifted in exchange for long-term
limits on Iran’s nuclear program could result in a slow but
steady “mainstreaming” of what may be the most dynamic
economy in the Middle East and perhaps EMEA. With
favorable demographics, skilled manpower, a strong naturalresource basket and a strategic geographic position, Iran can
be a winner. It won’t be a straight line up, nor will it be easy
to access that market and there will be difficult rhetoric from
many sides but thoughtful investors will find ways to make
money.
Bill: You can never discuss emerging markets without
mentioning China. Investors’ appetite for China seems
to be rather varied at the moment, with many typically
avoiding government-owned entities, while others view
the economy’s slowdown as potentially hazardous –
particularly for the property market. Are there interesting
developments and investment ideas that the market may
be overlooking?
Gaurav: I am not a believer in an existential crisis or blow-up
in China. That said, I do see serious issues of overleverage
and a lack of competitiveness. At a very high level,
sociopolitical evolution has lagged economic evolution, and
that’s hindering progress. First, China, unlike the U.S., has
not been able to build an ecosystem for innovation and
innovation-driven productivity gains, which are necessary
to transform a maturing lower-middle-income country to a
high-income country. Second, many industries dominated by
SOEs are plagued with overcapacity in areas that were driven
by the fixed asset and construction boom over the past two
decades; they now must be restructured and reformed, just
as the economy slows and diversifies more toward domestic
consumption. Third, there is a legacy of mal-investment
and, as mentioned, overleverage in certain areas of the
property market, but that can’t be changed overnight. One
way to release some pressure is through the currency, and
that’s exactly what they have done.
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4. Perhaps most important, these banks sit on trophy real
estate and subsidiaries. There are several banks where our
assessment of their real estate value (branches and offices)
is several times their market capitalization and/or capital
shortfall. Some have highly successful insurance/assetmanagement subsidiaries that can be monetized.
Bill: What is the next big thing in emerging markets — a
left-field idea with a 10-year runway?
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Emerging Markets: From Discovery to Distinction
Most importantly, Xi Jinping has very shrewdly assumed
political and structural power, unlike his predecessor, Hu
Jintao. The highest political level has a clear understanding
of the issues, but there is no easy switch from being a
manufacturing-driven economy to a services-driven one. The
country is going through the motions of settling down into
a 4-5% growth, services-dominant, middle-class economy.
Bill: Finally, can you talk a bit about where you foresee the
most risk?
Gaurav: I am worried about a couple of things. First and
foremost, I’m worried about emerging-market debt. (See
Exhibit 4.) During the global hunt for yield, the market for
emerging-market corporate bonds denominated in dollars
and other hard currencies has more than doubled to $1.5
trillion, exceeding the amount of outstanding U.S. high-yield
bonds.3 The relative attractiveness will dissipate if rates go
higher here and there’s no liquidity in this market. Declining
market maker (broker) inventory is going to be a big problem.
Exhibit 4: Rising Debt Levels
of the sovereign wealth funds in the Middle East and Asia
have been big investors in emerging markets, but the recent
volatility in oil prices may have weakened these traditionally
strong hands. This could create some vulnerability in those
funds where most of the money is concentrated.
Bill: In conclusion, what is your general view on emerging
markets right now? What are you watching?
Gaurav: I’m maintaining a favorable view on the asset class
for long-term investors, but I think investors need to be very
selective in picking their spots. I’m keeping a close eye on
credit spreads in emerging markets, especially corporate,
foreign-exchange fluctuations and, of course, economic data
points from China.
Despite the widespread recent disenchantment with emerging
markets, I’m still finding many compelling opportunities in
the space. It’s a large asset class that has been trading like a
busted growth stock, and there are good opportunities for
select companies to fire on all cylinders here.
2.1
1.8
US$tn
1.5
1.2
0.9
0.6
0.3
0.0
Non-financial corporations
Banks
Non-bank financial institutions
Source: BIS, BCA Research. Emerging market private-sector international debt securities
outstanding. International debt securities outstanding by nationality of issuers.
Although I don’t anticipate a cataclysmic capital withdrawal,
it is worth watching this segment for signs of weakness.
According to data analysis from JPMorgan Chase & Co.,
the VIP stocks have recently been underperforming the
benchmark. For the 20 most illiquid names, the trend is similar
over recent weeks, although stronger over a three-month
period. This makes sense, as building redemption pressure
likely results in the sale of widely held/liquid stocks. Some
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Second, I also have some concerns about the concentration
of emerging-market funds. Five asset managers control
about 40% of the U.S. diversified emerging-market mutual
fund market, and roughly 50 emerging-market names — we
call them “VIP stocks” — are commonly held across their
portfolios. As such, significant redemptions could cause
major problems for their investors.
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Emerging Markets: From Discovery to Distinction
End Notes
1. Howard Silverblatt, “S&P 500 2013: Global Sales Year in Review,” S&P Dow Jones Indices, McGraw Hill Financial, August 2014.
2. M. Rochan, “India needs reforms in banking sector, says finance minister Arun Jaitley,” International Business Times, January 3, 2015.
http://www.ibtimes.co.uk/india-needs-reforms-banking-sector-says-finance-minister-arun-jaitley-1481716
3.
Carolyn Cui, “Investors Grow Wary of Emerging-Market Debt,” The Wall Street Journal, April 19, 2015. http://www.wsj.com/articles/investors-grow-wary-of-emerging-market-debt-1429473506
Disclosure
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About the Authors
Gaurav Patankar
Managing Director, Portfolio Manager
Gaurav is a portfolio manager and senior research analyst on The Boston Company’s Global Research
team. Before joining The Boston Company, Gaurav was a portfolio manager of Global Absolute Return
and Emerging Markets strategies at Lockheed Martin Investment Management Co. Prior to Lockheed, he
served as a sector strategist focused on emerging markets and global financial institutions, at Millennium
Management, LLC, a global multi-strategy hedge fund. Before this, he was an equity research analyst
at SuNova Capital and Citigroup Investment Research, covering large- and mid-cap banks. Previously, Gaurav was a corporate
strategist and senior research analyst at M&T Bank and a co-founder of Information Interface India, which went on to become
one of India’s largest treasury network platforms. Gaurav received a bachelor’s degree in electrical engineering from the
University of Mumbai, India, an M.B.A. in finance and strategy from the University at Buffalo, and a Ph.D. in corporate
governance and social economics from TMV, University of Pune, India. He received the 2011 Institutional Investor “Rising
Star in Hedge Funds” award.
William J. Adams
Managing Director, Senior Portfolio Strategist
Bill is a senior portfolio strategist for The Boston Company’s Non-US and Emerging Markets
investment disciplines, involved in the daily activity of the investment teams without stock
decision-making responsibility. He is responsible for communicating the teams’ strategies
to clients, prospective clients and consultants, serving as the critical interface between
client-facing staff and investment teams. In this role, Bill guides the messaging and
positioning of investment strategies, helping to create marketing materials and content, responding to investmentrelated client inquiries, and ensuring that relevant investment insights of the portfolio-management teams are
delivered internally and externally in a timely and effective way. Prior to joining The Boston Company, Bill was
an associate at Deutsche Bank, where he was responsible for European equity research sales. Before that,
he was a senior account officer at Putnam Investments, where he managed 401(k) relationships, and a senior
account administrator at State Street Research and Management Co. Bill earned a B.A. in political science
from Boston College and an M.B.A. in finance from the University of Maryland.
For more market perspectives and insights from our teams, please visit
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