Asian and emerging market equities: Where next for investing?

Investing in Asian and emerging market equities offers diversification benefits to clients’ portfolios. Our strategies take a contrarian approach and seek our new investment opportunities in unloved areas of the market.

Although emerging market economies are interconnected, they are unique, and often driven by entirely different factors. Latin America’s abundance of natural resources means the region is playing a vital role in the renewable energy revolution. Meanwhile, economies in emerging Europe and Mexico are gaining market share in manufacturing given a shift towards more decentralised and resilient global supply chains.

Headwinds for emerging markets are starting to shift. The earnings outlook is improving. The US dollar is off its peak and range bound, inflationary pressures are subsiding, and interest rates appear to have peaked in this cycle. Rising incomes, urbanisation and positive demographic trends are creating an ever-growing cohort of middle-class consumers.

Valuations for Asian and emerging markets appear attractive relative to historic levels and continue to trade at a discount to developed markets, particularly the US. We believe there is scope for this to narrow.

What are the benefits of active investing in Asia and emerging equity markets?

We take an active, fundamental approach to investing in Asia and emerging markets. We analyse the fundamentals of individual companies using a bottom-up investment approach, looking at things like financial statements, competitive advantages, supply and demand dynamics, and management quality to name just a few. We find value for investors over the long term by buying companies for much less than they are worth.

Companies with exposure to the most popular trends are often priced at a premium. We are contrarian in nature, looking for opportunities in unloved areas of the market. The most promising areas of ‘value’ are often accompanied by temporary issues at the company level or macro level.

We also actively engage with companies on environmental, social and governance (ESG) issues as these considerations can have a material impact on a company’s fair value. We seek to quantify the impact of material ESG factors and actively engage with company management on these issues to help enhance the value of our investments. 

How do valuations compare in the various Asian and emerging equity markets?

The heterogeneous nature of emerging markets means there can be significant divergence in valuation and performance between different countries and sectors.

These markets can also experience greater volatility than developed markets, a feature we embrace as active managers as a source of potential mispricing. Opportunities often arise from the market’s negative reaction to surprises, as pessimism feeds on itself leading to attractive entry points.

As can be seen in the chart below, China appears cheap in absolute terms and relative to history. The Chinese market had de-rated from its 2021 peak following cyclical and structural concerns, combined with elements of geopolitical risk. Furthermore, Indonesia and South Africa are also trading well below their historical averages following recent elections.

Conversely, India is currently the most expensive emerging market in terms of price-to-book (P/B), trading at a significant premium to its long-term historic average. India appears to be in a macro sweet spot, with a bull market supported by extrapolations about a strong capex cycle and robust domestic demand. Meanwhile, Taiwan’s exposure to technology and AI has led to a re-rating of its market although in selected cases valuations remain reasonable compared to US peers.

Where are you currently finding the best opportunities?

Opportunity can come from deeply entrenched negativity. This is the case with China, Indonesia, and explains the ‘Korea discount.’

We believe that gradual improvement in Korean corporate governance and dividend pay-outs are being underappreciated by the market. This has provided the opportunity to own operationally solid companies, with good balance sheets. 

How can the macro-economic outlook influence strategies?

Our investment edge is in taking advantage of macro dislocations rather than depending on macro predictions. As seasoned investors, we expect the unexpected and thus believe in the benefits of having a resilient, well-balanced and diversified portfolio, with performance driven by stock selection as opposed to big macro bets.

While we closely monitor macro risks such as inflation, recession, changes in monetary policy, geopolitical risks, we believe these factors get priced in very quickly. The biggest risks are those that nobody is predicting, they are ‘unpredictable’ in the literal sense.

What really matters for future returns is starting valuations. A positive macro view on a specific country will not necessarily result in a strategy tilt unless we are able to find companies trading at a significant discount to what we feel is fair value.

There’s also a risk of the markets having a consensus bullish view. Stocks get priced for perfection, and any macro disappointment can leave valuations vulnerable to swift de-ratings. 

What are the main investment risks in Asia and emerging market equities?

One of our primary objectives is to avoid the permanent loss of capital. However, as active managers our role is not to eliminate risk entirely but to capture the premium that comes with the market’s perception of risk. This can be especially excessive in emerging markets.

Regulatory and political risks have always been a feature of investing in stock markets. However, they are widely perceived to be greater in Asian and emerging markets and at times of risk aversion share prices can end up being hit indiscriminately.

The region’s valuation discount compared to developed markets can partly be explained by episodes of political instability. Emerging countries encompass a variety of political systems. There are plenty of examples of diplomatic skirmishes and military tensions, that very occasionally escalate to military engagement, and are very difficult if not impossible to predict. China’s relationship with Taiwan and the prospect of reunification by force is frequently cited as a concern. We believe the probability of military conflict remains very low on a medium-term view.

Regulatory risk can also be hard to analyse, especially in markets where there is less consultation in policy development, with changes sometimes appearing arbitrary. Large firms tend to have closer relations with regulators and policy makers. They are often better able to anticipate and manage the related risks and opportunities, providing something of a competitive advantage.

We reduce risk by keeping our strategies well-diversified. We don’t allow one theme country, sector, or industry to dictate performance and ensure balance sheet strength can mitigate any negative unpredictable events.

Risk can also be a source of opportunity. Risk that is well-known by participants in the market can nevertheless lead to steep declines in share prices. Political or regulatory uncertainty have typically been good times to take on selective exposure.