Knowing Where to Look

Note: This article is part of Morningstar's December 2013 Emerging-Markets Week special report. It originally appeared in the December/January 2014 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.

The approach into Wilson airport in Nairobi, Kenya, seemed normal enough to Laura Geritz, the lead manager of the Wasatch Frontier Emerging Small Countries (WAFMX), at least until the wind picked up. Geritz, who was seated behind two co-pilots on the tiny 11-seater plane, watched as it was pulled to the right by a strong cross wind just as one of its three tires blew. The plane would have completely veered off the runway if it wasn't for the quick thinking of the lead pilot, who jerked it back on to the pavement.

Geritz downplayed the situation in her shareholder letter a few months later since she and several colleagues walked away without a scratch. But there was a tense moment or two. "One of the pilots was in training," she says. "I could see his eyes pop wide open."

Geritz and team were in Kenya as part of a broader trip through Africa that took them to Tanzania, Rwanda, and Uganda. On these due-diligence trips, there is a singular goal in mind: Find quality companies in developing markets with sturdy balance sheets, good management teams, and attractive valuations. In most cases, the team is laying the groundwork for eventually investing in a company three or five years down the line. But there hasn't been a shortage of good ideas they've put to work now. During its 20-month lifespan, the fund has gained an annualized 28.5% through Oct. 31, 2013, versus 12% for the MSCI Frontier Emerging Markets Index thanks to strong performers such as East African Breweries, a distributor of beers (Guinness) and spirits (Smirnoff vodka), and Vietnam Dairy Products, one of the largest dairies in Asia.

"What many emerging markets were 10 years ago," says Geritz. "You have that happening in frontier markets right now."

That pronouncement likely resonates with a lot of investors. Traditional emerging markets such as China and Brazil have been relative disappointments the last few years due to a combination of slowing economic growth, rising inflation, and concerns about the side effects of U.S. monetary policy (which was behind a sell-off earlier this year). That pullback has coincided with a recovery of performance in developed markets such as Japan and the United States. While investors aren't completely dumping their holdings in emerging markets, they are contemplating whether they need complements for the countries that provided a powerful performance punch the last decade.

"The last two years emerging markets have been a significant drag," says Stephen Barnes, founder of Barnes Wealth Management in Phoenix, Ariz. "But if you don't have [exposure to them] you are missing the boat."

While Barnes may be right, it may not be enough to just have exposure. Indeed, to advisors such as Barnes the story line isn't about buying big state-controlled oil or finance companies on the cheap or simply scooping up a market-capitalization-weighted emerging-markets index fund. Now, investors are looking for ways to get direct exposure to rising middle classes around the world that are spending the wealth they have accumulated. That theme isn't new. But what is are the means to do it: Funds that invest down the market-cap spectrum, across more sectors, follow alternative strategies and invest in countries that 10 years ago would have been deemed too risky.

The money trail is telling. Emerging-markets ETFs, which are largely owned by institutions, have endured mixed net flows in 2013.  Vanguard FTSE Emerging Markets ETF (VWO) and  iShares MSCI Emerging Markets (EEM) ETFs, two of the five largest ETFs, have seen roughly $4.9 billion and $2.5 billion leave coffers this year, respectively. Those funds still tower over the emerging-markets category. But investors have been gravitating toward funds such as  iShares MSCI Emerging Markets Minimum Volatility (EEMV). This ETF tracks an index of 200 stocks from the broader MSCI Emerging Markets Index that together make for a low-volatility portfolio. It has taken in $2 billion this year through Oct. 31, 2013. iShares has also seen $2.5 billion-plus flow into the  Core MSCI Emerging Market (IEMG) ETF, the only cap-weighted emerging-markets fund to include small-cap stocks, which tend to have better exposure to domestic trends. ETFs that focus exclusively on dividends and consumer stocks have also sold well in 2013.

The overall outflow trend doesn't apply to actively managed emerging-markets funds. These funds, which are traditionally favored by retail investors, have enjoyed positive net inflows for much of the year. That could be an indication that investors think a given mutual fund manager can exploit local market inefficiencies. A recent Vanguard study found that across 46 countries there isn't a strong correlation between GDP growth and earnings growth. To translate, that means investing in emerging markets isn't as simple as finding the fastest-growing country (although that helps).

Company fundamentals also matter. That is something a stock-picker can exploit. Silver-rated  Oppenheimer Developing Markets (ODMAX) is up 8.1% this year, thanks to web services firms such as  Baidu (BIDU) and Yandex (YNDX), which are located in China and Russia, respectively. That tally easily exceeds the returns of the large iShares and Vanguard emerging-markets ETFs. (Almost 40% of the Oppenheimer fund is in consumer-oriented stocks.) Geritz's fund has taken in more than $650 million the last year. That fund has 80% of its assets in small- and mid-cap stocks, including a 6.6% position in Pakistan, the second-largest stake of any fund in Morningstar's diversified emerging-markets category.

It's unclear whether institutional or retail investors are right. Morningstar data shows that over the past 20 years investors have, at times, poorly moved in and out of emerging-markets funds (Exhibit 1). In particular, they added to international and emerging markets just as the last two bear markets in 2000 and 2007 were taking hold. They then sold those positions as the subsequent recoveries were taking shape.

"The old adage was that retail money was the dumb money, but I am not so sure that is the case this time," says Robert Luna, the chief executive officer of SureVest Capital Management in Phoenix, who has added to his clients' emerging-markets exposure recently.

Luna suggests putting things in context. Slow growth in emerging markets is still faster than the developed world. And middle classes in regions such as Latin America, Africa, and Asia could be a powerful catalyst for stocks for years to come. Luna also points out that investing outside the emerging markets' largest stocks and into frontier markets means lower correlation to developed world holdings.

"There will always be political risks," he says. But the regions "are an alpha generator."

(Very) South of the Border
Outside of China, Brazil is by far one of the developing world's success stories having posted an average 4% GDP growth the last decade. Boston Consulting Group estimates that 55% of the country's adults live in middle-class households, up from 39% in 2002. By the end of the next decade, those households should account for an overall market of around $1.6 trillion. BCG estimates the country will spawn 13 new $1 billion-plus companies that will be global players, second only to China and India.

But Brazil is now partly a victim of its own success. The slowdown in China's economy has rippled through Brazil's as well since the two are major trade partners. The government has struggled to rein in inflation, which currently hovers around 6%. GDP growth should come in around 2.4% this year.

The pullback in Brazil has stung funds such as  T. Rowe Price Latin America (PRLAX), which had 57% of its assets in that country as of Oct. 31, 2013. Top-five holding Petrobras (PBR), the big state-controlled oil company, has dropped 6% this year. In addition, miner  Vale (VALE) has seen iron ore shipments to China slip. Both stocks are partly behind the fund's 10.9% loss through Oct. 31, which lands it in the bottom quartile of the Latin America stock category.

Other funds such as Seafarer Overseas Growth & Income (SFGIX) have also felt the pullback. Manager Andrew Foster initially stayed out of the country due to valuation and currency concerns when he first launched the fund in early 2012. But over the summer he started slowly buying when stock prices fell. While he owns Vale, Foster has leaned toward more consumer-oriented holdings. Odontoprev is a provider of dental services and insurance. The fund also owns Aliansce Shopping Centers.

Brazil, though, isn't the only option in Latin America. Chile, Peru, and Colombia make up what BCG calls the "Andean Three." These three emerging markets are predicted to grow at a combined faster rate than Brazil and Mexico, respectively, and like Brazil, these three countries have seen the poorer parts of their populations rise into middle class status the last decade. They also have mutual trade agreements between them.

While mining and financial stocks typically make up the exposure from these countries in emerging-markets funds, the T. Rowe Price offering does own Chile-based department store chain Falabella, and Wasatch's Geritz recently scooped up Forus, a clothing retailer also based in Chile. These countries hold promise, but not every manager is sold.

Deborah Velez Medenica, the lead manager of Alger Emerging Markets (AAEMX) owns in her fund Peruvian bank Credicorp (BAP). She stresses, though, that until liquidity improves she is hesitant to take on additional country risk. "You could see pension money there if [the markets] develop liquidity," she says.

Changing Face of Africa
"We have a continent that is largely at peace,"says Oliver Bell, the lead manager of T. Rowe Price Africa & Middle East (TRAMX), pointing to a map of Africa that shows just three hot spots on the continent versus one next to it that shows 20 in the same region in the 1970s.

Given his fund's mandate, Bell has reasons to be a believer in the potential of the region. But he is also armed with some powerful statistics. Eight of the 10 estimated fastest-growing economies in the world over the next five years are located on the continent. Aggregate debt to GDP has fallen to 20% from 60% in 2000. Africa has one of the largest populations of young people, which is rapidly expanding the workforce. That population is also becoming more educated.

One of Bell's top picks is MTN Group (MTNOF), a large mobile phone operator in Africa. While his thesis is based on soaring mobile phone usage, he also points to the changing face of banking on the continent as a reason to own the stock. MTN has a service that acts as a mobile wallet, allowing users to transfer money via entities such as  Western Union (WU). Bell thinks such services will reshape the banking system as consumers avoid branches altogether. Like MTN, most of Bell's holdings are located in South Africa, but give the fund broad exposure to the continent.

Geritz is playing the consumer angle from a different perspective. She owns Nigeria-based subsidiaries of  Nestle (NSRGY), Cadbury, and  Unilever in addition to several breweries such as East African Breweries, Nigerian Breweries, and Guinness Nigeria.

Both managers admit there are several key concerns that come with investing in Africa. The first is liquidity. Most of the continent's individual stock exchanges aren't liquid enough to allow prompt buying and selling. So portfolio candidates are usually located in South Africa. Indeed, Geritz will on occasion resort to buying positions in a company from an institutional investor in order to avoid a fluctuating stock price. Both managers are also keenly attuned to any new conflicts.

"It's not in anybody's interest to let things flare up again," says Bell.

Eastern Europe Opens Up
In addition to Africa, Geritz and her team are also spending a lot of time researching companies in Europe's frontier markets such as Poland, Turkey, Croatia, Lithuania, and Latvia. "A lot of these countries got hit by the Eurozone crisis," she says, adding that while valuations look cheap, liquidity is an issue.

Poland, in particular, has proven to be fertile ground. That country saw a rebound in GDP growth in the first half of 2013, according to Credit Suisse, driven by higher exports and increases in household and government spending. Inflation has also been kept in check by the country's central bank. In addition to running a frontier fund, Geritz is also a comanager on  Wasatch Emerging Markets Small Cap (WAEMX). That fund owns LLP, a Polish high-end clothing company, and Eurocash (EUSHY), a consumer goods company that has a 19% market share of the retail supermarket industry in that country. Both stocks have been performance drivers for the fund in 2013.

Turkey is another country on a lot of mutual fund managers' radar. Alger Emerging Markets' Medenica thinks it is a compelling option.

"It's had a stable government for a decade that has undertaken economic reforms," she says. "They have delivered good GDP growth."

The only concern, she adds, is its proximity to Middle Eastern hot spots such as Syria. Her fund owns Coca Cola Icecek Sanayi , the distributor that supplies the soft drink to most of Eastern Europe and the Middle East. The fund also owns Emlak Konut Gayrimenkul Yatirim Ortakligi, a real estate investment firm. Geritz also has exposure to Turkey. Her emerging-markets small-cap fund holds Ulker Biskuvi, one of the country's largest biscuit makers.

China's Influence Hasn't Waned
Franklin Templeton's Mark Mobius has been investing in emerging markets perhaps longer than any other mutual fund manager. So his answer is telling when he was recently asked whether the United States or China had a greater influence on emerging markets.

"China," he says. "Trade with China is the largest with emerging-market countries in Asia, [which is] the largest emerging-market area in terms of market capitalization."

Indeed, China's slowing economic growth the past few years has rippled through countries who count on it for exports. So any news about its GDP growth is quickly digested by international fund managers.

Adds Norm Boersma, Mobius' colleague and president of Templeton Global Advisors Limited: "The government is content with having things slow down a bit. Right now the magic number is 7.5% to 8% [GDP growth]." Some context: Even though that growth rate is considered slow on a relative basis, it is still considerably higher than the developed world.

China's impact on the region can be seen in counties such as the Philippines, one of its largest trading partners. The Philippines economy should grow a strong 7.2% this year on exports and private and government spending. (It has been averaging 5% annualized growth the last decade, according to the World Bank.) Infrastructure investment has been particularly important for a country that has lagged others in the area on that front. Indeed, recent severe flooding revealed just how vulnerable the country can be to erratic weather.

The Wasatch Frontier Emerging Small Companies fund counts Universal Robina amongst its holdings. The consumer products company distributes snack foods, beverages and grocery items. The fund also owns Philippines-based International Container Terminal Services. "There is a fantastic rising middle class story [in frontier markets]," says Geritz.

While Geritz started a previous shareholder letter talking about her travails flying into Nairobi, she concluded her most recent one by writing from the Hill of Muses in Athens, Greece, a country she is researching. In the letter, she pondered Greece's recent troubles in the context of its history.

"I want to capture the next great economy and miss the worst, but I don't think that can be done from reading the headlines," she says. "It is done by picking companies with the potential to be great that can operate in the wake of the worst events."