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This number provides the most compelling reason to add emerging-market stocks to your portfolio

By Philip van Doorn, MarketWatch

About 44% of global GDP comes from emerging markets -- but you might have little exposure to those rapidly growing economies

Emerging-market stocks have been hot lately, as anticipation builds that there will be a real trade deal between the U.S. and China after many misfires. But that may not be your best reason to consider EM stocks for your portfolio.

Andrew Mathewson, a portfolio manager of the Martin Currie Emerging Markets Fund, argues that lower valuations and the evolution of emerging markets as compelling reasons for investors to diversify beyond U.S. stocks.

Martin Currie is based in Edinburgh, Scotland, and has a history stretching back to the 1880s. The firm was acquired by Legg Mason in 2014. The Martin Currie Emerging Markets Fund was established on June 1, 2015.

Lower valuations

The S&P 500 Index trades for 17.6 times weighted aggregate consensus earnings estimates for the next 12 months, among analysts polled by FactSet. The MSCI Emerging Markets Index trades for only 12 times forward earnings estimates.

Under-represented in portfolios

Emerging-market economies contributed 43.8% of global GDP in 2018, according to the IMF World Economic Outlook. But EM stocks made up only 11.9% of the MSCI All Countries World Index at the end of 2018. This reflects, in part, the prevalence of private ownership in EM, as well as MSCI's underweighting of China in the index.

But when talking about U.S. investors, Mathewson said most are underweighted to EM even relative to the rather low 11.9% weighting of the broad MSCI index.

An investor who really wants to be diversified should consider adding exposure to what is close to half the world's economy.

Where the growth is

Some investors may be well aware that the old view of emerging markets -- that they are mostly about commodities, materials and cheap manufacturing -- is outdated.

But Mathewson believes some U.S.-focused investors may still be under a misconception about EM: "Ten years ago, we would have talked about consumer-staples products," he said during an interview. But now that there are high levels of market penetration in emerging markets for basic consumer-staples products, "the exciting areas of consumption in EM are about services, experiences and premium-ization."

He gave an example of a company held by the Martin Currie Emerging Markets Fund that is taking advantage of this trend: LG Household & Health Care of South Korea (051900.SE). The company mainly distributes skin-care products.

"Their key product is an item that costs $150," Mathewson said. (The fund tends to buy locally traded shares. American depositary receipts (ADR) for LG Household & Health Care trade under this ticker: .)

The fund manager pointed to something else that may fascinate investors: "This is not a story of a Western brand. This is an emerging-markets luxury brand for emerging-markets consumers."

Distribution across emerging markets has gotten easier. "Historically, if you were a Korean brand and wanted to sell it in China, you would open a counter in a department store," he said. Now, "you can expand into markets much more rapidly than you would have been able to."

Mathewson gave two other examples of stocks held by the fund that underline the evolution of emerging-markets consumers. Odontoprev (ODPV3.BR) is a dental insurer in Brazil and Ping An Insurance Group Co. of China (601318.SH) (ADR: ) is a giant and rapidly growing conglomerate that provides life and property and casualty insurance, as well as investment services.

Here's a comparison of the MSCI Emerging Markets Index's allocation to six sectors at the end of 2008 and at the end of 2018:

Sector                   Share of MSCI EM Index - end of 2018  Share of MSCI EM Index - Jan. 1, 2008 
Financials                                                25%                                    22% 
Consumer                                                  17%                                     9% 
Information Technology                                    14%                                    10% 
Communications Services                                   14%                                    12% 
Materials                                                  8%                                    15% 
Energy                                                     8%                                    18% 
Other                                                     14%                                    15% 
                                                                     Sources: Martin Currie, FactSet 

Financial services remains the largest sector, though consumer, IT and communications have increased greatly as energy and materials have lost importance.

Technology growth

Ten years ago, "emerging-markets tech companies were assemblers of laptops, etc.," Mathewson said, but today they are manufacturers of batteries and "leaders in memory."

He sees the battery space as the best way to invest in the transition to electric vehicles. Mathewson named two Korean manufacturers held by the Martin Currie Emerging Markets Fund: Samsung SDI (006400.SE) (whose global depositary receipts trade under the ticker (006400.SE)), and LG Chem (051910.SE) (ADR: ).

The fund's largest holding is Samsung Electronics (005930.SE), which Mathewson expects to continue to benefit from high rates of e-commerce penetration in emerging markets.

How to beat the benchmark

The Martin Currie Emerging Markets Fund's institutional shares have a five-star rating from Morningstar (the highest) and are available through investment advisers. They have a 1% annual expense ratio, which Morningstar considers "below average" for U.S. diversified EM funds. The fund's FI shares can be purchased without going through an adviser, are rated four stars and have annual expenses of 1.35%, a level Morningstar considers "average."

The fund's benchmark is the MSCI Emerging Markets Index , which includes more than 1,100 stocks across 26 countries.

Mathewson and his colleagues try to beat the performance of the index by managing a concentrated portfolio of 40 to 60 stocks, among index components. He said that the Martin Currie team selects stocks from the bottom up, but it is careful not to let its country allocations differ significantly from those of the index.

They look for high-quality companies that are "mispriced by the market." Mathewson defined high-quality companies as "businesses that make good returns and have a balance sheet that will allow them to invest and take advantage of the growth opportunities we believe they will have."

He cited Tencent Holdings (0700.HK) as an example, because of the "monetization being developed" through its "integrated payments and QR codes."

QR codes are identifiers for small merchants that can be used to pay them with smartphones.

Mathewson drew a contrast between Tencent and Facebook (FB): "Facebook has WhatsApp and Instagram, but they are relatively stand-alone businesses. We all use WhatsApp but they are not earning from it."

This points to much more rapid adoption of electronic payments in emerging markets than in the U.S. and other Western countries. E-commerce made up 23% of China's retail sales in 2017, compared with 9% for the U.S., according to Statista.

Here are performance comparisons for the Martin Currie Emerging Markets Fund's two share classes against the index, net of expenses, in U.S. dollars, through Nov. 12:

  Total return - 12 months  Total return - 3 years  Total return from inception: June 1, 2015 
Martin Currie Emerging Markets Growth Fund - Institutional shares  21.0%  44.0%  31.7% 
Martin Currie Emerging Markets Growth Fund - class FI              20.6%  42.5%  30.0% 
MSCI Emerging Markets Index (U.S. dollars)                         12.2%  35.2%  19.6% 
 

For an annualized comparison, the fund's institutional shares had an average annual return of 12.9% for three years through Nov. 12, while the class FI shares had an average return of 12.5% and the index's average return was 10.6%, according to FactSet.

Here's a list of the top 10 holdings of the Martin Currie Emerging Markets Fund as of Sept. 30, with their current weighting in the iShares MSCI Emerging Markets ETF (EEM), which tracks the benchmark index:

Company                                               Country      Ticker  Share of portfolio as of Sept. 30  Share in EEM as of Nov. 8 
Samsung Electronics Co.                               South Korea  KR:005930  7.96%            3.80% 
Taiwan Semiconductor Manufacturing Co. ADR            Taiwan       US:TSM  7.70%            4.34% 
Tencent Holdings Ltd.                                 China        HK:700  6.55%            4.25% 
Alibaba Group Holding Ltd. ADR                        China        US:BABA  6.43%            4.69% 
Ping An Insurance Group Co. of China Class H          China        HK:2318  3.28%            1.15% 
Industrial and Commercial Bank of China Ltd. Class H  China        HK:1398  2.98%            0.82% 
OTP Bank Nyrt.                                        Hungary      HU:OTP  2.94%            0.18% 
Titan Co.                                             India        IN:500114  2.90%            0.09% 
Lukoil PJSC                                           Russia       RU: LKOH  2.63%            0.65% 
Credicorp Ltd.                                        Peru         US:BAP  2.56%            0.24% 
                                                                                                           Sources: Martin Currie, FactSet 

Aside from Taiwan Semiconductor (2330.TW), Alibaba (BABA) and Credicorp (BAP.VL), the fund's top holdings are stocks bought in local markets. For some of these, American depositary receipts are available:

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