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Three Risks to Emerging-Markets Investing

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. We're reporting from the 2011 Morningstar Investment Conference, and today we're sitting down with Andrew Foster. Andrew is formerly of Matthews Funds, but now he is the founder of Seafarer Capital Partners. We're going to talk a little bit about the opportunities and the risks overseas which are particularly important given that we've seen some economic slowing here in the U.S.

Andrew, thanks for joining me.

Andrew Foster: Great. Thank you.

Stipp: I wanted to start and talk a little bit about the emerging markets. This is an area where there is a lot of momentum behind the notion that the fundamentals in emerging markets are very strong, especially compared with the U.S., the debt levels of the governments are lower. The growth looks potentially brighter and emerging middle class could prop up growth in some areas.

But at this time, when we've seen emerging markets gather assets and we've seen that the performance has been good, I wonder are there risks that investors are overlooking or that should be on their radar that they are not seeing given that the story over here sounds so good on the positive side?

Foster: Yes, well, I think I would draw attention to three points, two of which are readily talked about, one maybe a little less so. Of the points more commonly discussed, one would be inflation. That's been a headline issue for many of the emerging markets, and to some extent it's been an issue for some of the developed markets. I think when I look at most of the emerging markets that I cover, I see more entrenched inflation than most analysts are willing to admit. As an example of that, the central government of China just came out yesterday and warned folks to expect a higher rate of inflation for quite some time to come. And inflation in and of itself, is not necessarily a terrible thing unless it escalates terribly out of control but it can create a headwind for growth as the economy restructures to deal with changing and volatile price environments.

The second thing that I would draw people's attention to is currencies. There is a lot of talk about emerging-markets currencies given the concerns over the dollar right now, and I think there are some reasons to be positive and optimistic about select emerging-markets currencies. But I also think some are very stretched at this juncture. I think one that I could easily highlight is the Brazilian real. It is a currency that's been pushed very high by foreign flows into the country, and I'm concerned about the volatility around currencies in some emerging markets. Even as some of the stock markets themselves might be enjoying healthier evaluations, the currencies may be a source of risk or at least volatility.

The last thing that I would draw attention to that's maybe less discussed is the fact that some of the bigger emerging markets may actually need to see moderating growth going forward. I think probably China is the best example of this. China's growth really needs to change in the coming decade, and I think people are accustomed to very high rates of growth with emerging markets, especially with places like China, maybe India, and I think the growth model in China is changing very substantially, and I think it will mean a moderation in growth. It won't mean that growth disappears but a moderation that may not be built into peoples' expectations or valuation models.

Stipp: I want to talk about valuation in a moment. But with the first one you mentioned there, inflation, I have a couple of follow-up questions for you. First of all, are the governments equipped and willing to deal with inflation that could be heating up in emerging markets? Secondly, if we do see inflation in emerging markets, what might that mean for the domestic market here in the United States?

Foster: I think the point on equipped and willing is tricky. I think all the governments do have the tools to rein in inflation if they do wish to do so. The problem that they face is it's a political question in managing a socioeconomic situation. These economies are growing very strongly, there's a lot of pressure to keep the growth up, and in the past a lot of central banks around the world were able to tie their policies more explicitly to those of the Federal Reserve. But with the sort of policies we have in the States, such as quantitative easing, central banks in emerging markets would be flooding their own markets with liquidity if they were to follow the U.S.

They used to have a convenient excuse to follow the Fed's own interest-rate cycle, but now they're under more direct pressure to manage the situation on their own. They have less of a crutch in that respect, and I think they are unfortunately sometimes pushed by political masters more than they should be. They don't enjoy the same sort of independence. And as a consequence, it means that economies can see inflation get away a bit from them, and right now, I don't see any major economies at least in danger of hyperinflation, but I do see escalated and elevated levels of inflation that will have significant cost pressures for individual companies. I think it's really a question for investors as to how individual companies can adapt to those sorts of pressures.

Stipp: So, if inflation is something that we may need to get used to, do you think the emerging-markets inflation will lead to more inflation here in the U.S.? Is that something that we need to be keeping a close eye on, and what's the connection there?

Foster: I have to say I am not enough of an economist to really discuss the transmission mechanism in detail, but I have no doubt in my own mind that at an anecdotal level, I see those pressures being pushed through, particularly in our own trade flows in the States. I know that a lot of Asian manufacturers in particular are beginning to be more resilient or firm on not swallowing cost increases in their own margins. They're beginning to push higher prices through to their export and trading partners in the States, and in so much as we import inflation via that mechanism, I would be a little bit worried about it.

I think the offset to that is the U.S. has reclaimed a bit of manufacturing and industrial presence in the last two or three years. As some of our own flexibility has come to the fore, we've seen our economy grapple with some of the world changes. It's has not been easy, but we've actually seen the manufacturing base return in some industries to the States, even from gaining share from markets like China, and that might offset some of these cost pressures in the country. But I would say on balance I'm more worried than not.

Stipp: I just want to talk a little about valuations which you mentioned earlier. Given the fundamental case that we've seen, but also given some of the risks out there and the fact that we've seen emerging markets perform relatively well over lots of trailing time periods, what do valuations look like broadly? Does it seem like there is still opportunity there, that there still could be some areas that are priced attractively or do you really need to go in selectively and kind of look on a case-by-case basis to find that value story?

Foster: Well, I think if we talk about equities for a moment, I think equities with I'm generally comfortable if valuations are friendly to investors in a sense that, especially if you were to look at price-to-earnings multiples, they are not egregious or exceptionally inflated at this moment in the cycle. I think the important caveat around that though is that while valuations hover near long-term averages or maybe even just below long-term averages, the caveat is that earnings are at a new all-time high in the Asian markets and close to that for emerging markets in general. So, I'm not saying we're at a cyclical peak but we're certainly not at a trough where you could expect maybe a rebound in earnings and be buying earnings cheaply at that moment.

We're at more of a normalized state or maybe even closer to the top of a cycle than the bottom in some of the emerging markets. So, that's something to be worried about. That shows up in the price-to-book multiples. The price-to-book multiples are a little more elevated than long-term averages right now. What that's expressing is that the earnings are healthy. But price-to-book multiples have not necessarily caught up on that measure, and there's not enough retained profit to help price-to-book multiples out.

But I think valuations all told are not terribly difficult for investors to approach at this juncture. But, again, currencies are the issue. If currencies have some froth in them or are maybe a source of volatility, you might be buying a cheap equity, but if you are going to suffer some volatility in the currency going forward, I think that's a cause for concern for a U.S.-based dollar-denominated investor.

Stipp: We could see a headwind there. So the last question I have for you, Andrew, also involves from a U.S. investor's perspective, we do know that, just looking at the S&P 500 which is considered a proxy for the U.S. market, we know that around 40% of the firms' sales come from overseas, some of that is going to be coming from emerging markets, as well. For a U.S. investor, thinking about that, what's the story for why should I go overseas when I can already get international exposure just with my domestic companies here in the U.S.? What can I get by looking at companies that are domiciled overseas?

Foster: Well, I think that argument has been definitely at the forefront of foreign and emerging-markets investment for 15-20 years now. And I will say that compared with where we were 15-20 years ago, it's far more relevant. The S&P does truly have penetration into these markets, the S&P 500 companies do, and there are more meaningful earning streams coming from foreign markets in a way that it was really hard to observe it on the ground in these markets previously.

But that said, a lot of these larger multinationals are not the ones pioneering new markets in the emerging markets, new economic opportunities. And some of the most attractive opportunities are ones where you can see an existing market, one that is seasoned elsewhere in the world, maybe it's a developed market for a particular consumer good, but it just simply doesn't exist in an emerging market. Mapping that opportunity to an emerging market is usually an interesting opportunity for an entrepreneur because there is maybe little competition, and it provides a seasoned business model. You're not taking a lot of business model risk. You may be taking some execution risk, but those sorts of opportunities are not the ones exploited by the big multinationals to the same extent. So, if you're trying to capture that sort of nascent growth that these markets can provide, you tend to need to be with the local companies more often than not, even as I would concede the S&P 500 delivers more than it once used to.

Stipp: Andrew Foster of Seafarer Capital Partners thanks so much for joining me today and your insights on internationally emerging markets.

Foster: My pleasure. Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.