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Wall St. and Business Wednesdays: Emerging Markets Enter The Mainstream by Charles Batchelor

Emerging markets – countries that would have barely caught the investor’s attention a decade ago – have become almost mainstream. Globalisation and the collapse of communism have created investment opportunities where none existed before.

Bric – the quartet of countries consisting of Brazil, Russia, India and China – is being promoted as a convenient market tool for the largest of these sectors.

Investors desperate for higher yields than could be achieved in the more developed parts of the world fell upon the attractive returns that were available.

But high returns almost inevitably means high risks and the emerging markets have been hardest hit by the downturn that hit the global stockmarkets in the second week of May.

“Emerging markets have always been a high risk/high return asset class,” says Richard Titherington, fund manager at JP Morgan Emerging Markets. “They are more volatile investments. When markets are going up everyone is happy but when markets fall, as they have over the last two months, everyone is nervous.”

In the three and a quarter years since markets began recovering from the dotcom bust, the FTSE All Share Index has risen by 80 per cent, compared with a 125 per cent rise in the MSCI Emerging Markets Index, in sterling terms.

In the six weeks since stock markets began to wobble, the All Share index has fallen by 8 per cent compared with a 20 per cent drop in the MSCI index.

Price/earnings ratios reflect the greater volatility of emerging markets stocks. The All-share has fallen from a p/e of 14.4 at the recent market peak on May 9 to 13.2. Datastream’s emerging markets index has fallen more steeply, from 15.2 to 12.6.

“Emerging markets overshoot in both directions,” says Plaven Monovksi, director of developing capital markets at Merrill Lynch Investment Managers.

Historically, there are plenty of examples of the vulnerability of emerging markets.

Mexico went through its “tequila crisis” when banks got into difficulties in 1994; the Asian economies slumped after the collapse of the Thai baht in 1997; while in the following year Russia was forced to declare a moratorium on its debt.

Volatility aside, one of the reasons why emerging markets have become a more attractive proposition is that, for the most part, governments have become better at managing their economies. In eastern Europe, a desire for membership of the European Union and the eurozone has marshalled finance ministries into line.

Floating currencies have also played their part, introducing an element of flexibility into economic management.

“There was nothing in the emerging markets that was likely to lead to a correction,” says Jeff Chowdhry, head of emerging market equities at F&C Asset Management.

“Current account deficits are comfortable, with a few exceptions. In previous downturns there have been other factors. In 1993, for example, emerging markets were at a premium to developed markets and that led to a correction.”

When the emerging markets first came to prominence, investors tended to lump them together and when one ran into difficulties, brokers would mark them all down. Fund managers are now better at distinguishing between the different markets although “contagion” is not entirely a thing of the past.

Brazil has its supporters because it is an important commodity supplier, including iron ore to China, although some foreign investors are still cautious about the presidency of Luiz Inacio Lula da Silva.

“The economy is in great shape and valuations are cheap,” says Chowdhry. “We like the banking and telecoms sectors.”

Monovski also regards Brazil – and Turkey – as good value. “But one key call that investors should make is on the direction of commodity prices,” he says. “If they see commodities collapse they should not trade these markets. But if they stay in range then markets such as Russia look cheap.”

Richard Titherington is less convinced about Turkey, however, saying its economy does not look strong and that the country is too reliant on foreign capital.

“The weak currency is also hitting the economy,” he says.

He believes that Korea, alongside Brazil, looks cheap. The powerful role played by family-dominated conglomerates known as chaebol means foreign investors are reluctant to get involved.

“Corporate government issues keep market price-earnings ratios low but profits are strong,” he says.

India still looks expensive to Chowdrhy, who says he has been underweight in Indian stocks for some time. He says he is not convinced by the general enthusiasm for India’s high-technology sector.

There is no shortage of global, regional and country-specific funds to ease investors into emerging markets but an alternative is to buy UK-listed stocks of companies that have exposure to these markets.

“These economies may be growing but you don’t necessarily make a lot of money from owning the shares of local companies,” says Carl Stick, a fund manager at Rathbones Unit Trust Management.

“There are lots of ways you can play this without necessarily investing overseas.”

He points to Burren Energy as a way of gaining exposure to oil and gas exploration and production in Turkmenistan and Congo-Brazzaville and JKX Oil, which is active in Ukraine.

He has also looked at Tarsus, an exhibitions organiser that is expanding into emerging markets.

The question facing investors now is: should they buy stocks at their current, relatively depressed, levels or will the markets fall further? If they do, emerging markets are once again likely to drop more sharply.

Opinions are divided. What fund managers do agree on though is that emerging market investment, more than most, is a matter of taking a long-term view. Investors should not focus on very short-term movements.

This article appears in The Financial Times.

Copyright The Financial Times Limited 2006

Charles Batchelor

Wednesday, June 28, 2006

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