Casey Files:
Another Look at Emerging
Markets
By the editors of Without
Borders
Casey Research
Feb 16, 2009
After passing much of 2008
standing thankfully on the sidelines, we believe that with current
valuations, opportunities have returned for putting capital back
into long-term positions in emerging markets. In fact, we believe
that emerging markets will recover faster and outperform developed
markets over the long term.
In our December 2007 edition
of Without Borders we wrote:
"So much money has been
sloshing around the globe in search of an "above average"
return that even risky assets have been bid up tremendously.
At this stage, however, with new holes in the financial dike
showing themselves almost weekly - more holes, we suspect, than
officialdom has fingers - the money flows are building toward
a reversal. This will hammer the emerging markets the hardest
because, historically, in times of crisis, capital packs up its
bags and goes home. When that happens, shares of good companies
get sold at the falling bid simply because the seller must get
liquid, whether to calm his fears or to cover his losses elsewhere.
Asset prices become screaming passengers strapped into a luge
ride.
"This creates opportunity,
of course. Even though the economies of all the most prospective
emerging-market countries are strong enough to weather any likely
storm, their financial systems aren't. This is emphatically true
in India, China, Brazil, and other fast-track economies. Even
so, when foreign financial capital has fled, the physical and
human capital will remain, it will still be valuable, and good
investments will be cheap in the extreme. But the opportunity
won't be available for everyone - just the investors who've been
patient." [Dec
2007]
Then in April 2008, we gave
our presentation on "Bottom Fishing for Stocks in Emerging
Markets," during which we highlighted that the single most
important factor in emerging-market stock markets is capital
flows. In the emerging markets, the time to invest is when
capital has fled the country.
We know we disappointed the
crowd when we said that there was not one emerging market we
found attractively priced and that shorting in emerging markets
is almost impossible, so our strongest recommendation was to
do nothing.
It's quite a skill to do nothing
and do nothing well. We sidelined ourselves and watched, staying
away from emerging markets for most of 2008.
But now, finally, the
catastrophic sell-off in global financial markets had the effect
that we expected: there was a huge sucking sound coming from
public equity and currency markets in Russia, Brazil, China,
Taiwan, Malaysia, India, South Korea, Colombia, Chile, etc. Foreign
institutional investors came face-to-face with the reality of
lower risk tolerance and deleveraging and were forced to sell.
Everything.
The ensuing flight to quality
left emerging markets and their currencies decimated, but herein
lies the opportunity. We just hope the IMF and World Bank will
run out of money or leave them alone, thereby preventing the
return to the boom/bust cycle of the 1990s.
Bullish long-term outlook
Remember, the sell-off in emerging-market
equities, bonds, and currencies reflects a rush for the exit
sparked by global deleveraging and a need to raise cash, rather
than any change in the fundamentals. When the current turmoil
subsides, we believe that emerging markets will fare better than
developed markets and will outperform the latter over the long
term. As such, we find that current valuations are solid entry
points for putting our hard-earned capital into long-term positions.
Consider:
* Emerging-market economies
will prove resilient during this economic slowdown and may account
for all of world economic growth in 2009 as developed markets
slow to zero.
* Emerging economies are not
nearly as dependent on consumer spending and almost not at all
exposed to consumer credit.
* Emerging markets by and large
suffer neither the demographic imbalance nor the entitlement
imbalance that plague the developed nations.
* Corporate and personal balance
sheets in emerging markets are stronger than those in the developed
markets.
* In many emerging markets
(Brazil, most of South East Asia, India) as well as several African
nations, domestic or regional demand is now more important than
exports for GDP growth.
* Among stronger economies,
high foreign-exchange reserves and lower foreign debt levels
act as insurance against the global slowdown; reserves have grown
six-fold to over $4 trillion over the last ten years.
* Over the past ten years,
emerging-market companies have produced higher profits with lower
(but not necessarily low) leverage, while profits expanded annually
by double digits during the past ten years.
Cash Rich, Resource Rich
Compared to the late 1990s
Asia crisis, the present situation is much more stable for emerging
markets. While we expect current account surpluses to deteriorate
given the global slowdown and recessionary pressures, emerging
markets will face this challenging period with cash in their
bank accounts.
The importance of this change
cannot be overstated.
Much like individual households
that stash away something for a rainy day, many emerging-market
countries now have a greater reserve of wealth with which to
buffer financial market headwinds. This gives them the option
of taking fiscal stimulus measures to offset the effects of a
developed-markets slowdown without having to go into debt.
While we decry these neo-Keynesian actions as throwing water
on an electrical fire, historically they have boosted share prices.
As part of their fiscal stimulus,
we also expect to see higher infrastructure spending by countries
with the financial muscle to do so. China, for example, which
is projected to have more than 200 cities with populations exceeding
one million people by 2025, up from just 23 in 2005, announced
in early November 2008 a two-year infrastructure investment and
stimulus package of up to 4 trillion yuan ($586 billion). While
much of this stimulus will come in the form of strong-arming
banks, there will be substantial cash injections in the Chinese
economy, and they have the cash to do it: highways, railroads,
and airports. The government hopes that this stimulus package
will also encourage increased consumer consumption. All this
is good news for raw-materials companies, one of which is an
undervalued Chinese cement company that is a cornerstone of our
portfolio. (Learn more about this
company here.)
The turning point
Emerging markets will be the
catalyst for global economic recovery, not the West. Like China,
many emerging markets that have been saving for a rainy day have
the cash and political will to spend on development projects
that require raw materials. Others, like Chile and Angola, have
the raw materials to sell. Even more so, a few countries like
Brazil and Saudi Arabia have both. The economy will get jumpstarted
with these countries initiating their own trade without the leadership
or consumptive traditions of the Western world.
Perhaps even more pointedly,
we foresee a highly inflationary environment over the next several
years... all of the dollars with which President Obama will be
flooding the world will have to find a home somewhere. This will
more than likely spark another commodities boom, which is supported
by the world's ever-growing demographics, resource scarcity,
and climate-change legislation.
As such, resource-rich emerging
markets are going to find themselves being the future home to
foreign investment capital again. Institutional capital will
trickle, then gush into these markets as the world wakes up one
day and finds oil and copper trading at twice their present levels.
Consequently, today's emerging
markets will be the net recipients of the future inflation that
is being created by the West.
Capital Flow Conclusions
We have long said that capital
flows are the most important indicator for emerging equity markets.
Investor outflows in the second half of 2008 already equal one-third
of the total inflows into emerging-market equity funds over the
prior five years. This is a positive sign for contrarians looking
for a bargain. There has been a bloodbath, and this is a buying
signal.
We recognize that the ride
will likely be bumpy. Fiscal stimulus, trillion-dollar deficits,
and politicoramus bickering may cause a roller-coaster ride to
the top... but the evidence strongly suggests that, once institutional
funds finally realize that U.S. Treasuries are a fool's bet,
remaining capital will be on the hunt and flowing back into emerging
markets. The window is open, and we are dedicating our efforts
to finding the most undervalued companies with rock-solid management
and balance sheets.
***
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###
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