Global emerging markets… An exciting prospect or a daunting challenge?

By their very nature, emerging markets can be volatile and fragile. However, in this exclusive interview with IFA Magazine, M&G Investments’ Michael Bourke explains how and why his team could be ideally placed to navigate the challenges posed by this sector and achieve long term investment success for clients and advisers alike.

In this exclusive Q&A, Michael Bourke, Head of Global Emerging Market Equities at M&G, tells us why he believes that a shift in the mindset within Chinese corporates, paired with a long-term approach from his team, has allowed them to spot opportunities that others may have missed.

Bourke also highlights why his team’s value-oriented approach could allow them to be very well positioned to deliver for investors both now and in future.

IFA Magazine: What shifts are happening in global emerging markets right now?

Michael Bourke: “Inside emerging markets are a number of different dynamics. China has been very weak and, as it is about a third of the asset class, it has been a key driver for underperformance relative to global markets, in particular US equities. We see several factors here which are pointing towards change. Firstly, regarding China, many investors are very concerned by the drift of the weakness in the economic environment there following the drop of COVID-19 measures last year, but also the geopolitical situation and this confrontation between the US and China. So, regarding the economy, we see several considerations here which are proving that even though China's economy has been growing very strongly for 30-40 years, the equity returns over the last 20 years have been very poor.”

“A large part of the reason for poor returns is that a lot of corporations in China have been over-investing because they expected the growth to remain high. As the growth has faded, excessive investment has driven a collapse of profitability. This is key to understanding why China has been weak, but also key to unpicking what might drive an improvement in profitability levels going forward. We see fundamental behaviour happening in China at a corporate level, driven by a realisation that growth is no longer as high. Chinese companies are not investing as much and  are providing more dividends and more buybacks.”

“We see a very sharp inflection in the dividend payout ratio in China which is symptomatic of a corporate culture which is shifting towards thinking much more about return on invested capital to investors, rather than growth at any price, which was the previous mindset. So first and foremost, we see Chinese corporates improving and driving counterintuitive improvements in returns  and profitability , which will be at odds with the discussion around a weak economy  which will naturally slow further.”

“Given the influence of Japan across the water, we see a very strong reform agenda happening in Korea as well as amongst certain conglomerates. Particularly SK Hynix and Samsung Electronics, which of course are both beneficiaries of an improving memory semiconductor cycle. In addition, we have the AI excitement and penetration of AI, particularly regarding Nvidia's use of Hynix memory chips.”

"In general, across the rest of the asset class, currencies are very weak in the face of the dollar strength and high dollar rates. That's normal, but they've not been as weak as we've had in previous cycles because external accounts are no longer as vulnerable to the cost of debt as they used to be. A number of emerging markets, particularly Brazil and Indonesia, are not net borrowers. We see potential improvements there. Currencies that are, in real inflation-adjusted terms, undervalued and are therefore your starting point as an investor, with the fundamentals improving.”

IFA Magazine: Why is a value-oriented approach key in emerging markets?

Michael Bourke: “We've long been focussed on return on invested capital and valuation of the businesses we invest in to ensure that we convert those returns into positive results for our investors. We think this approach works well in emerging markets for a number of reasons. Firstly, the nature of the asset class means that investors in the past have been obsessed with this idea that emerging markets will provide growth and that obsession with growth has affected profitability and caused some companies to overinvest.”

“Also, it has meant that investors tend to go through very highly pronounced swings in sentiment. Emerging market equities are more volatile equity markets and are more fragile, therefore you have much greater volatility at certain points with the valuation of businesses. This provides strong entry points for the discerning investor who is happy to wait for valuations to subside and for opportunities to come towards us.”

“In addition, the nature of the asset class means that there are more cyclical companies and companies involved in economic sectors which, by definition, have much more cyclical profitability. Fewer quality companies have  stable earnings in emerging markets, as compared to developed markets. As value investors, we are accustomed to investing in those kinds of sectors, we are more comfortable with the idea of the cycles and therefore are happy taking advantage of that volatility in pricing, to time our entry points, pick up value and remain disciplined around the price we pay, as well as when we sell. This has worked well despite the headwinds to value as a style of investing. Over the past decade it has proven to be successful for us.”

“We have shown that the value approach does work, and our value approach is not simply value in isolation. It's not simply the price to earnings valuation of a business, it's the value relative to earnings and profitability generation. For us, sometimes we find value in quality businesses, even in good growth businesses. Much depends on the discipline and on our application and the degree to which we are rigorous around waiting for the valuation opportunity and then buying at that moment when we see the upside, rather than just following the market dynamic.”

IFA Magazine: Why do you believe that emerging markets present such an opportunity for stock picking and delivering an investment edge?

Michael Bourke: “If you refer to the emerging markets index, it has become dominated by Asia. That has as much to do with China's size as it does with the underperformance of other  non-Asian countries in EM . In China, there are a lot of companies which means it has come to dominate close to 30% of the emerging markets index. With its large neighbours, Taiwan and Korea and the very large technology businesses there and of course, India itself, Asia has become the dominant part of the asset class. In the last ten years, non-Asian, South African and Latin American countries have struggled. Today, this represents the biggest opportunity  in our view. The index is inefficient and what that means in practice is that non-Asian markets are very underrepresented in the index; for example, Vietnam is not in the index today. If we take Mexico, which is a beneficiary of the diversification of multinationals away from China and bringing those supply chains closer to home (which is called nearshoring or fringe shoring), it is still only 2% of our index. This is a huge opportunity and a compelling investment opportunity for active investors like us who can include more exposure to Mexico, and other countries in Latin America . It's about finding the very best opportunities rather than following the winners of yesterday which the index represents. That’s why for us this is now a key opportunity.”

“In terms of investment edge, there are two important factors. Firstly, our biggest edge is the fact that all equity markets, but particularly emerging markets, are very focused on the short term. There is a huge narrowing of many investors’ time horizons towards the short term, even to the immediate. This for us is our very biggest advantage, using our long-term mindset, understanding our businesses and their ability to earn profits and deliver return on capital over time. Our skill is interpreting the shape and pattern of returns over time and by understanding market short-termism and turning that into an advantage, we are well positioned to interpret when the market is overreacting. By remaining long-term in thinking and focussed on fundamentals, we can advantageously invest at a time when the market is excessively short-term focussed.”

“A similarity between global and emerging equity markets is that they tend to value quality businesses with stable profitability more efficiently than more cyclical businesses. These businesses are often well understood by the market and tend to be stable and fairly valued. As investors we are waiting for an opportunity to enter these types of companies and the naturally higher volatility within EM often gives us that opportunity. Where the market is much less efficient and where we have a real edge and expertise is in evaluating cyclical businesses that operate by definition in cyclical sectors.  We look for companies that may not be able to outperform the cycle, where pricing power may be poor, and where the return profile is driven largely by external factors. There are more of these businesses in cyclical industries in emerging markets given the asset class as a whole is more fragile and more GDP sensitive. Therefore, with our keen philosophy of focusing on understanding external and internal cyclical change, we believe we are in a good position to invest in those opportunities.”  .”

Making patient and positive moves

In conclusion, it’s clear from this Q&A that Michael and his team not only deeply understand the shifts that are occurring in the emerging market equity sector but are also poised to take advantage of the opportunities these shifts are providing.

Using a value-orientated approach and focussing on returns on invested capital means they have become masters of employing patience.  Remaining disciplined and waiting for the right opportunities at the right time, looking to maximise positive results for their investors.

What really gives them an edge over other investors is their long-term approach to investing in the global emerging market sector. In what can be a volatile and unstable investment environment at times, Michael and the team simply see it as full of investment opportunities for active investors like M&G where they can have the resources and the experience to capitalise on the opportunities in front of them.  

The views expressed in this document should not be taken as a recommendation, advice or forecast. The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide for future performance.