Copyright Rogers Publishing Limited Summer 2006| [Headnote] |
| Investors have been pouring money into emerging markets. Is it too late to join the party? |
When we surveyed the state of emerging markets in last year's Investor 500, the question asked at the time was, how much higher can these stocks go? It was a good question then -the Morgan Stanley Capital International Emerging Markets Index had risen nearly 300 points in the previous two years-but it's an even better question now. Investors have continued their love affair with developing economies, dumping even more money into this supremely trendy asset class.
Emerging markets, of course, arc those in the less developed economies of countries like Brazil, Taiwan, India, China and Russia. As such, they feature slightly higher risk levels than the developed nations of the world. But investors are shrugging off that risk in a rather big way these days. Every manager we talked to for this story agreed that the volume of funds moving into emerging markets is massive right now.
Charles Biderman is the CEO of TrimTabs Investment Research, which provides daily coverage of fund flows through the world's capital markets. His stats should be considered by anyone thinking of investing in emerging markets. Over the past 12 months, says Biderman, Americans have saved roughly US$700 billion, of which US$140 billion was parked in U.S.-based mutual funds. (Only USS35 billion, however, went into funds that invest primarily in U.S. stocks.) A far bigger chunk has gone to emerging markets: US$300 billion over the past 16 months. "They're putting half a billion a day into the U.S. and US$1 billion a day into global funds," says Biderman. In just the first four months of 2006, emerging-market funds attracted US$62 billion, over half the amount they did in 2005. That's hot, as Paris Hilton might say.
The returns arc hot, too. Since the end of 2004, the iShares MCSI Emerging Markets Index Fund has risen an impressive 59%, a great advance compared to the dismal 10% gain scraped out by the 
S&P 500 index over that same period. Investor appetites appear insatiable. A plunge in the index in early March resulted in a massive volume spike as investors "bought the dip."
So what's the attraction? Well, many investors are running from the U.S. dollar, which they think is in a long decline phase. By plunking money down across a border, they are setting themselves up to catch the extra return that will occur when, or if, the dollar slides. But investors are also reacting to the good news in emerging markets. Over the past couple of years, the risk factors feeding the higher risk premiums in the less developed areas of the world-political instability, shabby corporate governance, currency concerns-have subsided. "Political risk is not as big a factor as it once was," says Ed Baker, a London-based fund manager who oversees the BMO Emerging Markets fund. "The potential for currency collapse seems to have decreased."
Another part of the story is the growth within emerging markets. One phrase you here often from foreign-fund managers is "de-linking" Explains Baker: "For a long time, emerging markets were dependent on the First World for consumer demand. But that's not as true today as it was. Emerging markets can sustain themselves better than they have historically." The good global economic growth story is also helping. As is the high price of oil, which is helping markets like Russia-fast becoming an energy superpower-deliver large returns.
So, emerging markets are the place to be. But is now the right time to buy? Baker estimates upcoming earnings will come in above consensus. That is, firms in emerging markets will, as a whole, surprise on the upside-and that means the current strong multiples are supported. But Baker is admirably honest when he admits the boom is getting slightly long in the tooth. "We're in the middle of the third of four quarters," he says.
If there is a consensus view, that's it. Valuations are still credible, but caution is becoming the rule of the day. "From our point of view, emerging markets are generally reasonably priced," says Carl Bang, president and managing director of State Street Global Advisors Canada. He mentions dividend yields, which are big, and earnings, which are coming on strong. The result, Bang says, is that, "long-term valuations still look attractive." He does not rule out the possibility of a pullback in the short term, though.
Nor does Peter O'Reilly, a vice-president and portfolio manager at Investors Group. "Near term, we would see there is some potential for some consolidation," he writes in a market summary prepared for Canadian Business. O'Reilly explains that emerging-market strength has been concentrated in three sectors-energy, materials and financials-all of which have benefited from low interest rates and the ongoing strong demand for commodities and energy. O'Reilly calls the EM sector a convergence play on local economies, a phrase indicating that, basically, you're betting on the less developed nations of the world closing the gap with the developed world.
Though there's still some way to go. The point is, there is plenty of room for an investor with a longer-term perspective. "While one is reluctant to say it's different this time, the strong current account surpluses, along with superior economic growth driven by the emerging engines of China, India, Russia and Brazil, are likely to ensure that these markets remain better supported than in previous growth cycles," says O'Reilly.
Fair enough. But what about those fund flows? They sure do look frothy, especially considering the steep peak that formed in the first part of this year. Could that have been the signal that it's the start of the fourth quarter in emerging markets? Biderman, the fund flow expert, thinks the patterns are eerily similar to those of 2000, the year the dot-corns crashed. New savings in 2000 were also near US$700 billion. Of that, US$300 billion went into equities, with most going into U.S. equities, or US$260 billion-an amount similar to what has just moved from the U.S. to emerging markets.
It may not be scientific, but you might also want to consider the remarkable knack retail investors have for being perfectly out of sync with the broader market. All that money U.S. investors sank into the market in 2000? It was just in time to hit the very peak of the biggest bubble in history. And the herd was right on again for the market bottom in 2002 when US$440 billion went into savings vehicles and US$100 billion was redeemed from equities. Truly remarkable timing, that. "Individuals usually buy high and sell low," says Biderman. "Retail investors are particularly adept at following performance. They're like a driver who is looking in the rearview and has his foot on the gas." His take on emerging markets is that many of those rushing in are overlooking a cheap U.S. market that will become progressively attractive to investors as the overseas herd grazes on diminishing returns. "In the U.S., you have companies buying US$1.7 billion worth of shares per day through share buybacks and insider purchases," notes Biderman. There are few better forward-looking signals than corporate buying.
His advice? "I would not be buying emerging markets, China or India right now," Biderman says. "If I was already in, I wouldn't sell. The time to buy the global market is after the next sell-off." And remember: Don't be part of the herd.
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