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Five Compelling Reasons to Allocate to Emerging Markets: Brandes Investments

March 29, 2012 | About:
Holly LaFon

Holly LaFon

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Many investors are hesitant to allocate a portion of their portfolio to emerging markets, in part due to perceived high risks. Although historically these risks may have presented a barrier, the situation has changed dramatically over the past decade. Emerging markets are no longer the uncharted markets they were in the past—they are advancing economies with growth opportunities and continually improving economic and political conditions.

Emerging markets may be an attractive investment opportunity now for five compelling reasons:

1. ECONOMIC GROWTH. Emerging markets are growing at a faster rate than developed markets.

2. CORPORATE STRENGTH. Corporations are becoming stronger and more competitive.

3. WEALTHY CONSUMERS. Middle-class consumers are becoming richer and spending more.

4. IMPROVED POLICIES. Inflation and government debt are manageable; corporate governance is improving.

5. A WINDOW OF OPPORTUNITY. Valuations appear attractive.

1. Economic Growth

EMERGING MARKETS ARE GROWING AT A FASTER RATE THAN DEVELOPED MARKETS.

Twenty years ago, emerging markets represented only 19% of global gross domestic product (GDP); today they account for 36%1—and are expected to increase even more in the next few years, as shown in Exhibit 1. Exhibit 2 shows how quickly GDP is growing in emerging markets, and it is expected to continue to grow at a faster rate than advanced economies.

This growth in GDP has lifted the market cap for emerging markets from approximately 6% of the world's total to 13%2 since 2004. If GDP continues to grow as expected, the market cap for emerging markets is likely to grow as well, potentially opening up even more investment opportunities.

2. Corporate Strength

Companies are becoming stronger and more competitive.

Companies in emerging markets are becoming stronger and better able to compete with companies in developed regions.

• Industrial production growth for companies in emerging markets has outpaced developed companies every year for the past decade.3

• Corporate balance sheets and profitability have been improving, and growth in shareholders' equity has significantly outpaced net debt. And year-over-year earnings growth has been close to or greater than 20% every year in the past decade (except for the two recessions in 2002 and 2008).4

You may not be familiar with companies in emerging markets, but there are many large companies there with successful track records and a broad client base. China Mobile (CHL), for example, is the largest telecommunications company in emerging markets, and has more than 600 million clients worldwide—six times the number of Verizon (VZ) mobile customers!5 Businesses like China Mobile may not be as well-known as Verizon here at home, but there are many well-established companies across emerging markets with a vast—and growing—client base.

3. Wealthy Consumers

Middle-class consumers are becoming richer and spending more.

Consumer spending in emerging markets is expected to continue to grow because:

• Emerging markets represent a large percentage of the global population. Consumers in emerging markets account for 86% of the world's population, and emerging-market populations are growing at a faster rate than developed nations.6

• Individuals have become wealthier. In the past decade alone, wealth has improved over five-fold, leading to increased spending.7

• Consumers have excess cash. Emerging-market consumers have a large portion of their wealth in savings,8 leaving significant room for discretionary spending.

This expected increase in spending will likely fuel growth of the companies in emerging markets (and for companies in developed regions that market to emerging-market consumers), potentially leading to increased investment opportunities. The automobile industry is one example: consumers in emerging countries are now purchasing more vehicles than consumers in developed nations, as illustrated in Exhibit 3.

4. Improved Policies

INFLATION AND GOVERNMENT DEBT LEVELS ARE MANAGEABLE; CORPORATE GOVERNANCE IS IMPROVING.

Emerging-market countries are catching up with—and in some instances surpassing—the rest of the world, reining in inflation, government debt and enhancing corporate governance.

Inflation Inflation has historically been a major deterrent to investing in emerging markets; memories of triple-digit inflation still haunt some wary investors.

But the majority of emerging-market countries have made remarkable progress in recent years, and may no longer merit the reputation of uncontrolled inflation. Average inflation rates have declined to close to 6%, and inflation rates have tended to mirror those in developed markets over the past decade, as indicated in Exhibit 4. Decreased debt levels, flexible policy rates, and more stringent monetary controls may continue to help minimize inflation going forward.

Declining sovereign debt levels

While many developed nations (United States, Spain, Italy, France, etc.) have received credit-rating downgrades, ratings in emerging markets have been improving. As a percentage of GDP, aggregate government debt for emerging countries is less than 40% while for developed nations it is more than 100%.9

Improving corporate governance and disclosure

Companies in emerging markets are becoming more transparent, and accountability to the public is improving. In December 2000, financial reporting for companies representing less than 5% of emergingmarket total market capitalization conformed to IFRS or GAAP standards—10 years later that has grown to more than 40%.10 This means easier access to reliable financial information on companies.

5. Window of Opportunity

Emerging-market stock prices appear attractive when compared to estimates of what companies are actually worth (based on measurements like earnings and cash flow)—both compared to a year ago, and compared to home markets and global developed markets. And, the MSCI Emerging Markets Index is yielding a higher dividend yield than 12 months ago—and higher than the S&P 500 Index and MSCI World Index!

Understanding valuations: what are price ratios?

Price ratios are one of the ways investment managers and industry professionals measure how cheaply (or expensively) a stock is trading compared to fundamental characteristics of the company, such as earnings, book value and cash flow.

For example, the price-to-earnings ratio (P/E) is the current stock price divided by earnings per share. A lower P/E (compared to the index or another stock) means a stock may be affordable relative to its earnings.

CHOOSE YOUR INVESTMENT CAREFULLY SO YOU CAN ALLOCATE TO EMERGING MARKETS WITH CONFIDENCE

When selecting your emerging-market manager, look for:

• A flexible portfolio that allows for diversification across many countries, industries and market caps: many attractive opportunities in emerging markets may be found in frontier markets and smaller companies

• An investment team with a wealth of experience in emerging markets

• Proven long-term track record with a clearly defined, repeatable investment process

DISCLOSURES and FOOTNOTES

1 Source: MSCI ACWI via FactSet

2 Source: MSCI ACWI via FactSet

3 Sources: IMF, Haver, CEIC, UBS as of 8/3/2011

4 Sources: GEM Inc., UBS estimates as of 7/31/11 and MSCI, UBS Estimates as of 8/3/11

5 Sources: China Mobile and Verizon Wireless as of 1/31/2012

6 Source: OECD as of 11/28/2011

7 Sources: World Bank, IMF, BIS, Haver, CEIC, UBS as of 8/31/2011

8 Sources: Bank of America, Merrill Lynch Global Equity Strategy, Haver, IMF

9 Source: IMF as of November 1, 2011

10 Source: MSCI via Factset as of 12/31/2011

Price/Book: Price per share divided by book value per share.

Price/Earn: Price per share divided by earnings per share.

Price/CF: Price per share divided by cash flow per share.

Price/Book: Price per share divided by book value per share.

Price/Earn: Price per share divided by earnings per share.

Price/CF: Price per share divided by cash flow per share.

Price/Sales: A company's market capitalization divided by its total sales over the past 12 months.

The MSCI Emerging Markets Index with gross dividends is an unmanaged, free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of 21 emerging market country indices. This index includes dividends and distributions, but does not reflect fees, brokerage commissions, withholding taxes, or other expenses of investing. One cannot invest directly in an index.

The S&P 500 Index with gross dividends is an unmanaged, market capitalization weighted index that measures the equity performance of 500 leading companies in leading industries of the U.S. economy. The index includes 500 leading companies in leading industries of the U.S. economy, capturing 75% coverage of U.S. equities. This index includes dividends and distributions, but does not reflect fees, brokerage commissions, withholding taxes, or other expenses of investing. The MSCI World Index with net dividends is an unmanaged, free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The MSCI World Index consists of 24 developed market country indices. This index includes dividends and distributions net of withholding taxes, but does not reflect fees, brokerage commissions, or other expenses of investing.

The foregoing reflects the thoughts and opinions of Brandes Investment Partners® exclusively and is subject to change without notice. The information provided in this material should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any security transactions, holdings, or sectors discussed were or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance discussed herein. Portfolio holdings and allocations are subject to change at any time. Strategies discussed herein are subject to change at any time by the investment manager in its discretion due to market conditions or opportunities. Indices are unmanaged and are not available for direct investment. Market conditions may impact performance. Diversification does not assure a profit or protect against a loss in a declining market. International and emerging markets investing is subject to certain risks such as currency fluctuation and social and political changes; such risks may result in greater share price volatility.

Brandes Investment Partners® is a registered trademark of Brandes Investment Partners, L.P. in the United States and Canada.



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