Q&A: Emerging Markets Challenges with Opportunities
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- Jeffery Palmer
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1 Q&A: Emerging Markets Challenges with Opportunities DECEMBER 2014 / JANUARY 2015 The significant equity sell-off among emerging-market countries in the last 90 days has sparked many important questions about the slide s impact on the affected regions and the companies linked to these markets. The Situation Q: What is causing the emerging-market turmoil? A: In addition to the sharp drop in oil prices to five-year lows, 1 it is the culmination of the meaningful devaluation of several major currencies, especially the Russian ruble, but also the Indonesian rupiah and Venezuelan bolivar. Political and economic instability in Brazil, Turkey, Argentina, Hong Kong and Thailand are also contributing to the overall weakness. In the case of China, we are selective due to our skepticism surrounding the rapid growth of fixed capital and financial assets in that country, among other reasons. Q: Is this situation unique? A: Emerging-market downturns are not unique. As an asset class, emerging markets have a history of severe volatility. In the past 20 years, there have been three extended periods of significant declines in emerging markets as represented by the MSCI Emerging Markets (EM) Index: , and Q: How did emerging markets fare after those three bear markets? A: Following the bear markets of , and 2008, the MSCI EM Index made solid gains, returning over 66%, 56% and 79% in calendar years 1999, 2003 and 2009, respectively. Relative to the S&P 500 Index, the MSCI EM Index outperformed it by 16%, 115% and 26% based on subsequent three-year cumulative returns. 2 Impact on Brandes Q: What impact is the downturn having on Brandes emerging-market portfolios? A: In the short run, our overweight allocations to Russia and Brazil, two countries that are particularly struggling, have presented a challenge from a performance perspective for our suite of emergingmarket portfolios. Longer-term, however, we have been pleased with the performance of our emergingmarket portfolios. Q: Has China s continued growth helped Brandes emerging-market portfolios in the recent downturn? A: Our portfolios haven t benefitted from China-based companies as significantly as the benchmark. We are extremely selective in all of our investment strategies. In the case of China, we are selective due to our skepticism surrounding the rapid growth of fixed capital and financial assets in that country, among other reasons. This has led us to take a conservative stance on valuation of companies within certain sectors (e.g., financials). Although China has held up better than the overall MSCI EM Index year to date, 3 our underweight positions in that country have had a negative impact on the recent performance of our emerging-market portfolios.
2 PAGE 2 Action & Outlook Q: How is Brandes maneuvering through the emerging-market downturn? A: We re constantly looking at each holding in every portfolio we manage to determine its long-term value and growth potential at the company level. The recent emergingmarket slide, of course, is disconcerting from a global perspective. When any market struggles, however, it certainly weighs on our views of the companies caught in the downdraft. But we don t make blanket buys and sells based on the performance of the markets whether up or down. We buy individual businesses, as opposed to industries, sectors, countries or regions. So, any maneuvering is done at the company level based on its margin of safety, which is the difference between a company s stock price and what we believe it s actually worth or intrinsic value estimate. Our thesis on Russia has not changed, which means we still believe it can offer some of the most potentially undervalued businesses in the world right now. Q: How are you approaching your holdings in Russia, a region hit hardest by the emerging-market downturn? A: Our thesis on Russia has not changed, which means we still believe it can offer some of the most potentially undervalued businesses in the world right now. On a macro level, valuations in that nation are about half those of the next closest country, China. In general, valuations have only been this low twice, namely in 1998 and 2008, after which the world saw returns of 247% and 105% in the subsequent calendar years 1999 and 2009, respectively. 4 But we re attracted to undervalued companies first, not regions. So, we re watching our holdings in Russia very closely and believe our holdings there offer attractive risk/reward trade-off over the long term. Q: In general, aren t emerging markets just too risky right now? A: You have to define what risk is. Are you referring to volatility or the permanent loss of capital? As active value investors, we re looking beyond this short-term volatility to gauge the long-term value of each company we hold in our emerging-market portfolios. Our primary yardstick to measure this potential is margin of safety. Many drivers impact margins of safety. For example, we believe companies that are caught up in the larger downdraft may still be undervalued despite or perhaps even because of their current declines. This is true wherever you re looking, emerging markets or not. Q: Should investors be selling their emerging-market holdings now? A: Investors should remember why they were attracted to emerging markets in the first place. We believe emerging-market countries have much more room to grow in terms of wealth creation for billions of people. Economies tend to grow and contract in cycles as we have been acutely reminded of in the United States and Europe over the past decade. Trying to time the right moment to buy and sell based on forecasts of economic cycles is not an advisable strategy, in our opinion. Holding equities from different asset classes at attractive business valuations is a diversified approach that we believe, over time, offers an advantage compared to buying and selling based on emotions. And, from a valuation perspective, emerging markets have recently traded well below their historical averages and at significant discounts to developed markets as well as the United States.
3 PAGE 3 MSCI EM Index Valuations vs. History, Developed Markets and United States vs. 10-Yr. Average vs. Developed Markets vs. U.S. Valuation Discount % 22% 17% P/E P/B P/CF 11% 30% 29% 28% 34% 32% 44% Source: MSCI as of 9/30/2014. Developed Markets represented by the MSCI World Index; U.S. represented by the S&P 500 Index. Past performance is not a guarantee of future results. Please note that all indices are unmanaged and are not available for direct investment. Price/Book, Price/ Earnings, Price/Cash Flow for each security provided by Bloomberg, L.P. Please note that Bloomberg does not provide negative numbers in the data feed. Index fundamentals are calculated from holdings data as provided by the relevant index or by Thomson Reuters Worldscope, excluding negative numbers for consistency. Thus, index fundamentals calculated by Brandes may differ from those computed and published by index providers. Q: Where is this emerging-market crisis heading? A: It is too soon to tell and we can t foresee the future. But we have been in similar situations before. The recent oil price tumble, in fact, has a very familiar ring to it circa 1998, when crude dropped so dramatically it sent Venezuela and Russia into widespread debt crises. However, history shows that these markets proved to be more resilient over the longer-term. For more information about the Brandes Emerging Markets Equity Strategy, visit 1 Source: S&P Capital IQ McGraw Hill Financial as of 12/18/ Source: MSCI via FactSet. Past performance is not a guarantee of future results. Please note that all indices are unmanaged and are not available for direct investment. 3 Source: MSCI via FactSet as of 11/30/2014. China represented by the MSCI China Index. Past performance is not a guarantee of future results. Please note that all indices are unmanaged and are not available for direct investment. 4 Source: MSCI via FactSet. Russia represented by the MSCI Russia Index. Past performance is not a guarantee of future results. Please note that all indices are unmanaged and are not available for direct investment. VALUE SPECIALISTS SINCE 1974 CALL BRANDES BRANDES.COM
4 PAGE 4 Appendix Calendar-Year Returns of the MSCI EM Index Since MSCI EM Index Inception Year Return Year Return Year Return Year Return % % % % % % % % % % % % % % % % % % % Source: FactSet. Past performance is not a guarantee of future results. Three-Year Cumulative Returns MSCI EM Index vs. S&P 500 Index Since MSCI EM Index Inception For 3-Yr. Period Ended MSCI EM Index S&P 500 Index Relative Returns 12/31/ % % % 12/31/ % % % 12/31/ % % % 12/31/ % 41.46% % 12/31/ % -3.06% 15.79% 12/31/ % % 1.29% 12/31/ % % 55.09% 12/31/ % 11.15% 73.87% 12/31/ % 49.70% % 12/31/ % 34.70% 89.98% 12/31/ % 28.16% % 12/31/ % % 9.81% 12/31/ % % 33.10% 12/31/ % -8.32% 8.23% 12/31/ % 48.59% 26.02% 12/31/ % 36.30% % 12/31/ % 56.82% % Source: FactSet. Past performance is not a guarantee of future results.
5 The margin of safety for any security is defined as the discount of its market price to what the firm believes is the intrinsic value of that security. Price/Book: Price per share divided by book value per share. Price/Earnings: Price per share divided by earnings per share. Price/Cash Flow: Price per share divided by cash flow per share. Past performance is not a guarantee of future results. Diversification does not assure a profit or protect against a loss in a declining market. The MSCI China Index captures large and mid cap representation across China H shares, B shares, Red chips and P chips. With 139 constituents, the index covers about 85% of this China equity universe. The MSCI Emerging Markets Index with gross dividends measures equity market performance of emerging markets. The MSCI Russia Index is designed to measure the performance of the large and mid cap segments of the Russian market. With 22 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Russia. The MSCI World Index with net dividends measures equity market performance of developed markets. The S&P 500 Index with gross dividends measures equity performance of 500 leading companies in industries of the U.S. economy. MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or use it as a basis for other indices or investment products. This material is intended for informational purposes only. 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. Market conditions may impact performance. International and emerging markets investing is subject to certain risks such as currency fluctuation and social and political changes, differences in financial reporting standards and less stringent regulation of securities markets which may result in greater share price volatility; such risks are increased when investing in emerging markets. Additional risks associated with emerging markets investing include smaller-sized markets, liquidity risks, and less established legal, political, social, and business systems to support securities markets. Some emerging markets countries may have fixed or managed currencies that are not free-floating against the U.S. dollar. Certain of these currencies have experienced, and may experience in the future, substantial fluctuations or a steady devaluation relative to the U.S. dollar. The foregoing reflects the thoughts and opinions of Brandes Investment Partners exclusively and is subject to change without notice. Brandes Investment Partners is a registered trademark of Brandes Investment Partners, L.P. in the United States and Canada. Brandes Investment Partners, L.P El Camino Real, Suite 600 P.O. Box San Diego, CA PUB 1214 VALUE SPECIALISTS SINCE 1974 CALL BRANDES BRANDES.COM
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