Welcome to Soundbites, weekly insights on market trends and investment strategies, brought to you by Investment Executive, and powered by Canada Life.

For today’s Soundbites, we discuss emerging market valuations with Ross Cameron, a portfolio advisor and analyst with Northcape Capital. We talk about finding gems, avoiding value traps, and applying sovereign risk and currency overlays. But we started by asking why emerging market valuations currently look attractive.

Ross Cameron (RC): Really what’s happened is since the GFC, developed markets, central banks have all engaged in unorthodox monetary policy. And that’s been a tailwind to developed market equities values. By contrast, emerging market central banks have — really with just the exception of China — engaged in very orthodox monetary policy. So, if you look today, most emerging market central banks have strong positive real rates, which means in this current environment, when the Fed is beginning to tighten, emerging markets are actually already ahead of the curve. And that’s why today we find emerging markets at a 20-year low versus developed markets.

Regions that are particularly attractive.

RC: We’re very excited about South Korea and Indian equities at the moment. Korea has a new president-elect, Mr. Yuen. His credentials in anti-corruption are about as good as you get and he has pledged to remove “the Korea discount.” Now what are we talking about when we say Korea discount? Korea is the cheapest emerging market and really a large part of that reason, that Korea discount, has been a history of poor government. And so, to have a president-elect who’s focused on removing that discount is very, very positive and we’re very optimistic. Now, India is, in many ways, the ultimate emerging market. [It has] A vast population, very young population. That maturing of the population pyramid is going to underpin decades of strong consumption growth. India produces hundreds of thousands of graduates every month, so there is a huge pool of talented, English-speaking resources to pick from. [They have] A pretty stable government there under Modi [Narendra Modi, of the Bharatiya Janata Party]. Modi has his detractors but he has done a good job with the economy. And Indian companies structurally earn higher returns on capital than the emerging market benchmark. So, there’s lots to be excited about.

Avoiding value traps.

RC: This is a major issue and one of the reasons we take a high-conviction concentrated approach. One of the classic value traps, over the last five years or so, was Russia. Russia looked cheap, but it was cheap for a reason. It was a classic value trap. One more example is the Chinese VIE (variable interest entity) sector — Alibaba [Alibaba Group Holding Limited, based in Hangzhou, China], Tencent [Tencent Holdings Ltd., based in Shenzhen, China] and so on. They’ve been a value trap for two reasons. One is that there’s a murky relationship between the investor and the underlying business in China. So, the “G” in the ESG is very weak. And the second is because we’ve seen a vast array of Chinese legislation come through, to damage the position and the competitive dynamic in the industry, to the detriment of shareholders. It’s the same with Turkey. We think the sovereign risks of the Erdoğan regime [Recep Tayyip Erdoğan] and the geopolitics of the region are not priced in. Turkish stocks have performed relatively well in lira terms over the last decade, but they’ve been an abysmal investment in U.S. dollars or Canadian dollars because of the depreciation of the Turkish lira.

A hidden gem in emerging markets.

RC: We’re generally excited about Korea, as I said. One example is Coway [Coway Co. Ltd., based in Seoul, South Korea]. This is the world’s leader in water and air filtration technology. It’s not a typical kind of white-goods manufacturer. You can’t readily buy their products. You rent them or lease them over seven years, and so it’s a kind of subscription-style business. The churn rate is less than 1%. It’s trading on just 12 times earnings. Because of the Korea discount, Coway should have good, solid, underlying earnings growth, which I suspect, is going to look very attractive.

And finally, the bottom line on valuations in emerging markets.

RC: The current environment with the Fed beginning to hike, combined with emerging market equities trading on a historic low versus developed markets, has created the conditions for a multi-year period of EM outperformance. So, given this dynamic, if you pick the right countries, so you’re in the right markets, the right geographies, the right sovereign risk, then this should underpin strong absolute returns and also this should outperform expensive developed market equities.

Well, those are today’s Soundbites, brought you by Investment Executive, and powered by Canada Life. Our thanks again to Ross Cameron of Northcape Capital.

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