Lam (pictured), who runs the five crown-rated Somerset Emerging Markets Dividend Growth fund, thinks consumer-related stocks are susceptible to a correction and has been slashing his exposure to them as a result. "Our view of emerging markets is very different to the others," he said.
"I think the consumption story is overblown and most certainly overbought. Valuations are very high in this area and I don’t necessarily think they are justified."
"What’s most concerning is that the likelihood of disappointment in this sector from a fundamental perspective is very high, which makes valuations even more problematic."
While consumer growth has risen in a number of countries in recent years, the manager says the rate of growth cannot be maintained.
"If you look at somewhere like Thailand, real wage growth in recent years has been 2 or 3 per cent, but in many markets consumption growth has been 15 per cent year-on-year. This isn’t sustainable," he explained.
"There’s a lot of debt in these countries and fiscal tightening, which I think will put a strain on consumers, which investors need to be aware of."
"We’ve had this view for the last year and have been bringing down our exposure to consumption as a result," he added.
Among the stocks he has been selling out of is the Mexican Walmart.
"If you look at something like Walmart-Mex – like-for-like sales have been declining in all stores for the last eight to 10 months, which is no coincidence – this is a real trend," he explained.
"Yet still, it’s on 20-times earnings as people buy into the consumer story. A stock like this is definitely at risk."
One region that Lam is optimistic about is the Philippines, which he says is much earlier in the credit cycle compared with Malaysia and Thailand. However, as with the consumer market in general, Lam says he is struggling to find attractively valued businesses.
Lam’s comments are in stark contrast to the majority of emerging markets managers, who tend to highlight the rise of the middle classes as the standout long-term theme in their portfolios.
Industry legend Anthony Bolton, for example, pointed to the consumerisaiton of China as the principal reason why he launched the Fidelity China Special Situations trust back in 2010.
He has major stakes in businesses with direct exposure to the spending power of the middle classes, including internet and digital media companies Tencent and Alibaba, which are both top-10 holdings.
Lam sees better value in some cyclical and state-owned enterprises, which he says he is currently "sifting through". He explains that all companies must hit certain criteria for them to be included in his fund: namely strong cash-flow and balance sheets – which increase the likelihood of stable returns – low volatility and strong dividend growth.
"We like the areas that most investors are overlooking at the moment, which aren’t necessarily associated with emerging markets. Things like long-term insurance, textiles and technology," he added.
South Africa is currently a major overweight for Somerset Emerging Markets Dividend Growth, as are Taiwan and South Korea.
Lam’s weighting to China and Hong Kong is well below average however, reflecting his cautious stance on the recovery taking place in those regions.
The manager is generally quite cautious at the moment, but thinks that valuations are in his favour.
"The fact is, emerging markets went through a recession in 2012," he explained. "Even if they didn’t officially, there was a retraction in earnings of between 5 and 8 per cent. This was very much under-reported."
Performance of indices since Jan 2012
Source: FE Analytics
"Data is still weak and I think too much attention was given to the Chinese PMI [purchasing managers index]. At 51 it is OK, but if we were looking at a strong recovery it would be more like 56 or 57."
"The consensus view on emerging markets has changed. The consensus was once overweight, but now it’s underweight. The silver lining is that we’ve been in this environment for some time, which means we should be starting to think about it a bit more positively," he added.
The fund’s underweight position in China has contributed to the fund’s slight underperformance over the last six months or so. The MSCI China is up almost 5 per cent over the period, and saw a particularly big spike in light of breakthrough reforms outlined in the Third Plenum last month. Over the same period, the MSCI Emerging Markets index is down 5.29 per cent.
However, Somerset Emerging Markets Dividend Growth remains a standout performer since its launch in March 2010. Our data shows that it has returned more than 20 per cent over the period, compared with 1.35 per cent from the IMA Global Emerging Markets sector average and 1.49 per cent from the MSCI EM index.
Performance of fund, sector and index since launch
Source: FE Analytics
The fund has been significantly less volatile than the sector and index over this period, and also has a much lower max drawdown. With a yield of 3.3 per cent, it is also one of the few emerging markets funds that is attractive from an income point of view.
On a more general note, Lam thinks that emerging markets investors need to readjust their expectations over the coming decades. He thinks dividend growth will be much more important than it has been in the past, which is why his now $1bn strategy was launched in the first place.
"Emerging markets are very different to what they were five or 10 years ago," he said.
"Returns from hereon in will be lower in the next 10 years compared with what we’ve had since 2000, as markets are now more fundamentally driven."
Performance of indices since Jan 2000
Source: FE Analytics
"We’ll see less in the way of multiple expansions and more in dividend and earnings growth, as these economies are now more developed."
Somerset Emerging Markets Dividend Growth requires a minimum initial investment of £1,000 and has ongoing charges of 1.3 per cent, making it one of the cheapest funds in the IMA Global Emerging Markets sector.
FE Trustnet will look at some potential long-term alternatives to emerging markets in an article this weekend.
