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Kaloo: No short-term rebound in emerging markets

17 January 2014

The head of emerging market equities at Aberdeen says that while there is political will to solve the structural problems that are weighing on share prices in the sector, there is no quick fix for these issues.

By Thomas McMahon,

News Editor, FE Trustnet

Investors shouldn’t expect a short-term turnaround in performance in the emerging markets, according to Devan Kaloo, head of emerging market equities at Aberdeen.

Kaloo (pictured), who heads up the team that run the £2.7bn Aberdeen Emerging Markets fund, says that there are headwinds from economics and politics that will dog the region this year.

ALT_TAG However, he says that investors have become too bearish on a medium term view, and there is political will to solve the structural problems in these market that are weighing on share prices.

“Concerns that the issues in emerging markets are structural are exaggerated,” he said. “They are certainly cyclical, and there are issues to be addressed but they are being addressed.”

“We are seeing both governments and companies getting used to this idea of slower growth and more expensive capital and this is a good thing as it will be the catalyst or incentive for companies to improve margins.”

“We are cautiously optimistic over the medium- to long-term, but there remain significant headwinds,” he added.

Emerging markets have struggled over the past three years, although it was only 2013 when investors really started to take note and outflows increased.

Some of the best-known portfolios on the market were affected, including Templeton Emerging Markets and Aberdeen’s Murray International trust, as FE Trustnet reported this week.

The FTSE All World Emerging index has underperformed the FTSE All World developed index by 31.88 per cent over three years, according to data from FE Analytics.

Relative performance of indices over 3yrs


ALT_TAG

Source: FE Analytics

The key issues have been tapering in the US, which has encouraged outflows from emerging markets, weaker growth in China and lower profitability from emerging market companies, Kaloo says.

The manager adds this latter reason has been more of a concern to the Aberdeen Emerging Markets team, because it uses a bottom-up stockpicking approach.

“Emerging markets profitability has followed growth rates in emerging markets down,” he said.

“Profitability and earnings have declined and that’s in marked contrast to what has been happening in developed markets.”


Emerging market companies have not made sufficient efforts to offset pressure on their margins through cost-cutting, he says.

“One of the key reasons for this is that emerging market companies saw the slowdown in top-line growth as a blip before stronger growth came through, so they have invested through much of that slowdown,” he continued.

“As a result, they have not really been that focused on taking costs out of the business and so margins have been under pressure and this has flowed through into a weaker bottom line.”

In the developed world, companies have been cutting costs but also had an artificial boost to margins from share buybacks, which have been at historically high levels.

The manager says that there is a great deal of resolve in emerging markets to repair this weak profitability, however, and companies are beginning to cut costs.

“With regard to margins, the last 12 months have refocused the minds of many corporates with regard to the outlook for growth and the need to manage costs,” he said.

“Certainly across many of our companies we are seeing management refocused on taking costs out and they have reined back on some of the capex plans and doing some of the things that you expect management to do in tough times.”

“So there is scope for margin expansion in the years to come as these cost-cutting exercises bear fruit.”

Kaloo says that top-line expansion in emerging markets will begin to be seen as exports increase from countries with devalued currencies, and the cycle will turn back in favour of emerging market companies.

On top of this, there will be a swathe of elections across the developing world this year which Kaloo says will demonstrate policymakers' determination to regain their competitiveness.

“One of the benefits of the past six to 12 months is that politicians have had to wake up to the fact that they are in a global competition for capital, and ultimately if they want to grow their economies they’re going to have to use foreign capital.”

Kaloo’s Aberdeen Emerging Markets fund has also gone through a rough patch as its sector has suffered. Over the past year the fund has lost 13.43 per cent while the MSCI Emerging Markets benchmark has lost 8.11 per cent.

Performance of fund vs sector and benchmark over 1yr


ALT_TAG

Source: FE Analytics

This is disappointing to investors who view Aberdeen as a defensive choice: the fund house has a reputation for performing well in down markets through choosing dependable, all-weather companies.

However, as Kaloo points out, the fund’s returns look better over the three-year period of poor emerging markets performance.

While it is down 3.37 per cent, this compares with losses of 11.68 per cent from the index, according to FE Analytics data.

Performance of fund vs sector and benchmark over 3yrs

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Source: FE Analytics


Kaloo also explains that the fund has been hit by poor performance in some of its preferred markets which were more sensitive to the Fed’s talk of tapering last summer.

“Our positions in some of the more fragile emerging market countries such as Brazil, India and Indonesia haven’t helped us,” he said.

Kaloo says that the team is not making any major changes to the portfolio, or to Aberdeen Emerging Markets Smaller Companies.

It has taken profits from Samsung and some Indian companies that have performed particularly well and used them to top up its weighting to Yum!, which is expanding the KFC brand into China.

The manager also says he won’t chase his competitors into the hot internet technology sector, which has seen strong growth over the past year.

One of the major reasons for the fund’s relative underperformance on a stock-selection level was its underweight in Tencent, China’s equivalent to eBay.

The stock has been a favourite of many emerging market and Asian managers, and has made 21 per cent over the last year.

“Chinese internet companies have had a huge re-rating, but we struggle with their structure,” he said. “It isn’t clear who owns the company and your rights as a shareholder are not protected.”

“Similarly in internet businesses, their business models are evolving and it’s still not clear to us what are the barriers to entry that will make them successful in the longer run. Plus, valuations aren’t too cheap.”

The result of the poor period for emerging markets has been $7.2bn of outflows from Aberdeen’s emerging markets operations as a whole, according to a trading update the company released today.

Aberdeen is completing an acquisition of SWIP which will see it boost its presence in the UK market.

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