Lam, who heads up the five FE Crown rated Somerset Emerging Markets Dividend Growth fund, warns emerging market consumer stocks are most at risk.
Lam is looking to alternative sectors such as insurance as a way to gain access to the emerging market consumer story, he explains.
“It’s something we’ve cautioned our clients about, is that particularly last year and the year before there was a lot of over-optimism on dividend stocks and income stocks and there has been a significant premium paid for high dividend yield stocks,” he said.
“The stocks in the consumer staples-type sectors [are most at risk] that are trading on very high valuations.”
“So if you look at India, for instance, Hindustan Unilever continues to trade at 20 or 30 times price to earnings. It pays out a very steady dividend which is why obviously dividend hunters like it but actually the valuation is very high.”
“There are other stocks, some that we’ve been buying into like Pou Chen in Taiwan – which is an exporter of shoes for Nike and Adidas – that trades at closer to 10 times price per earnings but still has a very good dividend yield.”
“We have been adding much more to certain kinds of sectors, like exporters,” he added. “We’ve also been adding a lot of exposure to insurance companies, which I think is an interesting way of getting consumer exposure in emerging markets now,” he said.
Lam says there are two key reasons insurers look attractive in emerging markets, first off because they are trading at substantial discounts to the other “more typical” consumer stocks in emerging markets and because they are one of the few consumer-orientated stocks that can benefit from increases in interest rates.
“On a price to sales basis they are often half the price to sales of the consumer stocks,” he said. “If interest rates are going up, therefore credit is being constrained, consumers tend to spend less.”
“That will also affect insurance companies, but insurance companies benefit because the float that they have to invest actually gets invested to generate a higher rate of return. There is a mild benefit there for insurance.”
The share price of many of the UK’s major insurances companies was slammed last week after Chancellor George Osborne announced sweeping changes to pensions, but Lam says insurers in emerging markets are more insulated from this type of risk.
“In any financial sector and in the pension sectors in general there is definitely regulatory risk across the board. I think we’re fortunate in emerging markets for two slightly different reasons.”
“Often the regulation has been very different in emerging markets and then secondly, a lot of the pension-type products and long-term insurance products are actually very small-scale and haven’t been marketed a lot and had very small market share.”
“Whatever happens in terms of the regulation, it shouldn’t really have a large scale effect,” he said. “In many cases the regulation is actually improving.”
While Lam sees a number of opportunities cropping up for low valuations in emerging markets, he says investors should strap in for some short term volatility.
“It’s obviously been a terrible market for everyone in emerging markets. I think the short term in the next 12 months or so, I don’t think things look particularly better,” he said. “There are still a lot of risks, particularly in China and also parts of Eastern Europe have flared up again.”
However, he thinks investors who can sit through a few more years of pain, picking up cheap stocks, will be well-rewarded for their patience.
“In the longer term, things actually look quite good. The main thing I would focus on for long-term investors is that we’re now four to six years through a long-term bear market.”
“The average bear market probably last anywhere between five to 10 years. That will set us up for the next five to 10 years period.”
“I think the summary is short term – negative, but long term there’s a lot to look forward to,” he added.
During turbulent times for emerging markets, the Somerset fund has fared better than its peers and the MSCI Emerging Markets index, picking up 10.92 per cent over the last three years.
The IMA Global Emerging Markets sector fell 9.98 per cent over the period while the index lost even more, down 11.10 per cent.
Performance of fund vs sector and index over 3yrs
Source: FE Analytics
The fund is more cautious than its peers, which is why it has tended to protect better in down markets over its relatively short history.
In 2011, for example, the fund fell 5.97 per cent while the sector lost 19.02 per cent, according to FE Analytics. The index fell 17.82 per cent that year.
It is yielding 2.9 per cent. Among Lam’s top holdings are Korean electronics giant, Samsun Electronics, China Mobile and the National Bank of Abu Dhabi. His highest sector weighting is to financials, at 29.5 per cent, dominated by exposure to banks and insurers.
Telecommunications, media and technology stocks make up the second highest weighting, at 29.38 per cent of the portfolio.
Somerset Emerging Markets Dividend Growth has clean share class ongoing charges of 1.33 per cent and is available via Trustnet Direct.
