The emerging market rally is likely to be sustainable as it hasn’t even factored in improving fundamentals yet, according to Somerset's Edward Lam.
The FE Alpha Manager, who heads up the four crown-rated Somerset Emerging Markets Dividend Growth fund, says the market area has “turned a corner” generally when it comes to both economic fundamentals and corporate governance.
Performance of index in 2016
Source: FE Analytics
However, he points out that investors need to be selective given the wide differences between varying emerging markets.
“I would basically put emerging markets in three buckets. The first bucket is countries such as Hungary and India that actually turned around months, if not year or two, ago. They’re on a positive trajectory and there’s very strong fundamental support for the turnaround in sentiment,” Lam explained.
“You also have countries like Brazil and maybe Russia among a few others, where they’re improving but the turnaround in sentiment is probably discounting ahead of the actual results and numbers coming through. We’re still waiting for these fundamentals to come through.
“The third group of countries includes the likes of China, where they haven’t been through a full cycle yet, they’re still waiting for their debt cycle to come through and they’re still waiting for their real downturn in GDP. On both of those fronts they’re still behind.
“And, between Hungary and China there are many different countries in between.”
Nevertheless, he is positive that the market area as a whole will continue to do well and says he is seeing more opportunities than he has done in over 18 months.
One of the reasons for this is technological improvement and the advancement of products being manufactured. His largest geographic weighting is in South Korea, for instance, where he holds companies such as semiconductor supplier SK Hynix and Samsung Electronics.
Lam isn’t the only manager bullish on the region. In an article published on Monday, Orbis’ Dan Brocklebank told FE Trustnet that emerging markets are still likely to offer significant upside potential despite their strong performance year-to-date.
He said: “In emerging markets, companies with very good growth potential are far cheaper. This is where your macro risk comes in. A lot of people were saying this time last year that emerging markets are very risky and, low and behold, they’ve been the best-performing equity region this year.
“We have seen this start to unwind a little but we still think it has a long way to go. If you look at the price-to-revenue metric again, the divergence between emerging and developed markets is almost back to where it was in the early 2000s.”
Emerging markets suffered a five-year bout of lacklustre returns to the end of 2015, caused by low commodity prices, a strong dollar and macroeconomic uncertainty.
Due to dovish statements from the Federal Reserve, a slowdown in the strengthening dollar and heightened geopolitical concern in developed markets though, this performance has swiftly turned around in 2016 and has led to the MSCI Emerging Market index achieving double the returns of the FTSE 100 and the MSCI Europe ex UK to date.
Performance of indices in 2016
Source: FE Analytics
Ryan Hughes, head of fund selection at AJ Bell, says it is easy to think a market or region will soon grind to a halt after it has had a good run. Looking at the current valuations of emerging market equities, however, he says it is certainly possible to build a case that there is further to go in this performance cycle.
“This is evident when looking at the current price to book ratio which is still some way below its 20-year average while the broad PE ratio of the index is also below its long term average,” he explained.
“When this is combined with the sheer volume of yielding stocks in emerging markets, there is certainly potential for the region to continue to attract asset flows, not least because so many remain underweight.
“It won’t be without bumps in the road though as always with emerging markets, with a strengthening US dollar having the potential to change sentiment quickly, not least because it is likely to see some ‘hot money’ leave the region as investors look to capitalise on this year’s gains.”
Lam says it is important to look at emerging markets over a longer term time horizon. For instance, he says the change in the sector’s investment landscape since around 2004 has been significant.
“It was almost the fun period between 2004 and 2007 when it was the bull market and it was quite a different atmosphere. The sell side was much more vibrant, there was just generally a lot more optimism,” he explained.
“Then there was a transition phase between 2009 and 2012 which was everyone thinking we were still in the bull market for emerging markets but, psychologically, I think slowly people were realising it wasn’t looking particularly good at all.
“Now, finally, it’s coming round to the period where people are thinking we’re permanently in a bear market, we’re never going to get out of this and they’re questioning the reason to be bullish on emerging markets with currency collapses and everything else.
Performance of index since 2000
Source: FE Analytics
“This probably comes as no surprise to anyone who’s invested over long time periods but obviously it’s been the better choice to be invested in emerging markets now where long-term sentiment is, whereas the worst time to be invested was in that turning period when people were still optimistic but the fundamentals didn’t really match up.”
As such, the FE Alpha Manager says numerous opportunities have come to the fore in emerging markets.
While he particularly likes technology and financial companies at the moment, he says investors are able to find attractive stocks across a wide range of different emerging market sectors. Somerset Emerging Markets, which consists of around 50 holdings predominantly chosen using bottom-up selection, currently has exposure to nine different sectors.
“There are many more opportunities in the last few months than 18 months to a year ago and a lot of those are to do with how badly markets have performed in 2015,” Lam continued.
“The important thing from my point of view is that 2015 was a sell-off which was a bit more like 2008. Not in terms of severity but in terms of how broad-based the sell-off was.
“The interesting thing we’ve had in terms of the sell-offs up until 2015 is that they’ve been quite concentrated, narrow and sector specific. A lot of the corrections that we’ve had such as in 2011 was mostly commodities, mostly cyclicals or construction.
“That didn’t necessarily throw up many opportunities for us whereas, if you look at the index now, many other sectors or areas have also de-rated, which means there are a lot more opportunities going forwards.”
Since Lam launched Somerset Emerging Markets Dividend Growth in 2010, it has returned 59.76 per cent, outperforming its sector average and benchmark by 30.66 and 27.45 percentage points respectively.
Performance of fund vs sector and benchmark since launch
Source:FE Analytics
The £1.3bn fund has a clean ongoing charges figure of 1.3 per cent and yields 1.8 per cent. It also charges a 0.4 per cent dilution levy when units are bought or sold.