Investors need to change the way they think about emerging markets or risk missing out on some of the most attractive investment opportunities on offer right now, according to Franklin Templeton Investments’ Andrew Ness. 
Ness (pictured), who joined Chetan Sehgal on the £2.1bn Templeton Emerging Markets Investment Trust (TEMIT) last year, said investors are in danger of treating emerging markets as though they were the commodities-focused economies of yester year.
“This is a completely different asset class that we’re investing in than when we both started two and a half decades ago,” said Ness. “The danger is that investors fail to recognise the transformation of these economies.
“As a consequence of that, there’s a risk that they systematically under-allocate to what we think is one of the fastest-growing asset classes globally with some of the most exciting innovations and consumer-oriented opportunities that we can find.”
The first ‘new reality’ that Ness described was that authorities in emerging markets have made deliberate policy improvements to increase economic resilience during times of stress.
“October 1994 was my first foray into [emerging markets] and then I fell into the Mexican peso crisis,” said Ness. “That was a classic example of an emerging market financial crisis: we had excessive government spending going into an election with a fixed exchange rate regime and too much hard currency debt.
“We had a current account adjustment that led to the central bank’s bank reserves trying to protect the currency eventually had to let the currency go and default on debt. The local banks were full of that debt and defaulted.
“We saw an implosion and bank balance sheets, and then that started to contaminate the real economy.”
The collapse of the banking system and contamination of the real economy made these crises much more severe than they ought to have been, said Ness.
However, lessons have been learned and economies are much better positioned than in the past with significantly increased foreign reserves providing them with more padding during a crisis.
In addition, fixed exchange rate regimes have been ditched in favour of free-floated or managed forex regimes, giving emerging economies an element of flexibility.
There has also been a move away from the US dollar as a source of funding with the development of local currency debt markets.
“It’s important to note we’re not saying that this will fully immunise the asset class but they do provide support and padding during periods of an external market strife,” Ness added.
The second ‘new reality’ was that stock markets themselves have changed significantly.
“The emerging markets story back in the day was twofold,” TEMIT manager said.
“It was either resource-rich countries selling to the resource-starved or resource-strapped Western world, or it was countries with pools of cheap labour that were simply a low value-added manufacturing hub for the developed markets.
“There’s been a substantial change in that the composition of these domestic economies; there’s much more domestic consumption driving activity.”
The growth of the technology sector is one example of how emerging markets have begun to change, with a number of the world’s leading businesses located there.
“When I think of my first two companies that I met back in 1994-1995, they were a Polish tire company and a Hungarian sausage factory,” said Ness. “So the world has definitely changed.”
Materials, industrials and energy names make up far less of the index than a decade ago, with technology taking a far more important role in the index.
“They’ve been replaced by much more interesting, much more investable, higher-quality, and consumer- and technology-oriented businesses,” he said. “These high-quality businesses typically have less cyclicality to their return profile and typically come with more attractive capital returns.”
Sector breakdown of the MSCI Emerging Markets index
Source: MSCI
The final ‘new reality’ is that emerging market companies are leapfrogging established business models in the developed world through innovation and the use of technology.
“There’s a fallacy that the past predicts the future and people would look at emerging markets simply thinking that they would mimic the development path of the developed markets,” said the TEMIT manager.
“We think that assumption is wrong. There are countless examples where we can find emerging market companies that are using technology, using innovation and creativity, to leapfrog the typical development path of business models.”
This can be seen in areas such as the payments industry, banking and e-commerce, where large global players have emerged in recent years.
Co-manager Sehgal said that while it is true that many investors will have memories of emerging market countries lurching from one crisis to another during the past few decades, they have not remained static.
“They’ve really evolved and over a period of time this evolution has resulted in a lot of strong gains for emerging market investors,” he said. “We continue to believe that emerging markets are probably the right place to be for individual investors.”
Sehgal said its bottom-up process allows it to pick the best stocks generating strong cashflows, which are being returned to investors in the form of buybacks and dividends.
“This is a very positive sign because previously, one could make a case that a lot of emerging markets are making investments not based on returns but based on just trying to grow the industry or to achieve dominance,” said the manager. “But now you see that cashflow has also improved and this is at a time when the leverage of emerging market companies has come down.”
He added: “[Yet] the P/E [price-to-earnings] ratios, and the price-to-book value of emerging markets continue to trade at a discount and one can argue that on an aggregate basis, emerging markets are growing faster than the US.
“For emerging markets to continue trading at a discount and have better growth prospects, and cashflows in general is the reason why we are most bullish.”
Performance of trust vs sector & benchmark under Sehgal
Source: FE Analytics
Since Sehgal took over as lead manager on the Templeton Emerging Markets Investment Trust in January 2018, following the departure of former manager Carlos Hardenberg, it has made a loss of 5 per cent while the average IT Global Emerging Markets peer is down by 5.14 per cent and the MSCI Emerging Markets benchmark has lost 7.18 per cent.
The five FE Crown-rated trust is 6 per cent geared, has yield of 2 per cent, ongoing charges of 1.09 per cent and trades at a discount to net asset value (NAV) of 9.8 per cent.