Tempted by Emerging Markets? Buyer beware, there are better opportunities

By Robert Swift

We are going to briefly examine why diversifying into Emerging Markets is tempting, but potentially a mistake for Australian based investors.

First let’s recap on some basics of portfolio construction.  You should want to make as much money as possible but be aware that the volatility of your return matters.  It’s return on volatility (risk) that counts most.  For professional money managers a portfolio is not just a collection of ‘good ideas’ but a combination of stocks whose attributes in combination provide the best prospects for a high return on risk taken.

Consequently adding global equities to an Australian portfolio is a good idea.  Even if their future returns are lower than their past returns and now ‘only’ equal to future returns on Australian equities, this is still sound practice.  Check out the range of returns and risks in the chart below which combines Australian with global developed market equities (represented by the ASX300 and MSCI World total returns in AUD terms) in varying proportions for the 10-year period ending 29 June 2018.

Although this is based on actual returns there is no reason to doubt that the future will not show similar diversification benefits from adding international shares to an Australian portfolio.

Getting your portfolio ‘up and to the left’ should be everyone’s goal.

Source: Thomson Reuters

We think it is pretty well understood that the Australian equity market is dominated by banks and resource companies.  It also used to have a large telco exposure too however the shrinkage in market capitalisation of Telstra has made it much lower in terms of its index weight.

The demise of Telstra is testimony to the dangers of underinvestment and over distribution of dividends; and we may revisit that as a general issue for all companies in a future article.  Australia isn’t the only place where companies have been over distributing and underinvesting; the UK is another.  Some countries such as Japan have had the opposite problem.

For most investors owning the Australian banks is effectively a way to get exposure to dividends which increasingly depend on profits made from, less bad debts provided for, Australian housing loans.  Given that most people’s major store of wealth is in their own home, owning lots of Australian banks in addition, represents a bad idea.  You own your own home and then get exposure to the house price trends of other people’s homes.  It is a duplication of risk.

Some investors argue that they are diversified by owning all four major banks but from the table below you can see that they tend to behave in a very similar fashion to each other.

Even owning all four banks represents the same ‘bet’ and doesn’t help your overall portfolio of wealth especially if you include property assets in the mix, as you should.

So why are Emerging Markets a bad diversification decision for Australians?  They are international and represent and operate in faster growing countries so why not have a dedicated allocation to them?  See the table below which shows the sector weights for Australia compared to Brazil, South Africa and Russia.  We also compare this to the broader group of Emerging Market countries.

Source: Thomson Reuters

It is a sub optimal decision because the composition of many of these equity markets is very similar to the Australian market; especially some of the major ones such as Brazil, South Africa and India which, like Australia, are financial resource and utility heavy while also being net debtor countries, like Australia.

If something happens to iron ore prices it is as likely to affect CVRD in Brazil and Rio Tinto in Australia in the same way.  If global liquidity tightens (it will) and banks in net debtor nations (such as India, Brazil, Turkey, Australia) find it harder to secure deposits, then this too will cause similar effects in financials operating in all these countries.

Net foreign assets (NFA) is a simple but underutilised way to assess the likelihood of capital flight or vulnerability to rising interest rates.  It is simply a country’s asset stock less its liabilities to foreigners.  Running persistent current account deficits will add to liabilities; surpluses will add to assets.   At some point, seriously negative NFA countries will most probably see downward currency pressure to realign the assets and liabilities.  Reducing the currency will increase the value of the assets and reduce the value of the assets held by foreigners.  Australia’s net liabilities are almost a trillion A$.  The size of the economy is about A$ 1.6 trillion.  As a % of GDP it is about 60%.  Brazil is about – 35%; Turkey (which has suffered tremendous currency depreciation already ) is at – 55%, similar to Australia.
By comparison, Japan is a net creditor nation with net foreign assets of over US$3 trillion, approximately 65% of its GDP.  There is a lot of Japanese debt BUT they own a lot of foreign assets too.

Therefore think of investing in Brazil, Mexico, Turkey etc as owning a set of stocks which are likely to move up and down in similar fashion to those in your Australian equity portfolio.

Some people argue that higher economic growth will compensate for this correlation risk but this is not necessarily true.  Good long-term returns are derived from investing at low valuations with a lack of asset confiscation through debt default, inflation and currency depreciation; or forced seizure of assets.  These last three tend to occur when the macro picture is very stressed.

If you care to read about Turkey and the Turkish Lira, this is a classic example of an emerging market with decent demography; reasonable GDP growth, but a seriously indebted country which is very vulnerable to capital flight; happening now on a grand scale and causing well founded fears of asset seizure.

We are NOT claiming what is happening in Turkey is about to happen in all emerging markets, but adding all emerging markets to Australian equities exposes your portfolio to many of the same risks in countries with similar indebtedness and risk of downward currency pressure.  As an asset allocation it is not a good idea.

An analysis of this asset class also shows a very high allocation to Information Technology, which is of interest since this sector doesn’t make up a large part of the Australian market and potentially a good source of diversification.

What is interesting about this IT exposure within the broader Emerging Markets group is that the four largest companies in the region by free float market capitalisation are IT companies and these make up just under 20% of the MSCI Emerging Market Index; Tencent Holdings (China, market capitalisation USD 476 billion), Alibaba Group (China, USD475 billion), Samsung Electronics (South Korea, USD 272 billion) and Taiwan Semiconductor (Taiwan, 187 billion).

Over the last three years (to include since Alibaba started trading in late 2014), the correlation of the returns of these stocks in USD terms to the broader MSCI World Information Technology Index is higher than 0.5 – thus potentially replacing one group of a major four (the local domestic banks) with another (large globally focused Asian IT), also with high relative return correlations!

What is a good idea is to gain better diversification while investing at relatively cheap prices.  You can achieve this by investing some of your portfolio into small caps in Asia including Japan.

As smaller companies they tend to be less exposed to global factors; less vulnerable to government interference; more dynamic and faster growing; and most importantly for an active manager, inefficiently and incorrectly priced.  This is true of Asian smaller companies which we are recommending as a place for Australian investors to allocate some of their hard-earned savings.

Check out the sector weights of Asian smaller companies and see how they are different from Australia – thus providing genuine diversification.

We also generated an efficient frontier over the same timeframe as the earlier chart with combinations of Australian and Global equities where the non-Australian allocation is a fixed allocation to Asian small/mid caps and the balance in developed markets (MSCI World) over the same 10 year time frame to 29 June 2018.

Source: Thomson Reuters

This chart demonstrates how Australian investors with BOTH Global and Asian small caps can improve portfolio risk-return characteristics.  Asian smaller companies tend to behave differently from Australian companies AND differently from global large companies.  This is a good thing.
Finally we point out both the cheap valuations of Asian smaller companies and our Asian Small Cap strategy with PE ratios of approximately 10.2x and dividend yields of 3.2%, and the fact that they are very innovative with the majority of patent applications coming from this sector.

So as you increase your international allocations, and undoubtedly receive advice to add emerging markets, think again.  Much better to achieve decent returns from quality Asian small companies which are operating in economies with sound fiscal positions; economies with less risk of capital flight and currency depreciation; and more innovation.

As we say, by choosing Asian smaller companies, you ‘invest today in the companies of tomorrow’.

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