The Emerging Market You Might Have Overlooked
Deborah A. Velez Medenica, CFA, Senior Vice President and Portfolio Manager of the Alger Emerging Markets Fund
Deborah Medenica: Over the last one to five years, emerging markets have traded at around an 8% to 10% discount compared to the developed markets on a forward earnings basis.
Taking 12 months earnings and looking back, over that five-year period, every once in a while we get dislocations and markets that have opened up that gap. When that happens, emerging markets tend to trade at a much greater discount to the developed world — despite better earnings and better return on equity. We are in one of those periods right now. Starting a few weeks ago, the discount began widening out. As we stand today, the discount of emerging markets to the developed world is about 16%.
I think that is excessive given their underlying growth potential and presents a rather attractive opportunity for people who can consider emerging markets, can look out over the next ten or twenty years and want to get positioned for that growth. That would be my general outlook.
Wallace Forbes: That sounds like a favorable background for your area of concentration.
Medenica: I think so. We’re at less than eleven times forward earnings. We are now below the five year average price to book ratio, and the return on equity remains higher than that of the developed world. As I said, earnings continue to look robust. We’ve had really no change around the 18% or 19% earnings growth that we were looking at for 2011. So far, it has stayed relatively constant as we’ve moved into the year.
Forbes: Sounds good. Any particular facets of these emerging markets that you’re focusing on?
Medenica: When we think about emerging markets investing, we think about the bottom up – and Fred Alger is a very fundamentally strong bottom up shop. However, in the emerging markets space, we also think about the top down. We think about the top down because of the types of issues that we’ve seen in the last couple of months. In emerging markets, you cannot ignore the macro-economic and political variables that drive particular countries. And when you’re talking about a broad emerging market fund like ours, you’re talking about 20 to 25 different countries.
What we like to do, when we think about which countries we want to be positioned in, is to look at about a dozen economic, financial and political variables. We score each country, in terms of these variables, on whether it is improving or deteriorating. Then we get an aggregate score, which helps us think about how we want to be positioned in the country.
For example, we’re constructive on Russia at the moment. Why are we constructive on Russia? Well, we’re constructive on that market because as we moved into late last year, it became evident that Russia was finally pulling its economy out of the slump that was created by the global financial crisis. We began to see non-performing loan formation slow down. We began to see credit sneak back into the system. We began to see a little bit of loan growth. We began to see industrial production pick up. We began to see a bit more excitement in the retail sales numbers.
All of this suggested that the Russian economy was beginning to brew again. We had a couple of other events also, like Pepsi making an acquisition of a juice company there.
We had recent announcements in the hydrocarbon sector, and all of this suggests that maybe in the last two years the government has become a bit more open to foreign investment than they’ve been historically. This is also quite constructive. Then we looked at valuation; Russia had a market that was trading under six times forward earnings in an environment where oil prices were averaging $90, rather than $40. All of that showed us that Russia could be a very constructive and very interesting story.
A lot of people get excited about Brazil, because they’re going to have the Olympics. But Russia’s going to have the Winter Olympics in Sochi in 2014 and the World Cup in 2018. So again, there are other events happening that would suggest that Russia’s going to be thinking about some investment and infrastructure changes that perhaps will help diversify away their historical focus on hydrocarbons.
Forbes: So you feel that investments in Russia are currently priced to accept what might be their historically less-than-loving view of private investment?
Medenica: Yes. I think recent investments suggest to us that the government is being a little bit more circumspect and a little less antagonistic than what they’ve been historically towards foreign investment. You had Pepsi, BP and Total all making rather significant investments in Russia, and I think that’s a bit of a change from what we saw over the last couple of years.
When you look at a market and you say, “Okay, we’ve got earnings growth in line with emerging market averages at around 18% and a market trading under seven times earnings,” some of that’s priced in. Isn’t that discount a bit excessive for a market with that type of growth, and perhaps an inflection point in terms of how they think about foreign investment? That’s the argument that I would make.
Forbes: Do you have specific companies in Russia that you like?
Medenica: I do. A U.S. listed Russian company that we hold that is Mechel. It’s actually listed here in the U.S., and it’s one of world’s largest coking coal companies. It is what we call an integrated steel company. On the steel side it’s been expanding capacity. It is exposed to both long and flat products. But I think the more interesting aspect to them is this coal dynamic. Right now, they have enough coal that they’re also able to export and sell it onto international markets.
If you look at their planned capacity expansion over the next few years, a lot of people get excited about Mongolian coal. Well, Mechel happens to have this tremendous deposit in the Elga field of Russia, which sits above Mongolia. So Mechel has similar types of coal that they are going to be exploring and taking advantage of over the next three to five years.
As far as coking coal, the world is a bit short of it these days. The stock trades under $30 on the ADRs. It trades at a valuation, on the EV to EBITDA (enterprise value/earnings before interest, taxes, depreciation and amortization) basis, that’s in line with other steel companies around the globe. But because it has this coking coal aspect, we believe you can make an argument for why it should trade at a slight premium — more around 5.5 to 5.7 times EV/EBITDA, which gets you a price target in the higher 30s. So we see some room there for price appreciation. It’s in an interesting resource space at the moment.
Forbes: Great, great. What else are you looking at?
Medenica: One of our favorite names in the portfolio right now is a Brazilian bank, and it also has an ADR here in the U.S. The name of the bank is Itaú Unibanco.
That bank is the merger of two separate banks that happened in 2008. It’s now the largest bank in Brazil, but the bank hasn’t really pushed through their post-merger synergies yet. That’s going to happen this year and next year, so we’ll see the cost-to-income ratio begin to go down.
When you think about Brazil, banking penetration is only 50% of GDP. It used to be 20%, it’s now moved up to 50%, but we can easily see that moving up to 60% or 70% over the next three to five years. Mortgages have less than 5% penetration in Brazil, so a lot of growth on the mortgage side is possible down the road. Brazil, and Itaú Unibanco in particular, has net interest margins above 8%, and those margins are rising right now because the central bank is tightening monetary policy.
So you have loan growth between 15% and 18% and you have net interest margins that are high and expanding. You have cost-to-income ratios that are going to come down, and you have an evaluation that’s at a discount to historical averages, and at a discount to most of emerging markets.
Forbes: Sounds like a lot of pluses.
Medenica: It does. Any which way we do the analysis, in a cash flow or dividend discount model, we can’t get any downside to where it’s trading right now. You would basically have to assume that their cost-to-income ratio goes up, their non performing loans go up, and loan growth goes down to below 10% to not find any value in this name at the moment.
Forbes: Wow. Sounds very strong.
Medenica: And they don’t do any of the spiffy banking that we have here in the U.S. It’s a retail bank. Fee income is less than 20% of their business. It’s all about lending.
Forbes: I see. Any other companies you want to touch on?
Medenica: I hate to only talk about Brazilians, but another ADR we like is Embraer. They are an industrial firm that specializes in making regional jets. If you’ve flown a short haul here in the U.S., you’ve probably flown on one of their airplanes.
Coming out of the global financial crisis, not a lot of airlines have invested in capacity or replaced planes – they’ve all been trying to just survive. We think we’re at a turning point in the cyclical cycle where we could see more investments in jets, and we’re particularly excited about regional jets, because we think that’s a business model that will continue to grow.
We have a lot of airport growth in a lot of emerging markets. We can foresee not just growth in traditional markets here, but in markets like India and Brazil, as more airports and airport expansions are planned. A lot of carriers need the ability to fly short haul routes within countries. One of their main competitors is the Canadian company, Bombardier.
Forbes: And Embraer sells jets here in the United States also?
Medenica: They do, they sell to most major carriers here in the United States. Their jets used to be, 70-75 seaters, and they’ve slowly been expanding. Now they are seat over 100. They’re used on short haul routes, and they’re used by the low cost carriers.
Forbes: Terrific. Well, those sound very interesting and exciting. Thank you.
Medenica: Thank you.
Deborah Medenica: Over the last one to five years, emerging markets have traded at around an 8% to 10% discount compared to the developed markets on a forward earnings basis.
Taking 12 months earnings and looking back, over that five-year period, every once in a while we get dislocations and markets that have opened up that gap. When that happens, emerging markets tend to trade at a much greater discount to the developed world — despite better earnings and better return on equity. We are in one of those periods right now. Starting a few weeks ago, the discount began widening out. As we stand today, the discount of emerging markets to the developed world is about 16%.
I think that is excessive given their underlying growth potential and presents a rather attractive opportunity for people who can consider emerging markets, can look out over the next ten or twenty years and want to get positioned for that growth. That would be my general outlook.
Wallace Forbes: That sounds like a favorable background for your area of concentration.
Medenica: I think so. We’re at less than eleven times forward earnings. We are now below the five year average price to book ratio, and the return on equity remains higher than that of the developed world. As I said, earnings continue to look robust. We’ve had really no change around the 18% or 19% earnings growth that we were looking at for 2011. So far, it has stayed relatively constant as we’ve moved into the year.
Forbes: Sounds good. Any particular facets of these emerging markets that you’re focusing on?
Medenica: When we think about emerging markets investing, we think about the bottom up – and Fred Alger is a very fundamentally strong bottom up shop. However, in the emerging markets space, we also think about the top down. We think about the top down because of the types of issues that we’ve seen in the last couple of months. In emerging markets, you cannot ignore the macro-economic and political variables that drive particular countries. And when you’re talking about a broad emerging market fund like ours, you’re talking about 20 to 25 different countries.
What we like to do, when we think about which countries we want to be positioned in, is to look at about a dozen economic, financial and political variables. We score each country, in terms of these variables, on whether it is improving or deteriorating. Then we get an aggregate score, which helps us think about how we want to be positioned in the country.
For example, we’re constructive on Russia at the moment. Why are we constructive on Russia? Well, we’re constructive on that market because as we moved into late last year, it became evident that Russia was finally pulling its economy out of the slump that was created by the global financial crisis. We began to see non-performing loan formation slow down. We began to see credit sneak back into the system. We began to see a little bit of loan growth. We began to see industrial production pick up. We began to see a bit more excitement in the retail sales numbers.
All of this suggested that the Russian economy was beginning to brew again. We had a couple of other events also, like Pepsi making an acquisition of a juice company there.
We had recent announcements in the hydrocarbon sector, and all of this suggests that maybe in the last two years the government has become a bit more open to foreign investment than they’ve been historically. This is also quite constructive. Then we looked at valuation; Russia had a market that was trading under six times forward earnings in an environment where oil prices were averaging $90, rather than $40. All of that showed us that Russia could be a very constructive and very interesting story.
A lot of people get excited about Brazil, because they’re going to have the Olympics. But Russia’s going to have the Winter Olympics in Sochi in 2014 and the World Cup in 2018. So again, there are other events happening that would suggest that Russia’s going to be thinking about some investment and infrastructure changes that perhaps will help diversify away their historical focus on hydrocarbons.
Forbes: So you feel that investments in Russia are currently priced to accept what might be their historically less-than-loving view of private investment?
Medenica: Yes. I think recent investments suggest to us that the government is being a little bit more circumspect and a little less antagonistic than what they’ve been historically towards foreign investment. You had Pepsi, BP and Total all making rather significant investments in Russia, and I think that’s a bit of a change from what we saw over the last couple of years.
When you look at a market and you say, “Okay, we’ve got earnings growth in line with emerging market averages at around 18% and a market trading under seven times earnings,” some of that’s priced in. Isn’t that discount a bit excessive for a market with that type of growth, and perhaps an inflection point in terms of how they think about foreign investment? That’s the argument that I would make.
Forbes: Do you have specific companies in Russia that you like?
Medenica: I do. A U.S. listed Russian company that we hold that is Mechel. It’s actually listed here in the U.S., and it’s one of world’s largest coking coal companies. It is what we call an integrated steel company. On the steel side it’s been expanding capacity. It is exposed to both long and flat products. But I think the more interesting aspect to them is this coal dynamic. Right now, they have enough coal that they’re also able to export and sell it onto international markets.
If you look at their planned capacity expansion over the next few years, a lot of people get excited about Mongolian coal. Well, Mechel happens to have this tremendous deposit in the Elga field of Russia, which sits above Mongolia. So Mechel has similar types of coal that they are going to be exploring and taking advantage of over the next three to five years.
As far as coking coal, the world is a bit short of it these days. The stock trades under $30 on the ADRs. It trades at a valuation, on the EV to EBITDA (enterprise value/earnings before interest, taxes, depreciation and amortization) basis, that’s in line with other steel companies around the globe. But because it has this coking coal aspect, we believe you can make an argument for why it should trade at a slight premium — more around 5.5 to 5.7 times EV/EBITDA, which gets you a price target in the higher 30s. So we see some room there for price appreciation. It’s in an interesting resource space at the moment.
Forbes: Great, great. What else are you looking at?
Medenica: One of our favorite names in the portfolio right now is a Brazilian bank, and it also has an ADR here in the U.S. The name of the bank is Itaú Unibanco.
That bank is the merger of two separate banks that happened in 2008. It’s now the largest bank in Brazil, but the bank hasn’t really pushed through their post-merger synergies yet. That’s going to happen this year and next year, so we’ll see the cost-to-income ratio begin to go down.
When you think about Brazil, banking penetration is only 50% of GDP. It used to be 20%, it’s now moved up to 50%, but we can easily see that moving up to 60% or 70% over the next three to five years. Mortgages have less than 5% penetration in Brazil, so a lot of growth on the mortgage side is possible down the road. Brazil, and Itaú Unibanco in particular, has net interest margins above 8%, and those margins are rising right now because the central bank is tightening monetary policy.
So you have loan growth between 15% and 18% and you have net interest margins that are high and expanding. You have cost-to-income ratios that are going to come down, and you have an evaluation that’s at a discount to historical averages, and at a discount to most of emerging markets.
Forbes: Sounds like a lot of pluses.
Medenica: It does. Any which way we do the analysis, in a cash flow or dividend discount model, we can’t get any downside to where it’s trading right now. You would basically have to assume that their cost-to-income ratio goes up, their non performing loans go up, and loan growth goes down to below 10% to not find any value in this name at the moment.
Forbes: Wow. Sounds very strong.
Medenica: And they don’t do any of the spiffy banking that we have here in the U.S. It’s a retail bank. Fee income is less than 20% of their business. It’s all about lending.
Forbes: I see. Any other companies you want to touch on?
Medenica: I hate to only talk about Brazilians, but another ADR we like is Embraer. They are an industrial firm that specializes in making regional jets. If you’ve flown a short haul here in the U.S., you’ve probably flown on one of their airplanes.
Coming out of the global financial crisis, not a lot of airlines have invested in capacity or replaced planes – they’ve all been trying to just survive. We think we’re at a turning point in the cyclical cycle where we could see more investments in jets, and we’re particularly excited about regional jets, because we think that’s a business model that will continue to grow.
We have a lot of airport growth in a lot of emerging markets. We can foresee not just growth in traditional markets here, but in markets like India and Brazil, as more airports and airport expansions are planned. A lot of carriers need the ability to fly short haul routes within countries. One of their main competitors is the Canadian company, Bombardier.
Forbes: And Embraer sells jets here in the United States also?
Medenica: They do, they sell to most major carriers here in the United States. Their jets used to be, 70-75 seaters, and they’ve slowly been expanding. Now they are seat over 100. They’re used on short haul routes, and they’re used by the low cost carriers.
Forbes: Terrific. Well, those sound very interesting and exciting. Thank you.
Medenica: Thank you.
Comments
Post a Comment