Emerging market valuation opportunities
Emerging markets were caught up in the global equity rout over the third quarter. But was this a justified correction or has indiscriminate selling created compelling valuation opportunities?
Third-quarter market turbulence may have sent global markets sharply lower. But James Smith, manager of the Ignis International Emerging Markets Select Value Fund, believes it has resulted in attractive opportunities with emerging market fundamentals remaining sound.
As a value investor, James has been somewhat cautious of emerging markets in recent years given their relatively high valuations.
Yet panic-selling over the past three months, largely on the back of political and economic concerns in developed markets, has left emerging market valuations at appealing levels compared to their historic averages.
Given that emerging economies are expected to be significant drivers of global growth through to the end of 2012, James believes the asset class should see some upside once panic subsides.
Even before the summer rout, James felt that Eastern Europe provided a convincing valuation story and the fund has been overweight this region all year.
While this played out very effectively in the first half of 2011, Eastern Europe has been unavoidably caught up in the poor sentiment towards the eurozone.
James, however, retains his conviction in the region’s long-term outperformance potential.
In his view, markets such as Poland, Hungary and the Czech Republic still offer a decent growth outlook, while not suffering from the fiscal stress of countries such as Greece. Moreover, recent sharp falls have meant that valuations are even more compelling.
In addition, Argentina and Egypt are favoured thanks to their strong economic prospects.
Underweights in the BRIC region are gradually being unwound following price weakness.
Brazil appears increasingly attractive thanks to recent monetary easing. The underweight in South Korea is also being closed as this highly cyclical economy was heavily punished during the summer consolidation, even though earnings expectations are robust.
A unique valuation-led EM process
At the core of this strategy is James’ belief that asset allocation – through country selection – is the best way to generate alpha.
Generally, the variance in emerging market stock prices can be attributed to market conditions and how the country, in which the stock is domiciled, is perceived.
James therefore concentrates his efforts on selecting the correct markets, rather than individual stock selection, and believes a value approach can maximise the opportunities.
James’ process therefore starts with quantitative idea generation using a proprietary screening tool called MASAM (Market and Sector Allocation Model).
MASAM ranks allof the countries in the emerging markets universe on a relative basis, scoring them for attractiveness on a variety of measures.
The net result is an overall ranking allowing markets to be compared on a like-for-like basis.
James recognises, however, the weakness of a pure “black box” approach, and therefore adds a qualitative overlay to the MASAM ranking to guide the timing of buy and sell decisions. This is based on the team’s experience of emerging market investing.
The final step is implementing the team’s views in line with the MASAM ranking. This part of the process sets the fund further apart from its stock picking peers.
Rather than allocating to individual stocks, the fund seeks to gain exposure to the most attractive markets in the most efficient way.
The best way of achieving this is typically using Delta 1 instruments, such as futures, ETFs and MSCI OPALS, which cover the majority of the MSCI Emerging Markets Index.
However, where it is impractical or too expensive to use Delta 1 instruments, we will replicate the country index using the most representative stocks.
James believes that once normality returns, there is again upward potential for emerging markets, notably from the valuation opportunities the third quarter has provided.
The valuation focus of his process leaves the Ignis Emerging Markets Select Value Fund particularly well-placed to benefit.