Spotting new trends in emerging markets

Skagen’s annual New Year’s Conference in London has offered predictions of
performance from emerging markets in 2014.

Independent Norwegian manager Skagen, known for its global equity
views, believes that 2014 could bring some similar performances as 2013 –
such as emerging markets underperforming developed markets – yet also
some key differences – such as more volatility in equity valuations.

This is according to the outlook put forward at the manager’s recent New
Year’s Conference session in London, which also included views of investor,
author and adventurer Jim Rogers (see box below).

Harald Espedal, managing director and investment director at Skagen
Funds, noted that 2013 had been a good year for equities generally, with
multiple expansion driving up prices more than returns from dividends and earnings growth.

This in some respects ought to have been expected, as the data shows how historically years ending in ‘3′ have tended to do well – going all the way back to 1933. The markets benefited from factors such as continuing stabilisation in the global economy, continued low interest rates, and strong company earnings, he noted.

Certainly, these factors combined with a historic tendency for bull markets to overshoot historical price/earnings averages suggest that this year could see continued advances in equity markets. However, there are certain other
factors that, generally speaking, could make this a more challenging year.

For example, with higher equity valuations comes more room for doubt
in investors’ minds, which means volatility could be greater than in the
past year. Other key risks include a possible reversal in economic growth, higher than expected interest rates, and geopolitical risks.

Focusing in on the opportunities and challenges specifically relevant to Skagen’s flagship Kon-Tiki fund, the most recently joined member of the
portfolio management team, Hilde Jenssen, noted that emerging markets
could continue to underperform developed markets.

The evidence supporting this view is seen in a convergence of earnings
per share and return on equity data for emerging markets and global indices, she suggests.

OPPORTUNITIES
What this means for a stockpicking investor such as Skagen, however, is that there are opportunities for investing, based on average trailing price/earnings and price/book ratios, which have moved below their historical
averages.

Emerging market equities have not benefitted from the expansion in multiples as developed market equities have over the past year, and so are trading at a discount to both developed markets as well as their own historical averages. Emerging markets could also benefit if there is currency stabilisation.

As for stockpicking, among the examples put forward by Jenssen are Korean preference shares. These trade at a discount to ordinary shares, partly out of investor fears that they lack voting rights, that they may suffer lower liquidity, and lack transparency.

But Skagen’s view is that these types of fears are overdone, and that the
preference shares it owns over time have provided superior returns to ordinary shares. However, she also pointed to reasons why discounts alone are not sufficient reason to invest: Skagen is wary of state-owned enterprises, particularly where there is a potent combination of rich companies combined with poor householders and poor governments in certain markets.

This creates a new type of political risk to be avoided. Ecommerce and energy are themes where the Kon-Tiki fund sees ongoing opportunities, while the example of Malaysian company DRB-Hicom illustrates why it is important to be able to pick apart the valuations of conglomerate style businesses, to find the value that is not being reflected in the existing share price.

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