Emerging Market Equity is a useful addition to a South African investor’s Offshore Equity portfolio

One of the first lessons you are taught in investments is: ‘Don’t put all your eggs in one basket’. It underlines the need to diversify your investment portfolio across a number of asset classes or multiple geographies.

For South African investors, who are already based in an Emerging Market (EM), the usual recommendation is to add Developed Market (DM) exposure. We hold a slightly different view, because we believe diversification should be based on future return expectations, so it should drive asset allocation.

Here are a few points to consider when making an asset allocation decision:

1. Valuation: the ultimate driver of future returns and a key pillar of our investment philosophy. In the past 10 years DMs significantly outperformed EMs. DMs are heavily skewed to the US, which makes up roughly 60% of the MSCI World Index. This outperformance has reached unprecedented levels, with the US market trading at a price-to-earnings (PE) ratio of 29.1x versus the MSCI Emerging Markets index, which is trading at a PE ratio of 11.7x. The US Shiller PE ratio has only ever been higher in 2000 and the subsequent 10-year real returns were negative for the US market.

Source: CSSS

2. Another key consideration should be currencies. Global Emerging Market (GEM) currencies are close to 20-year lows versus the dollar, despite the basic balance of payments surplus being at an 18-year high, and they are delivering a near-record real yield over the dollar. When GEM currencies appreciate, GEM equities tend to outperform. The dollar has been strong since the Global Financial Crisis and this has been an important contributor to the underperformance of EMs as an asset class. Part of the reason for dollar strength has been that US interest rates were relatively high compared with other developed world countries. Another reason is that the dollar is seen as a safe haven during periods of economic stress. We therefore believe that the dollar is unlikely to present much of a headwind over the next 10 years and could even become a strong tailwind.

Source: CSSS

3. Markets tend to move in cycles and we believe EMs are on the cusp of re-rating, given their growth differentials, better earnings outlook and lower relative valuations. A weakening dollar provides an additional margin of safety for global investors. We can clearly see the past cycle outperformance of 188% from 1999 to 2009 and similar patterns since 1973. If we look at the last four material drawdowns, there is evidence to suggest there will be a strong recovery in EMs.

Source: CSSS

4. A key reason for buying an EM fund is not only the valuation support, but to buy into a basket of EM countries that provide diversification and reduce the risk of significant capital loss. For a South African investor, this diversification benefit might be offset by the apparent high correlation in the past of the South African market to EMs. We feel strongly that this high correlation has been partly driven by the market index contribution from heavyweight Naspers/Prosus and that the correlation is in a downward trend, as shown below. This justifies a higher allocation to EMs from a portfolio construction perspective.

5. While SA may appear to be a reasonable equity story due to cheap valuations, there are plenty of reasons for longer-term concern that would support a further weakening of the correlation between SA and other key EMs. SA’s public sector debt is very high, as is unemployment, and its growth outlook compared with many EM countries is weak and likely to stay so for the foreseeable future.

Source: HSBC

Source: HSBC

EMs afford us the opportunity to invest in countless high-quality companies with great business models, good management and access to high-growth regions. We believe there are EM companies with business models similar to those of well-known South African counters but which trade at significant discounts to their South African peers.

An example of one of those companies is Noah Holdings, which we own on behalf of our clients. Noah Holdings, listed in China, has a business model comparable to PSG Konsult’s: it is China’s largest independent wealth and asset management company, and is a key beneficiary of rising wealth in China. Given the attractive outlook for wealth creation in China, and still-low penetration rates, rapid growth in wealth management is likely to continue for many years. Noah’s cash-generative, asset-light business model and good margins are key drivers of high internal capital generation. Management incentives are also aligned with Noah’s long-term prospects, as visionary founders own a 38% stake in the business. Noah is currently trading at 11x 2021 earnings (7x excluding excess cash) which is too low, given Noah’s high quality and growth potential.

In summary, if you own a broad EM equity fund, you can access the systemic advantages of the EM trade without being over-exposed to SA-specific risks.  Many other EM countries have better demographics, stronger growth, lower debt, lower unemployment and less political risk.  From a risk-reward perspective, an EM fund is a much better way to play the developing favourable EM investment landscape than just owning exposure to SA. Our investment philosophy of quality growth at a reasonable price and good corporate governance has unearthed very attractive share opportunities (like Noah) that bode well for our fund’s future return.