Seize the moment: Add Emerging Markets equity to offshore portfolios
By Feroz Basa, Head of Global Emerging Markets at Sanlam Investments
In the world of investments, the cardinal rule is: “Don’t put all your eggs in one basket.” This rule underscores the importance of diversifying investment portfolios across various asset classes and geographical regions.
While the conventional approach for South African investors might be to favour developed market exposure, we take a slightly different view. We believe diversification should be based on future return expectations, which will drive asset allocation strategies.
Emerging Markets (EMs) offer opportunities to invest in numerous high-quality companies with robust business models, effective management and access to high-growth regions. Many of these companies trade at significant discounts to their South African counterparts.
An EM company example: Pinduoduo
For example, a company that we own on behalf of our clients is Pinduoduo (PDD). China’s largest e-commerce discount retailer is on its way to become the largest discount retailer in the world. It was only launched in 2015 (Alibaba started more than 20 years ago), exclusively selling mobile phones (no PC heritage). PDD pioneered the team/group purchase model and leveraged social networks like WeChat to encourage users to share and purchase with their friends or strangers.
PDD’s international expansion through its subsidiary, Temu, began in September 2022 in the US. After only one year, Temu is now present in 38+ markets (mainly developed). Its unique competitive advantages are economies of scale and products offering value for money, especially in apparel and household categories. In this, it is similar to US offline discount retailers like Dollar Tree and Family Dollar.
PDD is currently trading at 15x 2024 earnings for the Chinese domestic business (excluding losses from Temu) which we do not believe has fully priced in the growth potential within China from further market share gains and higher take rates, and attributes little value to Temu.
Points to consider in making EM investments
When weighing asset allocation decisions, it is worth considering a few pertinent points.
Valuation: Valuation is a cornerstone in projecting future returns. Over the past decade, developed markets have exhibited significant outperformance, with the US market commanding a substantial share of the MSCI All-World Index. However, this outperformance has peaked, and the valuation gap is striking. The US index is trading on a 29.1x PE compared with the MSCI EM on a 11.7x PE. Historically, such high levels of outperformance have been followed by negative real returns for the US market.
Source: Credit Suisse
Currencies: EM currencies are currently at nearly 20-year lows against the dollar, despite robust fundamentals. When these currencies appreciate, global EM (GEM) equities tend to outperform. Taking into account dollar strength since the Great Financial Crisis, and expectations that it will weaken over the coming decade, EMs present a compelling investment opportunity.
Source: Credit Suisse
Market Cycles: Markets are cyclical, and we believe EMs are on the cusp of a re-rating. Their growth differential, better earnings outlook, and lower valuations position them for a potential upswing. We can clearly see the previous cyclical outperformance of 188% from 1999 to 2009 and similar patterns since 1973. Looking at the last four material drawdowns, there is evidence to suggest there will be a strong recovery.
Source: Credit Suisse
Diversification Benefits: Investing in an EM fund is not solely about valuation support. It also means accessing a diversified basket of EM countries that mitigate the risk of significant capital loss. Local investors may be concerned about the high correlation between the South African market and other EMs. However, this correlation was influenced by the heavy weight of specific companies and is showing a downward trend, justifying a higher allocation to EM from a portfolio construction perspective.
SA’s Prospects: While South African equities might appear attractive due to their low valuations, there are substantial long-term concerns. Public sector debt, unemployment, and a weaker growth outlook than many other EM countries indicate a need to explore broader EM opportunities.
Diversify into other EMs
Embracing a diverse EM equity fund enables investors to harness the systemic advantages of emerging market dynamics without exposing themselves excessively to South African-specific risks.
Numerous EM nations exhibit superior demographics, robust growth, lower debt burdens, reduced unemployment, and diminished political risks. From a risk-reward perspective, an EM fund is the best way to navigate the increasingly favourable EM investment landscape, transcending the confines of a solely South African investment.
Our investment philosophy, underpinned by quality growth at a reasonable price and stringent adherence to good corporate governance, has unearthed compelling opportunities such as Pinduoduo, reinforcing our confidence in the prospects of superior future returns from our fund.