Have emerging markets bottomed? Q&A with money manager

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There has been a lot of doom and gloom surrounding emerging markets stocks this year: Share prices are down following a disappointing 2013, investors have been taking money out of exchange-traded funds that track emerging markets and a lot of observers are wondering if some economies are heading into a bigger crisis.

But downturns can bring opportunities, too. To explore these, we caught up with U.K.-based Phil Langham, senior portfolio manager and head of emerging markets equities at RBC Global Asset Management.

Among his insights: Emerging markets stocks trade at a 30 per cent discount to developed-market stocks, Federal Reserve tapering could be a good thing, and when everyone agrees that stocks have hit bottom it will be too late to take advantage of cheap stocks.

What signs are you looking for as an indication that the worst in the emerging markets selloff is over?
It's always very difficult with emerging markets, and markets in general, to get the timing completely right. First of all, it's important to think of the long-term – and there are several positives. Valuations have become much more attractive, particularly relative valuations. And compared to other crises, we've already seen a significant hit to many currencies. Currencies are acting as shock absorbers. We're starting to see the very high current accounts, particularly in the countries known as the "fragile five," start to improve. That's going to be quite important in timing the recovery.

Many commentators believe that disappointing economic points have been weather-related, and that global economic data will continue to pick up. If that were to happen, we would likely see developed-market equities pick up again and certainly that would help the performance of emerging markets.

Give us some more detail emerging market valuations. How cheap are they?
A good way of looking at it is to compare valuations with developed markets. In terms of price-to-book and price-to-earnings, emerging markets are currently trading at over a 30 per cent discount. The historic average has been about 15 per cent. I do think that emerging markets deserve to trade at a discount to developed markets, but it would be hard to argue that the discount should be much higher than where we are now.

At times of stress, we find that price-to-book works as the best valuation tool. The current price-to-book in emerging markets is between 1.35 and 1.4. Historically, that level of valuation has tended to mark a low in all cases apart from one – and that was the Asian crisis in 1997.

Is the turbulence all due to the Federal Reserve's tapering its bond purchases, or quantitative easing?
Really the key to what's going on is that we've had several years of very strong growth in emerging markets. Emerging markets have been growing at about 4.2 percentage points higher than developed markets, and it has been as high as 6 percentage points in recent years. In the past couple of years, that premium come down toward 3 percentage points. We would say that a reasonable long-term average from here would be something like 2 to 3 percentage points.

The much faster growth that we have seen had started to create some imbalances, so the current account surpluses that existed in many cases turned to current account deficits. Actually, I think that tapering will turn out to have been a good thing for emerging markets because it is checking some of that very fast growth and causing some very necessary adjustments to currencies and to credit growth through higher interest rates.

Are money flows out of emerging markets a concern?
I think what you often see with money flows is that they tend to be a lagging indicator. That's not to say that the money outflows aren't going to carry on for a while, but in general you tend to see good performance attract flows and poor performance attract outflows. It would be wrong to look at fund flows as a forward indication.

Should investors be adjusting their concept of emerging markets – say, seeing them as individual countries or sectors or stocks?
My view is that you should really focus on stocks. Focus on companies with good management, good corporate governance, strong franchises, good industry positioning. We are definitely going through a phase where country allocation is more important than usual: The performance difference between the good and the poor countries is much higher than normal, but I don't think that that's a permanent feature.

Can you name a couple of companies you like?
HDFC Bank. It's an Indian mortgage provider. They have the largest share of mortgages in India. Mortgage penetration in India is still low, at 7 per cent of GDP. That compares with typically well over 80 per cent in the developed world. There's a lot of pent-up demand for mortgages in India. They're also a high-quality institution with a low cost-to-income ratio of under 10 per cent.

SABMiller plc. It's listed in South Africa but very global. They're very well-diversified with operations throughout the emerging market world – in Asia, Africa and Latin America. Well-managed, with a high return on capital that we think is sustainable because of the strong positions they have. But they have lots of room to grow.

Is your stock-picking changing in light of rising interest rates? Are you getting more defensive?
Not really. One of the areas we have been very focused on over the last several years has been emerging markets consumption. Because it has done well, some of the valuations in this area have become quite high. We are finding a lot of attractive opportunities in other sectors, such as health-care, industrials and technologies.

But are you worried about the local economies?
We have already seen a partial slowdown, and we would expect to see more of a slowdown. We think a lot of it has already been discounted.

If we take the most extreme case, Turkey, credit growth has been particularly strong over the last few years and interest rates have recently risen substantially. The banks are already trading at valuation levels that are the same as during the credit crisis. They're trading below book. Typically these are banks that have been able to achieve a very high return on equity of 18 to 20 per cent.

How good is the buying opportunity today when compared to other emerging markets crises?
In absolute terms, there hasn't actually been that much weakness. The weakness has been much more in relative terms. What's really going to be key is to see earnings growth. There will be some dependence on what's going on in the global environment. We need to see the recovery continue, and it is hard to see any equity asset class perform well unless we see a broad global recovery.

How vulnerable is the world to emerging markets contagion?
Emerging markets have become much more important over the last few years, particular in terms of global GDP growth but even in terms of global GDP. Ten years, ago emerging markets represented something like 22 per cent of global GDP. Now they represent more than double that. And over the past few years they have represented typically over 80 per cent of global GDP growth.

Although we have seen a slowdown in growth, it is just a temporary slowdown and we don't expect it to be substantial. In China, we will see a gradual slowdown over the next few years. But a substantial slowdown is unlikely. If they are falling short of their growth target, they will implement policies towards the middle of the year to ensure that 7.5 per cent growth is achieved.

Some strategists have been saying that the situation in emerging markets could get worse before it gets better. What's your view?
I don't know when the bottom will be reached. But it is quite common for people to say that we're still months away from the bottom. And whenever the bottom is reached, that is going to be the prevalent view in the market.