Where to find bargains in the emerging markets
(The author is a Reuters contributor. The opinions expressed are his own.)
LONG BEACH, Calif.- Events in emerging economies these days recall the cynic's definition of history: one damned thing after another.
Currencies are plunging and interest rates are soaring in countries across four continents. Key industrial indicators in China, the biggest emerging market, suggest a marked slowdown. These inauspicious developments have sent the MSCI Emerging Markets Index down 8.6 percent in 2014 through Feb. 5, leaving it nearly 14 percent below where it stood a year earlier.
Conditions could worsen and depress stocks further. But if you believe in their long-term growth prospects and can tolerate further short-term turmoil, it's a prime time to seek out shares of fast-growing, financially stable businesses at reduced prices.
Michael Kass, manager of the $477 million Baron Emerging Markets Fund, whose returns rank in the top three percent among funds in the sector over the last three years, identified two such companies from his portfolio, both in the Chinese technology sector: 21Vianet Group Inc. and SINA Corp..
Kass calls SINA "the Twitter of China," something that presents a good news/bad news dichotomy. Its stock was hit recently after government threats of legal action were seen as an effort to crack down on critics of the Communist Party. But the scrutiny could help SINA preserve its dominant status, Kass says.
"The government isn't going to let anyone else become the Twitter, Facebook or Google of China, and there's no chance that a Western company is going to be allowed in to take that market," he says. "SINA is the only place people go to for a Twitter-like experience."
SINA doesn't make much money yet, but Twitter doesn't make any, and SINA is much cheaper than its American counterpart on a key valuation measure. SINA trades at about seven times revenues, compared to about 68 for Twitter.
21Vianet is a moderately sized web-hosting business that Kass expects to benefit from disenchantment with the three state-controlled phone companies that dominate Chinese Internet infrastructure. Each focuses on a different region, and he notes that the three don't play well together. In his view, that should allow 21Vianet, which has joint ventures with International Business Machines Corp. IBM.N and Microsoft Corp. MSFT.O, to usurp some of the telecoms' clientele in the next decade.
"The company serves multinationals that don't want to send data over state phone lines," he says. "It can create a seamless nationwide network of data centers that's more efficient, with less chance of outages and disruptions."
Right now the stock may appear expensive, trading at nearly 40 times analysts' estimate of 2014 earnings, but 21Vianet has very little debt. Kass finds that appealing during difficult times like these because it leaves companies less beholden to banks and bond markets for capital.
FOCUS ON BALANCE SHEETS
Steve Cao, senior manager of the $3.3 billion Invesco Developing Markets Fund GTDIX, whose five-year returns rank it in the top five percent among emerging market funds, says he's ignoring the turbulence and focusing on companies with "strong franchises, quality business models, sustainable long-term cash flows and decent returns on capital".
For example, Cielo SA, is the dominant processor of credit card transactions in Brazil, with 54 percent of the market. The company has very high operating margins, above 60 percent, Cao notes, and is not susceptible to the loan deterioration that can plague banks. Instead it lives off fee income, of which there has been plenty.
"Cielo recently reported double-digit revenue and earnings growth driven by strong volume growth in credit and debit cards," Cao says. The stock trades at about 16 times estimated 2014 earnings, he adds, and has a 3.6 percent dividend yield.
Another selection, Lee & Man Paper Manufacturing Ltd., makes paper board in China. An attraction for Cao is its comparatively low operating expenses.
"They have the lowest production costs in the industry," he says. "I really like a company that has low costs, so when things are going south they can maintain their competitiveness."
The Chinese government likes such businesses, too. Authorities have been shuttering inefficient manufacturers, something that he foresees giving Lee & Man a further edge. Despite its advantages, the stock trades at just 11 times 2014 estimated earnings.
Philippine Long Distance Telephone Co. is the larger of the two telecoms in the Philippines and one of the largest holdings in Cao's fund. The limited competition gives PLDT leeway to raise prices and maintain stable earnings growth in the mature market. The stock yields 5 percent, and there has been an additional special dividend in each of the last six years, he notes.
Cao has no target prices on his stocks and says he wants to hold them forever. He occasionally sells due to valuation concerns but that none of the three he mentioned are close to being overvalued.
Kass declined to state specifically what would make him sell his stocks, but he indicated that it would require developments that shake his belief in their long-term promise or a significant jump in stock prices that puts valuations out of whack. Investors in emerging markets don't have to contend with soaring equities these days, of course, but they will again some day, Kass predicts.
"It's an essential asset class," Kass says. "You don't want to abandon it. When it runs, it's going to be a vicious rally."