Two great ways to play the EM recovery

published 9 January 2012

One of the biggest risks we'll be facing in 2012 is regular financial calamities that take down all our investments at once. As fresh fears surface about a bank or European economy, investments could suffer across the board.

Worse, some of our best performers are most vulnerable. That's because as traderscash in profits to cover cash calls on losing bets, prices fall. In recent weeks, cash calls on European banks have been growing by the day sucking in good money from elsewhere.

But these panics could prove to be a great opportunity for us. Because, as investors dump everything wholesale, there could be a chance to pick up some seriously undervalued investments.

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Take one of my favourite themes for 2012 emerging markets (EM). These economies have formidable production, resources and workforce capacity all operating within a pro-business environment. There are great long-term factors underpinning EM stocks.

And yet as the euro crisis lumbered on last year, vast sums of money were pulled out of emerging markets.

That's great news for us. Today I want to look at why I think that is and show you at least two opportunities it offers.

The UK is in dire need of a system reboot

I like emerging markets. They've headed into this millennium with far better prospects than the West. It's not just the fact that they've got much lower debt and better demographics than us. What's really making a difference is the better business environment.

Take a look at our own for a moment. What we're looking at is an economic system that looks as much like socialism as it does capitalism. With around half of UK GDP running through the veins of government, our nanny state society could do with a reboot.

But it's difficult to see how that might happen. Last week David Cameron made a big speech about killing off the health and safety "monster" that threatens UK businesses. But how's he going to do that? There were no concrete proposals.

Emerging marketshave had their system reboot' already. Many now resemble the post-war West. With no despotic central authority (or at least reduced in the case of China) to meddle with the economy, they've been outperforming the West for years. Countries like China, India and Brazil have been regularly growing GDP at near 10%.

Meanwhile, our economy is flat-lining. If we can get back to 2% growth we'll be happy! And even 2% growth would effectively mean we're just treading water. That's because productivity gains tend to give us around 2% anyway. If you want more jobs and a real sense of growth, then you want to see 4% or more. And anyway, the ever inflating price of natural resources (as a result of EM demand) acts like a tax on both business and individuals, bringing down standards of living despite headline growth.

Relative to the West, the outlook for EM has never been better.

But and this is an important BUT thoughemerging markets arehaving a much better time of it, it hasn't meant their stock markets follow. So-called de-coupling, whereby EM stocks plot their own upward trajectory unaffected by Western markets, hasn't happened.

Here's why....

Wealth is beginning to accumulate in the East. And it's the best kind of wealth there is. Production capacity (plant and machinery) and resources capacity (mines, oil fields, etc) this is real wealth. And EM economies have it in spades. A skilled workforce is also wealth though it's what an accountant might call an intangible'.

What the West has is financial wealth (worst luck!). Nearly all the world's financial riches lie with the West. And any financial wealth the East does have is mostly controlled by Western institutions.

The problem is that much of our financial wealth has been created by debt. Banks and hedge funds can be leveraged fifty to one. Households too I mean a 95% mortgage (by no means uncommon over the last 30 years) is a financial position leveraged at 20:1.

And leverage can take its toll. Households in trouble sell investments to cover cash calls. Banks sell investments too. When in trouble, they'll dump foreign risky' holdings and bring the money home. When times are tough, the institutions want their money close at hand and in the supposed safety of Western currency, particularly US dollars.

What does this all mean for us?

Emerging markets have always been perceived as volatile and therefore less investible. But what you've got to remember is that much of that volatility is a direct result of the way the West manages its financial wealth. When cash is extracted from the relatively illiquidemerging markets then shares fall off a cliff.

But this can offer opportunities. Because the true value will out in the end.

As my colleague, EM specialist and MoneyWeek contributor, Cris Sholto Heaton pointed out last week: "The fact that emerging market economies overall continued to deliver better growth had absolutely no effect on their stock markets. Earnings growth for emerging market companies beat their developed peers - by a margin of 10-15 percentage points cumulatively over 2010 and 2011, according to UBS."

Two great ways to play the EM recovery

I can't see how EM shares can continue to underperform the West while their companies outperform. That's why, though my equity weighting is generally low, what I do have invested is biased towards EM.

I've mentioned ways of playing EM through two investment trusts in the past. You can read more about JP Morgan's emerging market fund and the Ashmore Global Opportunities trust by clicking on the links.

And if you want to stay abreast of developments and investment ideas for in EM, then sign up to Cris Sholto Heaton's MoneyWeek Asia. It's a great read. And it's free. Sign up here.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.

He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.

Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.