Who dares wins – it’s time to place your bets in emerging markets

Avoiding volatile markets to stay safe is self-defeating you need to go looking for value in Asia, says David C Stevenson.

I've always had a soft spot for Norwegians, although even I have to admit that with all that wealth, confidence and deep education comes a certain boring quality. The Norwegians are fast turning into the Swiss of the Nordics, largely because all that energy wealth makes it a civilised, smart place to live not to mention expensive.

But this boring bunch is actually making a rather adventurous investment call. You may not have heard of the Norwegian Government Pension Fund, but it currently sits on $760bn in accumulated wealth it's the biggest sovereign wealth fund in the world. It is trying to grow this already vast pile using both bonds and equities. And its chief executive, Yngve Slyngstad, recently admitted that his investment specialists were still quite keen on both emerging markets and even China.

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Apparently Norway's fund held 10% of its stocks in emerging markets at the end of June, a figure which has been consistently growing: 2% was invested in China, up from 1.7% in December, held via 303 direct investments in mainland China. That compares with 31% in the US and 14% in the UK. (The single-largest holding across the equity portfolio was in food giant Nestl.)

Why the enthusiasm for emerging markets and China in particular? According to Slyngstad, "growth that is expected by the [Chinese] authorities is still quite high. We still have confidence that long-term prospects for China are quite good." Now, this might not seem that radical we've all heard the arguments for investing in emerging markets countless times but the fact that the Norwegian pension fund has actually acted on its desire to capture more global growth, makes it really rather adventurous.

Fear of emerging markets

The truth is that while Western investors might talk the talk, they don't actually like investing in anything too risky when it comes to emerging markets. We nod when we hear about growth in the developing world, we agree that the West is mid-way through a decades-long crisis born of deleveraging and ageing populations but then we ignore it in portfolio terms.If you're looking for evidence of this, then I'd recommend a superb research paper by US exchange-traded fund firm EG Shares, which is available for free at their website.

In this paper, Emerging Global Advisors makes what I think is a very compelling case. For all the talk of buying emerging markets, in reality the typical Western investor's portfolio exposure directly to emerging-market equities (so we're ignoring emerging-market exposure via developed-world mega-caps) is actually very low. In other words, investors don't own many emerging-market stocks in their portfolio at all.

So what's putting them off? It's clearly not the fundamentals, as most emerging markets currently trade at big discounts to US stocks. To understand this valuation point, investment trust analysts at Cantor Fitzgerald recently ran the numbers on Asian stock markets (with a focus on China) as part of a report on a fund called the Asian Absolute Return Trust (run by managers from Schroders).

In short, they found that Asian stocks are clearly cheap right now. Using the MSCI Asia (excluding Japan) index as a benchmark, they found that Asian stocks currently trade at 13 times earnings (well below US levels), and 1.6 times book value.

Since 1975, this index has spent 81% of its time trading at higher valuations, and only 15% of its time at lower valuations than today. Using historic data as a guide, they reckon that in the three years to come, there's a one in 14 chance of losing money, and a 13 in 14 chance of making it. And on average, when valuations have been this low, investors have made a 100% return over the following 36 months. Obviously, these cheap emerging-market and Asian stocks could get a lot cheaper no one can predict the future after all. But the probability is that share prices will start rising.

It's not the price, it's the volatility

So, given these great fundamentals, are UK private investors rushing to pump money into emerging-market stocks? Far from it. In reality, it's not the fundamentals that worry private investors it's volatility. We look at the sharp ups and downs of Chinese shares, for instance, and say, "that's not for me". But if we go back to the EG Shares analysis, there's a hugely important insight about volatility. It's this: most volatility within emerging markets comes from just a few key sectors such as financials (banks to you and me), energy companies and miners.

Volatility can also be explained by regional differences between geographical markets in Russia, Brazil, India and South Korea which are much, much more volatile than say Malaysia or Thailand.

So taking a blanket "emerging-market stocks are too volatile for me" approach is stupid and self-defeating. Particular strategies within emering markets and especially Asia, can and have made sense in recent years. Two tried and trusted ideas in particular stand out.

The first is that if something is good value it'll probably end up being a good long-term investment regardless of where it is in the world. And although a broad sector or theme like emerging-market equities might face structural headwinds, a focused stockpicking approach to certain themes or sectors can still deliver value.

The proof of the pudding for this selective approach is that experienced Asian and emering-market-focused fund managers such as Hugh Young at Aberdeen have continued to deliver superior returns in the last few years, even while many of their rivals have struggled valiantly. The difficulty here is that although the numbers suggest there's decent value in emerging markets (especially Asia), Young has said that finding decent, good-value companies has become much harder in recent months.

Staying safe

So what should investors do next? Well, in my upcoming two articles I'm going to feature a number of practical fund-based ideas for anyone looking to invest in emerging markets. At the core of this approach, are four quite simple principles.

Avoid certain regions: these include the Middle East, Russia (an utter fiasco in investment terms) and Latin America. It's better to focus instead on Asia and smaller frontier markets, including Africa.

Avoid broad emerging-market funds in the short to medium term: focus instead on particular sectors or strategies.

Chinese equities are cheap and getting cheaper: this is a fact. But you have to invest intelligently more on that in my next article on this subject.

Focus on value: value-based investors, who focus on cheap, high-quality companies with increasing dividend payouts, probably have the best chance of navigating their way through the corporate governance omnishambles that is Asia.

Act fast this fund is closing soon

In this article I'm going to focus on that last principle value-investing in Asia, and why it makes sense. In particular, I want to look at a fund that is about to close its books to outside investors. Greg Fisher runs a unit trust that is available on some platforms (but not Hargreaves Lansdown among others) called the Halley Asian Prosperity fund.

In literally one week, Fisher will shut the fund because he's reached his maximum of $200m in funds. He takes a focused, value-driven approach to investing in small to mid-cap stocks around the Asian region (including Japan, about which he's much more optimistic than I am). He looks for companies in places like Vietnam or the Philippines where there's a real focus on the consumer sector, a strong balance sheet, and a growing and well-backed dividend.

You won't find many of these stocks in the world of large caps (inhabited by Young's funds at Aberdeen, for example which I own in my portfolio). Fisher's approach at his company Samarang requires burning through lots of shoe leather, talking to managers, and understanding national dynamics. That focus is why he wants to keep the fund small and why if you don't move fast, the fund will be locked up.

But don't despair if you are late: there are some mainstream alternatives, focused around Asian equity income funds. The idea here is to look for companies in the same places as Fisher, where that dividend is growing and backed up by a sound balance sheet.

The good news is that there is a growing number of these funds in existence. Somerset Capital's Emerging Market Dividend Growth unit trust is the pioneer, followed by Polar Capital's equally successful Emerging Market Income unit trust.

Among investment trusts I'd strongly recommend JPMorgan's Global Emerging Markets Equity Income trust (LSE: JEMI), the Henderson Far East Income Trust (LSE: HFEL) and the Schroder Oriental Income Trust (LSE: SOI) all have delivered more than 10% over the last 12 months in price returns and yield between 3.2% for the Schroder fund and 5.2% for Henderson's. I think that a relentless focus on dividend and its sustainability at the balance sheet level, especially in Asia, is the best way to navigate through emerging markets.

Next time, I'll be looking at an absolute returns way of playing Asia, and especially China, as well as emerging market infrastructure as a theme.