It’s time to go hunting for emerging-market bargains

Stock prices in Korea © Getty Images
South Korea: huge potential

Emerging markets have had a rotten time in the last few days. Shares and currencies have fallen pretty much across the board.

And many of the concerns that have driven the current slide are justified.

China’s financial system has looked shaky after a high-yield bond hit serious trouble. And in the US, any further tapering by the Federal Reserve will encourage more investors to pull money out of emerging markets and invest it in what they view as safer assets, closer to home.

However, it’s at times like these that calm, ruthless investors get to pick up attractive assets on the cheap.

So where should you be looking?

Not all emerging markets are the same

It’s easy to lump all emerging markets together. That’s certainly what investors have been doing over the last few days – we’ve seen pretty much uniform falls across the sector.

But that may not last. When problems start, it’s not unusual to see this sort of reflex, panic selling. But the fact is that not all emerging markets are the same. There are vast differences, both economic and political.

And once the initial knee-jerk sell-off is done, I think investors will start to pay more attention to these differences. Research group Capital Economics reckons you can split emerging markets up into five different categories.

The first category is countries where the economy has been seriously mismanaged. In all of these nations, there is a real danger of economic meltdown – Argentina, Ukraine and Venezuela all fall into this category.

In the second group are countries that have lived beyond their means. Both consumers and governments have borrowed too much. That’s meant high consumption and plenty of imports. Examples include Turkey, South Africa, Indonesia and Chile. These countries are at risk of currency crises as overseas investors pull their money out.

Thirdly, we have countries whose banking systems remain vulnerable, following the financial crisis. This category includes Hungary and Romania.

The fourth category is the largest. These are the emerging markets where governments need to make big changes to the way things are done, because their old growth models are reaching their limits. Here we’re talking mainly about China, Brazil and India.

Finally we have a group of countries where the outlook is much brighter. Economic reforms are already going ahead, and export markets are growing. Examples include South Korea, Philippines and Mexico.

Now I’m not saying there aren’t opportunities in the first three categories. But for now, I’m only tempted to invest in the final two categories.

Two markets with huge potential

Let’s start with South Korea and Mexico where Capital Economics is most upbeat.

As I said last month, we’re seeing real economic reform in Mexico now, including the abolition of the monopoly held by the state-owned oil company, Pemex. These reforms mean Mexico can more effectively exploit the advantage of living next to Uncle Sam.

As for South Korea, you could argue that its economic success means it’s moved beyond emerging market status. But whatever the country’s status, it looks attractive. As one very successful fund manager put it recently: “There is hardly any country in the world with so many undervalued shares.”

After recent falls, South Korea’s benchmark index, the Kospi, is trading on a multiple of nine times next year’s earnings. That’s too low for a country with many high-quality companies and a business-friendly government.

With both of these nations, you have the chance to buy into economies with huge growth potential, and at relatively low risk. Just to stress, when I say ‘relatively’, I mean lower risk that you’d normally expect from an emerging market. You can still expect plenty of ups and downs compared with the FTSE 100.

If you want to invest in South Korea, you could go for the iShares MSCI Korea Fund (LSE: IKOR), an exchange-traded fund focused purely on South Korea. If you’re keener on Mexico, take a look at these ideas from my colleague James McKeigue.

Why I’ve bought into China

As for Capital Economics’ fourth category – countries that need to implement major structural reform – I’m most drawn to China. The risk level is high, no doubt about it. It’s not just problems with Chinese banks – we could also see a big political flare-up with Japan.

However, I was really impressed by the results of China’s ‘Third Plenum’ last November. At this party meeting, it became clear that China’s leadership understood the need for reform and was determined to push through major structural changes.

It’s that determination which marks out China from Brazil or India, and that’s why I’ve invested in China in the last month. A price/earnings ratio of ten also helped. I’ve bought into the JP Morgan Chinese investment trust (LSE: JMC), a decent fund that doesn’t levy ridiculous charges, and has delivered strong performance over the last five years.

The trust is currently trading on a 12% discount, which means that the share price is 12% lower than its asset value. I don’t expect that discount to narrow hugely; if I make money from this, it will be because Chinese share prices move upwards.

I may be too early. There’s a good chance that there will be further emerging market ‘panics’ over the next couple of years, especially as the Fed wrestles with how to end its money-printing scheme. But right now, valuations look reasonable and in many cases – such as China – downright cheap. So I’m happy to buy now and wait it out.

My colleague John Stepek wrote more about particularly promising emerging markets in a recent issue of MoneyWeek magazine. If you’re not already a subscriber, subscribe to MoneyWeek magazine.

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