Emerging markets are changing – or at least some of their stockmarkets are. The largest firms in the MSCI Emerging Markets index were once banks, oil firms or miners. Now the top places are held by the Chinese internet giants Alibaba and Tencent, followed by Korean electronics conglomerate Samsung Electronics and Taiwanese chipmaker Taiwan Semiconductor Manufacturing. Further down the top ten you find Meituan-Dianping (a Chinese firm that offers food delivery, online booking and voucher deals), JD.com (China’s Amazon) and Naspers (a South African internet group with investments in several countries). Investors are also flocking to US-listed firms such as MercadoLibre (a Latin American eBay) and SEA (which offers online gaming, ecommerce and digital finance services in Southeast Asia).
All of these stocks are soaring, some by staggering amounts. Meituan-Dianping has gained 250% in a year, while SEA has surged 900% in 18 months. Valuations for the internet firms (the hardware stocks are lower) range from a price/earnings ratio (p/e) of 40-50 for Alibaba and Tencent to meaninglessly high (SEA, valued at $50bn, has yet to make a profit).
Priced for pessimism
We often say that the emerging markets look cheap, but the MSCI Emerging Markets was on a p/e of 17.4 at the end of July. Given that this won’t fully account for the impact of Covid-19 on earnings, a p/e in the high teens doesn’t look like a bargain. However, if you exclude a few of the high-priced tech stocks – most importantly Alibaba and Tencent, which together account for 14% of the index – valuations drop: I’d estimate the rest of the index is on a p/e of around ten to 11. There is a large pool of unloved and cheap stocks that have recovered little since March.
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It’s understandable that investors are wary. Risks are high. Emerging market countries mostly have less leeway to support their economies through this crisis. Many are geared towards commodities; their fortunes depend on how quickly energy and metals prices recover. Others rely on export manufacturing; if globalisation goes into reverse and factories shift back to North America or Europe, that will be a major headwind for their economic development. Individual risks abound: almost every country has worse political leadership than it did a decade ago, for example.
Nonetheless, much of the market is priced as if everything possible will go wrong. That seems unlikely – and if it does, it probably wouldn’t be that great for the high-priced internet stocks either. When the impact of Covid-19 fades, the opportunities this has created should give value investors a much greater chance to excel.
I wish I knew what core-satellite investing was, but I’m too embarrassed to ask
Investing strategies can be split into two broad types. Passive investments aim to earn the same return as the wider market as cheaply as possible, by buying all the stocks in an index such as the FTSE 100 or the S&P 500. Active strategies aim to earn a higher return by only investing in a smaller number of specific stocks or bonds that look particularly attractive. Core-satellite investing tries to combine both approaches to produce a portfolio that has low overall costs but may still be able to beat the market.
The core of the portfolio is one or more passive funds. This investment will usually be as broad as possible: it will either track your main domestic stockmarket index or a global benchmark such as the MSCI World or FTSE World index. You might put 50% of your portfolio in your core fund or funds – the exact amount varies depending on your aims and how much risk you want to take.
The satellites are a series of smaller investments – in this case, you might hold five of these with 10% of the portfolio in each. These will often be active funds in areas in which you think that individual managers have a greater chance to outperform the market: in theory, a skilled manager should have more chance of beating the market in under-researched small stocks than in large firms that are studied by many other managers and analysts. Alternatively, you might choose to use a tracker fund that focuses on a single country or sector if you think it looks very cheap or has excellent growth prospects.
Since each satellite is relatively small compared with the overall portfolio, core-satellite investing is only likely to deliver better performance if the potential returns in the satellites are significantly higher than the core. Portfolios that use lots of mediocre active funds in the satellites (or worse still, in the core) are unlikely to do consistently better than a broad passive fund, but will be more complex to run.
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