Beyond Bulls & Bears

Emerging Markets: Ugly Duckling or Swan?

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Stephen Dover
Stephen Dover

The late Sir John Templeton once said, “To buy when others are despondently selling and to sell when others are avidly buying requires the greatest fortitude and pays the greatest ultimate rewards.” Emerging markets have seen what could be described as despondent selling during the second half of 2013 and in early 2014. Investors may be wondering whether it’s time yet to buy—or to stay away. Stephen Dover, managing director and international CIO, Local Asset Management at Franklin Templeton, offers a reminder that even the hottest stock or market eventually cools and, as investors chasing performance pile in, they often wind up out in the cold. On the flip side, avoiding markets that may be out of favor today means missing out on potential gain tomorrow. For this and other reasons, Dover thinks it would be folly to ignore emerging markets, today’s ugly duckling, which he believes could be holding a future as a swan.

Stephen Dover, Managing Director, International Chief Investment Officer 
Franklin Templeton Local Asset Management

Examining global markets and asset classes over a long time horizon, you will see that the winners and losers rotate. For example, Europe was without question a pretty severe loser during the depths of its sovereign debt crisis, but rebounded in 2012 and was an investor favorite in 2013.

Most investors would probably classify emerging markets as a loser over the past year, but I believe the tide may be ready to turn, and in recent weeks, we’ve seen some more positive signs that investors may be returning. The problem is that most investors simply can’t successfully time the market. How do you know when the next great rotation into a particular market will take place, and which market will that be?


At Franklin Templeton, we try to look at the market primarily from a bottom-up perspective, but bottom-up can have a lot of different meanings. Bottom-up can mean looking at individual companies, but it can also mean utilizing a local perspective to really dive deeply into the differences in performance in different countries based on myriad factors, and seek to determine what is driving that difference.

When looking at potential investment opportunities, in our view, one of the worst indicators of future performance in a particular market is where the money is flowing today. The money tends to follow or go after performance. Some observers may look to economic growth as a predictor on a country level, but even if one could predict the economic performance of various countries, that doesn’t mean there’s a direct correlation with stock market performance, at least not in the short term. The country with the best economic growth at a given time isn’t always the country with the best stock market performance at that same given time. In 2013, for example, the best-performing equity markets (in USD terms) were largely the markets with the weakest GDP growth.


Investing in the Unpopular

In general, the reason we take a bottom-up approach is precisely because of the difficulty in making predictions based on macroeconomic trends, although certainly, there is value in paying attention to them. Franklin Templeton’s Local Asset Management Group takes a detailed look at specific companies that might not be on the radar screens of other investors. Local asset management refers to the strategic investments that Franklin Templeton has made in local asset management companies around the world to leverage the expertise of well-qualified investment and financial services professionals who have firsthand knowledge of their domestic markets. Today, the company has locally managed and distributed products in Australia, Brazil, Canada, China, Mexico, the Middle East and North Africa, Europe, India, Japan, Malaysia, South Korea, Vietnam and the United Kingdom. [perfect_quotes id=”4343″]

We have found that the tale of the ugly duckling becoming the swan often plays out in the global markets. What’s really quite unpopular at some point often becomes popular at another point. Europe was the ugly duckling at the bottom of its sovereign debt crisis a few years ago. That’s when our global equity portfolio managers entered the market, particularly the areas of financials and the banks, where other investors weren’t interested. We were not only looking at Europe overall, but at investing in local companies in Europe. Investors in Europe at that time were for the most part arguing that if you had to invest there, you should seek out global companies domiciled in Europe but without much exposure to Europe. Our local asset managers looked at it differently. While we knew Europe wasn’t likely to experience much, if any, short-term growth, many companies located in Europe with stakes in Europe were, in our view, very undervalued. We generally invested in companies whose revenues were more tied to Europe, and which also tended to be smaller-cap companies beyond the largest or most recognizable names.

The region known as MENA (Middle East and North Africa) was another area no one was interested in a few years ago, but one where we have local asset managers who offered us a different perspective. Widespread media coverage of uprisings tied to the “Arab Spring” caused many global investors to flee. However, investors who had entered Egypt or the United Arab Emirates at that time would be feeling more fortunate today as those markets have since been some of the strongest performers.

The Case for Emerging Markets Today

We are often willing to go into places other investors don’t have the expertise to or aren’t willing to go, but that doesn’t mean we are looking to board a sinking ship. We do our due diligence first in terms of what companies we feel may be unloved or underappreciated today, perhaps for the wrong reasons. If we were to look at equity flows over the past two years, they’ve been positive for the United States and Europe but quite negative for emerging markets, an unloved area today. Investors have often pitted or compared emerging markets against developed markets, but I think that approach no longer makes sense. I think we have to look at the world in a different way. Emerging markets, in many cases, are looking more like developed markets; there is no real standard definition of what makes a market emerging. Some observers would argue that places like South Korea and Taiwan look more like developed than emerging markets in many respects, and just look at the dramatic growth we’ve seen in China over the past few decades. Back in the 1980s, many investors were of the mindset that the emerging markets weren’t significant, were too much trouble to visit, and too hard to understand. I think it’s a mistake to ignore emerging markets today as they account for more than a third of global GDP and a growing percentage of the world’s market capitalization. I would propose that emerging markets should be a key part of a globally diversified portfolio, and some investors may even put a foot into frontier markets given the potential opportunities. [perfect_quotes id=”4341″]

In our view, investors should look at the world as a whole and not separate emerging and developed markets into different buckets. And, we should not look only at where companies are domiciled, but also where the majority of their revenues come from. You can get exposure to emerging markets from companies domiciled there, but also global companies whose revenues come from emerging markets. Additionally, we would argue that smaller-cap stocks offer more direct exposure to local economies and a greater opportunity to add value.

Another way to look at emerging markets is to look at growth drivers. Are the countries or companies more driven by global growth, domestic growth, commodities, or some other factor?

In sum, it’s very hard to time the markets to consistently pick the winners. That’s why we recommend looking broadly, and looking beyond the mentality of “risk-on” and “risk-off” that we have generally seen in the wake of the 2008–2009 financial crisis. We would suggest more of a tilt rather than a full-blown move from one market or asset to another. While I certainly can’t claim to predict where all the markets may be headed tomorrow,  I believe the best way for investors to lose money is to switch from one market to another market too quickly, to ignore investments beyond one’s borders—and to always follow the crowd.

Stephen Dover’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

What Are the Risks?

All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments.

Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets.

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