Tulloch (pictured), who manages the First State Asia Pacific and First State Asia Pacific Leaders funds, and Asante, head of emerging market equities at the firm, say that they are increasingly looking to western companies with a strong emerging markets presence.In part this is due to the poor quality of the companies on the emerging market indices, but they say it is also being spurred by the rapid consolidation of developed and emerging market companies, which is making the traditional distinction of little use.
"The connection between developed market companies and emerging market companies is so great you cannot invest in isolation," Asante said. "The world has merged."
According to recent reports, First State is considering moving Asante’s First State Global Emerging Markets Leaders fund from its IMA Global Emerging Markets sector to the IMA Global sector.
The fund is the second-best performer in its current sector over 10 and five years, having returned 83.76 per cent over the latter period.
It is also the third best over three years, with returns of 42.51 per cent against the index’s 13.64 per cent, according to data from FE Analytics.
Performance of fund vs sector and benchmark over 3yrs
Source: FE Analytics
There were some suggestions that the move of the £4bn fund, which has five FE Crowns, was motivated by liquidity concerns, as the fund was getting too big.
However, Asante and Tulloch’s comments suggest that the motivation is down to what they see as the poor quality of companies in the emerging markets.
"Expanding your remit gives you better opportunities to make money, not by going down the quality spectrum but going more global," Asante said.
"Do not let the money-printers deceive you that it’s not difficult to make returns in the current market."
"The emerging markets index is full of companies that are on balance lower quality than the developed world indices, so they are the sort that will struggle."
"The emerging market indices are full of companies that will find it hard to adjust to a tough world."
The developed world indices have held up well against the emerging market indices over the past few years, as FE Trustnet has recently highlighted.
Over the past three years the average fund in the IMA Global sector has beaten the average emerging market fund, according to data from FE Analytics.
Performance of indices over 3yrs
Source: FE Analytics
Asante and Tulloch say this is likely to continue for the foreseeable future, as the environment of low interest rates, low growth and quantitative easing is set to remain.
"Three out of our four top contributors are global multinational companies, so some of these companies that have 50 per cent of revenues exposed to the emerging markets are becoming more popular and we are looking for more of those," Asante said.
Tulloch adds that the Chinese stock market has also underperformed the Asian and emerging market indices.
The managers explain that many of the companies on the emerging market indices are not set up to perform well in tough times.
This is a particular problem for firms that have a strong element of state ownership, such as those in China or commodity producers across the region.
In the case of commodities, it is hard for a state-owned company to respond to a fall in revenues if it has no pricing power, as the obvious solution – to reduce employment costs – is a political problem.
However, the chief issue for the managers is the poor quality of corporate governance, which is why they are very selective in the companies they hold in emerging markets themselves and increasingly prefer to get access through western companies or nations such as Hong Kong.
"[From an investor’s point of view] a 5 per cent growth rate in China with improving governance is better than 10 per cent with deteriorating governance," said Tulloch.
Tulloch’s £901m First State Asia Pacific fund has the best returns of any IMA Asia Pacific exc Japan fund over the past decade, at 454.81 per cent.
Both it and the £7.3bn First State Asia Pacific Leaders fund – which also has five FE Crowns – are in the top quartile over one, three and five years.
Performance of funds vs sector and benchmark over 3yrs
Source: FE Analytics
Tulloch says that investors should beware the calls to invest in China, as its stock market is particularly poor.
"Good-quality, privately owned companies in China are expensive, and there are not many of them, which explains why we don’t have that much directly in China," he said.
"When you see all these ads saying 'buy China', it means everybody is there and there are too many people so there is over-capacity."
"And corporate governance and other factors mean this economic growth wasn’t reflected in the markets."
The manager says that on valuation grounds – using both CAPE and price-to-book methods – China remains cheap historically, but the issue lies in finding companies with good enough governance, which tend to be much more expensive.
He gives Western Digital as an example of a US-listed company that carries out most of its production in Asia, making it a suitable holding for the Asian funds.
"It makes hard disks, which is a sunset industry but it is very consolidated and pretty well positioned overall," he said.
Both managers have seen companies in the consumer staples sector make them a lot of money in recent years, but they say that this part of the market is reaching a peak valuation, making it important to look for alternatives.
"Consumer staples are increasingly fully valued, in other words earnings can rise 10 per cent or less," Asante said.
"Other areas where they are not fully valued, banks for example, are more straightforward in emerging markets."
"You can find them trading on 1.5x valuation having seen them on 3x. There are lots of other sectors that are really not that popular."
The manager says he currently has 12.7 per cent of his Leaders fund in what he calls multi-nationals and is looking to expand that part of the portfolio to include more companies that sell into the emerging markets.
He says that one issue for emerging market investors has been the poor quality of the BRIC markets.
"The BRIC countries have performed poorly over the past few years, and we don’t think defining investment strategy on a country-basis is likely to be successful," he said.