The emerging markets sector was named as the most likely to outperform across a number of asset allocation surveys at the start of the year. Analysts noted that despite improving fundamentals and strong gains in 2016 and 2017, emerging market equities continued to trade at a discount to their developed counterparts, while also offering comparable or better returns on equity and dividend yields.
However, Roddy Snell, manager of the Baillie Gifford Pacific fund, has warned investors not to get too carried away with their optimism towards the sector, pointing out it harbours a “dirty little secret” – which is that many emerging markets never truly emerge at all.
“The only former emerging markets that have ever truly emerged, such as Korea, Taiwan, Hong Kong, Singapore and China, have had a strong export and manufacturing sector, which is really what you need to fund a domestic growth story,” he said.
While Baillie Gifford Pacific invests exclusively in emerging markets, it does so only in Asia, which Snell said contains without doubt what will be the fastest growing developing economies over the next 10 to 15 years.
“Outside of the Asian emerging economies, the main emerging markets such as Russia, Turkey, South Africa and Brazil are all reliant on either commodities or foreign financing,” he added.
“And these have never put the reforms in to properly emerge, so they are never going to be great long-term structural growth stories. They are going to be cyclical in nature.
“By investing in Asia ex Japan, you get the best of emerging markets and you are truly investing for growth.”
To prove his point, Snell highlighted a graph showing that of all the “global winners” – meaning those companies that have delivered a 20 per cent return per annum in US dollar terms over the past 20 years – half are found in Asia ex Japan.
The manager also pointed out that since 1999, net profits of listed Asian companies have grown by 33-fold, compared with three-fold from the global average.
“And if we assume that over the long term share prices follow fundamentals – earnings growth and sales growth – then Asia is by far the best region for that. That’s why you get these high concentrations of returns,” he continued.
Snell said one example of an Asian country with the potential to “truly emerge” is Vietnam, which he described as possessing the best structural growth story of any emerging market. Returning to his point about the importance of exports, the manager noted that there has been a recession in this measure across emerging markets over the past 10 years. The only country bucking this trend and building a successful manufacturing base is Vietnam, which he said is “absolutely surging”.
So confident is Snell about its prospects, in fact, that he has put a quarter of his pension into Vietnamese companies.
“It’s got great demographics – a third of the population is under the age of 35 – it is in the right location and crucially its government can get things done and that is a fantastic foundation for a strong domestic economy,” the manager continued.
“But the big story is that as China moves up the manufacturing value chain, there is a potential market worth $2trn to go for and Vietnam is in pole position to grab this.
“It’s also got great businesses that are growing at about 20 per cent per annum and trading on 15 or 16 times P/E multiples. So they are about half the value of similar businesses in Asia.”
Snell admitted the reasons for these lower valuations is that liquidity is low and it is difficult for foreigners to buy certain stocks. However, he said that this is all changing as the government opens up its equity markets.
“So you’ve got a great structural growth story, great businesses at cheap valuations in a market that is opening up. That’s why Vietnam makes up 13 to 14 per cent of the portfolio.”
Baillie Gifford Pacific’s largest Vietnamese holding at 2.9 per cent of assets is a trust, Dragon Capital Vietnam Enterprise Investments, although it also has a number of individual holdings in companies ranging from property, steel and banks.
Snell said the long-term fundamentals for the Asian region as a whole continue to look strong. For him, the “big picture” story is the rise of the middle class which is expected to go from 600 million people today to between 2.5 and 3 billion in the next 20 years. This is a process that is being accelerated by technology and Snell is hoping to capture this growth through top holdings including Tencent, Alibaba and Samsung Electronics.
However, he said “the stars have also aligned” in the shorter term as well: “Asia has had some pretty significant headwinds, with a strong dollar, weak global growth and a weakish China as the country has rebalanced.
“But those headwinds have all started to reverse. Most promisingly, global growth has picked up and that massively benefits Asia disproportionately. The Chinese economy has proved to be far more resilient than people had feared and we have a weak dollar which improves liquidity to the region.”
He finished by pointing out that despite these improving fundamentals and earnings growth of 100 per cent since 2007, the Asian market has only just passed its 2007 peak in dollar terms – suggesting it still contains plenty of value.
Price and total return of index in US dollars since pre-financial crisis peak
Source: FE Analytics
Data from FE Analytics shows Baillie Gifford Pacific has made 158.37 per cent since Snell joined in June 2010, compared with 104.67 per cent from its MSCI Asia ex Japan index benchmark and 94.88 per cent from its IA Asia Pacific ex Japan sector.
Performance of fund vs sector and index over manager tenure
Source: FE Analytics
It is £377.3m in size and has ongoing charges of 0.74 per cent.