Special Report -- Global Investing
When investing in developing economies, it pays to do your homework. Just ask Josephine Jimenez.
Jimenez, co-manager of the $1.1 billion Montgomery Emerging Markets Fund, jetted to Chiapas after Indian peasants launched an uprising in the southern Mexican state early last year. Worried that the rebellion could signify deep problems for the economy, Jimenez spent several days poking around dusty public libraries and talking to local residents. But it was the impassioned sermons delivered by local parish priests that convinced the Philippines-born Jimenez that big troubles were brewing in a presidential election year. "I could identify the emotional chords they were playing," she says. So as soon as Jimenez returned to her San Francisco office, "I said, `Let's pack our bags now."' In one swoop, she dumped nearly all the fund's Mexican holdings and moved the proceeds to Asia.
Jimenez' shift was remarkably prescient. By yearend, the pressures of U.S. interest-rate hikes and the Mexican economic and political problems that surfaced first in Chiapas had come to a head. Unable to finance his country's imports with foreign cash any longer, newly elected President Ernesto Zedillo abruptly devalued the peso, sending Mexican stocks, bonds, and emerging markets around the world into a panic. Now, more than a year after her big move, Jimenez emphasizes the critical factor in her investment strategy for emerging markets. "It's important to follow the political situation as well as companies," says Jimenez, whose fund took a hit even with her Mexico exit. "You have to pay very close attention to political risk."
In this year of the Mexican meltdown, that's advice worth heeding. Politics were largely ignored in 1993 and much of 1994, when investors seeking an alternative to rock-bottom U.S. interest rates threw cash at emerging markets with abandon and assumed that rapid economic growth would continue for years. But now that sanity has returned, the interplay between politics and economics has once again become the factor to reckon with. "We have to be more focused on stresses and strains," says Mark Breedon, manager of the New York Stock Exchange-listed Global Privatization Fund. Indeed, Paul Durham, vice-president of Bankers Trust Co.'s Sydney (Australia)-based BT Funds Management unit, notes that "one of the lessons people learned in the past 12 months is that all emerging markets are not equal."
That maxim certainly holds true today. From Taipei to Moscow to Bogot, there is no shortage of political jitters roiling markets. To help decide which markets to favor, BT--like many of its rivals--has developed mathematical models that attempt to quantify the risks of investing in emerging markets. In this report, BUSINESS WEEK presents several of BT's key conclusions. Weighing the likelihood of political instability against such factors as liquidity, valuations, and expected earnings growth, Durham rates the Philippines, Indonesia, South Korea, and Israel among the top markets in the world.
In such top-rated markets, he believes, investors could reap total annual returns of 20% to 30%--much higher than they might expect in the U.S. Many of these markets have been rallying smartly in recent months (charts) as investors look to the developing world for a long-term payoff. Jimenez' fund alone has garnered some $2 million in new cash per day this year.
Why? At a time when the U.S. stock market is near a historic high, there is still plenty of action overseas. While it's way below its record highs, Shanghai's B-share market--the one open to foreigners--has moved up 26% since May amid signs that authorities soon may loosen their anti-inflation credit squeeze. The Philippines is winning adherents for its economic about-face. The Middle East is drawing plenty of interest, too: Israel's stock market, buoyed by a takeoff in high-tech issues, is soaring. Jordan is planning privatizations and new investment and tax laws to shock the Amman Financial Market out of its torpor. And Lebanon is preparing to reopen Beirut's bourse for the first time since civil war closed its doors in 1983.
Things also seem more secure for Latin America. The Mexico City market has rebounded 51% (in dollar terms) over the past six months. Chile, whose massive domestic savings pool helped protect the Santiago market from the past months' storms, is humming along nicely. Peru is in high gear as President Alberto Fujimori presses reforms. The Buenos Aires Stock Market has soared 70% since March as more than $4 billion in deposits have returned to local banks after President Carlos Menem's pledge to keep the Argentine peso firmly pegged to the dollar. "The tequila effect is gone from Argentina," Menem tells BUSINESS WEEK. "We have gotten over the main part of the Mexican crisis."
HUGE CASH FLOWS. All of this is music to the ears of many pros who have never gotten off the emerging-market bandwagon. Baring Securities International Ltd. strategist Michael J. Howell figures that investors will move some $25 billion into developing countries' bourses in 1995, the third-largest inflow on record. Already, the International Monetary Fund estimates, 16 cents of every dollar flowing into major Western mutual, pension, and hedge funds is going to emerging markets. In 1987, two years before the Berlin Wall fell and the number of investment opportunities exploded, emerging markets garnered barely a half-cent of every dollar fund managers raised.
But 3 billion potential new consumers are now striving to enter the global economy. That's opening up investment in such critical industries as telecommunications, banking, construction, and consumer goods, where demand has been repressed for decades. "The bottom line is that emerging-market economic development is happening on a titanic scale," says Arnab Banerji, chief investment officer for London's Foreign & Colonial Emerging Markets Ltd. "Mexico was just a hiccup. If you're really taking a five-year view, nothing has changed."
Since many markets and mutual funds have yet to fully recover their losses, that may be overstating things. And the "hiccup" was in fact an important warning to investors and government officials that they will have to factor into their calculations a powerful new force in global investing: so-called hot money--huge pools of institutional capital that can be moved in and out of economies with lightning speed.
To be sure, as the IMF recently concluded, Mexico's financial crisis was sparked as much by disillusioned domestic investors as by offshore money managers leaving town. Nevertheless, once the big-bucks foreigners joined the locals' stampede, there was little to stop the run on the markets. "The rules of the game have really changed," says Jorge Surez-Velez, managing director of Mexico's Afin Securities. When hot money flees, even a country such as Mexico, with a North American trade deal, a tight national budget, and single-digit inflation "can still get into trouble with the foreign funds."
That realization is having a potent disciplinary effect across the developing world. In country after country, government officials and central bankers are scrambling to find ways to boost savings, promote direct foreign investment, and stabilize their currencies as ways of easing dependence on volatile portfolio flows. They're also improving government and corporate disclosure to make investors feel more at home. As part of the price of its $50 billion bailout by the U.S. and other industrial nations, Mexico is now making weekly announcements about the level of its hard-currency reserves. Notes Buenos Aires Stock Exchange President Julio A. Macchi: "The way to cushion the effect of outside forces is to have as much information as possible about macroeconomic policy and companies."
PEACE TALKS. This change in attitudes will go a long way toward validating the fundamental case for investing in emerging markets. Simply put, for all their fits and starts, emerging markets still hold some of the world's best prospects for robust economic growth and healthy earnings. In a year when the gross domestic product of the U.S. and Western Europe may expand by little more than 2% and Japan is battling recession, Asian dutput, for instance, is expected to grow by a solid 7.6% in 1995, according to Union Bank of Switzerland. The Middle East, benefiting from Arab-Israeli peace, could grow by more than 4%. Even Mexico, which is likely to see its economy shrink a staggering 5% this year, is widely expected to be moving forward by 1996 or '97. All told, the IMF believes developing countries will grow twice as rapidly as the industrial world for the remainder of the decade.
Despite the growth story, stocks in many emerging markets still can be cheap. Take Telefonos de Mexico, the phone utility that many view as a bellwether for emerging-market stocks worldwide. Qith its American depositary receipts (ADRs) trading around $32, Telmex is now 56% off its record high of 1994 and is trading near where it was when the privatized company was floated on the NYSE in 1991. But since then, Telmex has poured nearly $10 billion into everything from rural phones to digital networks of fiber-optic cables. At today's stock price, you get all that investment for free.
The value gap is also apparent in the former communist bloc. Chinoin, a Hungarian pharmaceutical maker partly owned by French drug manufacturer Sanofi, has won plaudits for its strong research and development efforts and its 20% return on equity for the past three years. Yet its stock fetches a price-earnings ratio of less than 4. Surprisingly enough, however, it's Russia that is making some brave value investors take notice. Tumultuous politics, tottering banks, stumbling economy, and questionable corporate reporting faze all but the most intrepid investors. But Moscow's stock market is sending out deeper and deeper roots. A few privatized corporations even are working on issuing ADRs.
Many fund managers are high on Lukoil, the Russian energy giant whose shares trade in Moscow. Although it's one of the world's largest petroleum producers, controlling 15% of Russia's oil output, investors value Lukoil's reserves at a tenth of what they're willing to pay for those of Exxon Corp. But will such a gaping disparity persist? Atlantic Richfield Co., betting it won't, is spending $250 million on bonds convertible into Lukoil stock. Says Franklin Templeton emerging-market guru Mark Mobius, who recently launched a $70 million Russian closed-end fund in the U.S.: "Change is embedded in the psychology of the people."
WILD TIMES. While country funds such as Mobius' Russian vehicle appeal to many investors who want to take a direct stake in a single economy or company, many market pros suggest that a much safer approach is via emerging-market mutual funds that invest their assets around the world (table). That's because individual markets can be frighteningly illiquid and, as a result, often gyrate wildly. "I wouldn't want to concentrate on any one country or region," says Alliance Capital Management global analyst Robert G. Heisterberg, who helps manage some $2 billion in emerging-market assets spread among two dozen countries. "In a lot of markets, it's feast or really get hurt."
Choosing cheap investments, either funds or individual securities, won't necessarily insulate investors if politics go awry. Mexican President Zedillo is facing a 10.5% drop in GDP during the second quarter and a painful credit squeeze on the country's middle class. To defuse a political challenge from a restive debtors' movement, he is channeling more than $1 billion into a plan to slash interest rates for consumers and business. Investors fear that if he spends too freely, the peso will weaken again, erasing gains from the recent rally in stocks.
Politics are even dicier in Colombia. Bogot's stock market has fallen more than 10% over the past month as President
Ernesto Samper declared a state of emergency amid allegations that his election campaign received up to $6 million from the Cali drug cartel last year. But Baring Securities' Bogot research chief, Guillermo Serrano, thinks Colombia's democracy and markets are durable enough to weather the crisis without too much more damage if Samper should resign.
Some analysts are more concerned about the likelihood of political strife in Asia, up to now an oasis of comparative calm and torrid growth. Just last year, analysts and funds were promoting India as the new gold mine for investors. More recently, they were boosting Taiwan, saying that earnings were soaring and the market looked sure to climb. But Taiwan's stock market has plummeted nearly 40% this summer as China has stepped up pressure on President Lee Teng-hui by testing ballistic missiles scarcely 100 miles offshore and talking openly of an invasion. India, too, has become a question mark. A religious party coalition in the key state of Maharashtra is frightening away foreigners by canceling a $2.8 billion power-plant deal with Enron Corp. Developments such as these prompt analyst Alan Stoga of the consulting firm of Kissinger Associates Inc. to conclude that the potential for further instability looms over the entire region.
With the cold war over, China, Japan, India, Indonesia, and possibly Russia will be competing for influence in the Pacific. Moreover, most of the region's major countries face leadership changes in the next five years. That's certainly a point to consider in China, where the question of who will run the country after the death of the ailing Deng Xiaoping is a major concern. As a result, Stoga advises investors to look for "much higher returns than they seem willing to accept in Asia. The risk in the region is going to be higher, not lower."
ACHING HEADS. Others counter that they are factoring in the risks. The trick, they say, is to insist on high enough potential profits to compensate for the possibility that your holdings will be wiped out. "To invest in an emerging economy and have all the headaches that go with it, I should see substantial capital gain potential," says independent money manager Marc Faber. "Otherwise, it's hardly worth it."
To Faber, that means taking a flyer on oil and gas stocks in Russia. "If Russia can move successfully to be a Western capitalist society," he predicts, "its shares could be mind-boggling." But other Asian pros prefer sticking closer to home. Hong Kong-based analyst Alan Butler-Henderson of Baring Securities recommends moving into the British colony despite its imminent takeover by Beijing in 1997. He argues that Hong Iong's trade balance is improving as the economy slows. That will boost market liquidity, attract foreign investors, and push the Hang Seng Index, already up 12% this year, past the record high of 12,157 it set in 1994. Fund manager Mobius is so convinced that the colony will remain the gateway to the mainland's economy that he has plunged most of a $4 billion wager on China into companies based in Hong Kong. Says Mobius: "We're betting life will go on."
Other Asia hands are looking to South Korea, where declining interest rates, cooling inflation, and rapid earnings growth are giving equities a lift. Schroder Capital Management International Inc. Director Laura E. Luckyn-Malone is putting her faith in Samsung Group. Its semiconductor sales are surging, yet it trades at a modest price-earnings ratio of 8. "Samsung is really giving the Japanese a run for their money," she says. "They're going from strength to strength."
While Asia remains the world's growth machine, some pros believe South Africa has equal potential. Emerging from years of apartheid and worldwide opprobrium, heavily industrialized South Africa is vying to become the commercial hub of the vast area south of the Sahara. There are drawbacks: soaring crime and the nation's future after President Nelson Mandela, who at 77, has taken on legendary proportions. But that doesn't stop Carmen Maynard, director of fund management at Johannesburg's Martin & Co., from recommending such mainstays as Pepkor, a low-price retail chain, or South African Breweries Ltd., which provides 90% of the country's beer and is moving quickly into Zambia, Tanzania, Mozambique, and even China.
Still, for many investors, the region that's synonymous with emerging markets is Latin America, where once debt-ridden countries have taken huge strides toward restructuring their economies. In Mexico, the Zedillo government has struggled to set things right since the crash. Although the cost has been high, Mexico's trade balance is in the black, the peso appears stable, and the solvency crisis that triggered the meltdown has evaporated in the face of U.S. aid. Most of the government's tesobonos--dollar-linked debt that came back to haunt Mexican and foreign investors alike--have been paid off. And the government has returned to international capital markets, selling $2.1 billion in debt this summer.
Amid the rebuilding effort, analysts are starting to find value in Mexican stocks again. Many like Penoles, a big silver-mining group that has benefited from rising bullion prices and an export boom. Recently, analysts have added Desc, a conglomerate with holdings in petrochemicals and auto parts, as well as Empresas La Moderna, a cigarette producer that has moved into fresh vegetable exports and acquired Asgrow Seed Co. Grupo Carso, the big holding company that owns a chunk of Telmex, also remains popular for its hard-nosed skill at handling its finances.
Brazil and Argentina offer similar values. Malcolm Gibson, an analyst at Roberts Capital Markets in Buenos Aires, thinks Argentine steelmaker Siderca offers "tremendous cash flow," rising exports, and annual earnings growth of 35%. And Perez Companc, the big energy group, is expanding across the border. Its recent purchase of the Brazilian electric company Escelsa could bring "massive productivity gains."
Some Brazilian investors are taking heart from President Fernando Henrique Cardoso's efforts to turn the economy away from consumption and toward privatizations and investment-led growth. Ulysses Vasconcellos Diniz, director of global sales and distribution at So Paulo's Unibanco, thinks telecommunications will benefit most from this switch. With a Baby Bell-style industry restructuring likely, he is betting on Telebrs, the AT&T of Brazil, and Telesp, the So Paulo local phone provider, as big winners. Others are focusing on state-controlled Companhia Vale do Rio Doce, the world's biggest iron ore producer, which Cardoso wants to sell off for $9 billion next year. Raves Alliance Capital's Heisterberg: "The Brazilians have survived inflation of 5,000%. The quality of their business management is outstanding. Incredible levels of profitability are possible."
Although such euphoric forecasts have become increasingly common, no one will fault you if you gaze upon them with a gimlet eye. What the past few years have taught many investors is that in emerging markets, hot money can cover a multitude of shortcomings. As emerging markets come out from under the shadow of Mexico, it would be wise to consider a few key points before you take the leap. How stable are politics in the country and the region? How well are policymakers managing currencies and economies? Despite the markets' setbacks, maintains fund manager Breedon, "over time, you'll get better returns in the emerging markets." The question, as always, is whether you're willing to take on the risk.
How They Rate
Bankers Trust Co. fund managers have ranked leading emerging markets in terms of growth, politics, liquidity, and other factors. They view the U.S. as getting pricey. Other markets earn higher scores.
U.S. Rating: 100
Devaluation and the market crash are pummeling the economy. But exporters are thriving.
The economy is slowing, but so is inflation, and exports remain strong. Big privatizations loom.
Politics are scary. But the ruble has stabilized, and natural-resource stocks are cheap.
Booming high-tech stocks are enlivening the market. So are falling rates and cooling tensions.
Local companies are quickly expanding across Africa. But stocks are no longer
Growth should revive in 1996. But money is tight. And beware of rising tensions with Taiwan.
Stable politics, lower
interest rates, and economic reforms are boosting the market.
Stocks are bouncing back as interest rates ease. And electronics exporters' profits are surging.
DATA: BT FUNDS MANAGEMENT LTD., BUSINESS WEEKBy William Glasgall in New York, with Dave Lindorff in Hong Kong, Drusilla Menaker in Johannesburg, Ian Katz in So Paulo, Elisabeth Malkin in Mexico City, and Bill Javetski in Paris