Industry champions on the cheap: Emerging markets at the Morningstar Investment Conference

-- | 23/02/2022 Text size Decrease

Lewis Jackson: It's been a difficult year for emerging markets with China in particular down. Some say though that the selling is overdone. Investing greats like Ray Dalio still back the Chinese economy. I'm joined today by Dr. Joseph Lai of Ox Capital, an emerging markets specialist, to talk about emerging markets and how investors should approach them. Dr. Joseph, thank you for being here. Dr. Joseph Lai: Thanks for inviting me, Lewis. Jackson: Okay. Let's start with the overall case for emerging markets. For years, people have been told emerging markets grow 2, 3 times the developed world. That's going to translate into earnings and stock prices. But if we look at China and the U.S., Chinese GDP growth has been 2, 3 times the U.S. for the last decade and the share market has gone sideways or down. Why and why should anyone buy in emerging markets? Dr. Lai: Okay. That's a great question. So, I guess, the short answer is, I mean, at the moment it's a great time to have a look. It's always difficult to know when the bottom of the market is. But if we look at these markets, the valuation has come off a lot. You can buy a similar business in these emerging countries, be it China, be it Brazil, be it ASEAN countries, and literally, a fraction of the valuation is what you have to pay in the U.S. market. So, that's a great starting point. I've got a few theories as to why emerging countries have not done well despite this perpetual GDP growth even in the last 10 years. One is that last 10 years there's been a period of major adjustment for China, which is the engine for growth in the world and emerging countries. So, after the Global Financial Crisis, they actually created a lot of credit to build infrastructure like tunnels, railway, high-speed rail, bridges, whatever. So, as a result, it actually built up this huge – well, quite a big – I wouldn't say huge – quite a big debt load. And actually, it took the last 10 years to adjust, to actually work down the debt load, especially relative to their GDP. So, as you can appreciate, as the country delivers, it doesn't tend or reduce the debt load, it doesn't tend to help asset prices in these markets. And the second reason is just simply the starting valuation of China and emerging markets about 10 years ago, they were expensive. Remember, 20 years ago, people were amazed by this rise of the Chinese economy. There was a Chinese bubble 10 years ago. And so, the starting variation was high, and also, they actually spent the next 10 years after the GFC stimulus to clean up the balance sheet. So, the two combined meant that despite the growth in the underlying economy, the equity market has not been good. Jackson: Looking ahead though, I mean, you've talked about debt. I mean, debt is now the question for China. It's in the property sector, but more broadly, people are concerned about debt in state-owned enterprises. You spoke as if that deleveraging process was done. That doesn't seem to be the message coming out of China. What does that mean for GDP growth? And what does that mean for the shares? Dr. Lai: Yeah, the reality is this. I mean, if we look at the total amount of debt per GDP in China, it's actually very similar to that of Europe or to the U.S. The government is actually relatively unindebted and the households, so mortgages, are relatively unindebted. The thing that stuck out, as you said Lewis, was in these state companies. So, that's the corporate debt. Corporate debt to GDP is about 160% of GDP, which sticks out like a sore thumb. But the thing is, we're not too concerned about that because for two reasons. One is that a lot of these debts were used to build infrastructure, which will generate – which has generated economic benefits for the country – high-speed rail, link up the country. I mean, some might have – there may have been some malinvestment or capital misallocation. But as a whole, it's not a bad thing. The second thing is this – since a lot of these debts are linked to state companies, it is actually linked to the state. So, they're denominated in the local currencies. And the central bank, the People's Bank of China, can print money to actually bail out these companies, if needed. So far, they haven't really had to do a lot of it. So, we don't think it would lead to a big systematic problem. So, if we look at corporate debt or state government debt to GDP, it has not risen for five years now. So, that's been stabilized. And the total debt to GDP in China has not really gone up much, even during the pandemic, which has gone up in most other countries. Jackson: Okay. So, let's stay focused on China then. We've talked about the property sector, state-owned sector, infrastructure. Everyone is aware of the problems that have been gone in particular sectors – technology, Alibaba, Tencent. For someone who is looking now – they're looking at China and saying all the valuations are cheap, and we've got this economic growth story, but I'm worried about the Communist Party. Where and how does someone invest in China today? Dr. Lai: So, the main thing is this. I mean, I've got to say having invested in Asia, or emerging markets, or India, China for 18 years, crackdowns are not new. I mean, there's been crackdowns on number of hours kids can play video games, gambling elements on video games, game companies tend to sneak it in to make extra money and they cracked down on that, registration of real identity online for social networks like WeChat or whatever. There's been a lot of crackdowns on many different things, property sector, insurance. But the reality, I think, the way how I tend to think about that is these economies are growing fast. There's new industries getting born every day probably or every month. And this industry can go from 0 to 100 in two years. So, when that happens, the regulators can find themselves sort of behind the curve. And when they want to come – when the industry becomes a certain size and it's gotten to a certain size, the regulators tend to want to come in to weed out the dysfunctionalities in these industries. And so, when that happens, there's a lot of uncertainty because there's winners and there's losers out of these crackdowns. Jackson: On that question of the winners and losers and these sectors that can go from 0 to 100 in the Chinese case, but also more broadly across emerging markets, Latin America, India, what are some of these sectors that you're looking at now and you're thinking this has the potential to 10x or…? Dr. Lai: Yeah, sure. I mean it's just very interesting because we have scanned the environment in emerging markets, China included, Latin America, ASEAN. A few themes came to mind. One is actually the tightness of energy globally and the implication of that to developing countries. Because I mean years ago, if you go back 10, 15 years, what is emerging markets? Well, it's actually resources and energy. So, high energy prices will be favorable to some of these economies, which has not enjoyed that for many years. (Indiscernible) some of this economy has been in the low the last 5 or 10 years as China was deleveraging. With the squeeze on commodities – some commodities and also energy there were benefits. So, we have looked very closely in countries like Indonesia, which actually is a huge population, 200 million people. Some of these industry champions used to be able to buy them at probably 25 times earnings. Now, we're down to 10 times. One of the reasons why emerging countries, China included, that the market went down so much last year – and this market went down a lot last year – was that they actually tightened monetary policy way earlier than the U.S. So, China tightened monetary policy in second half 2020, the year when the pandemic started because they saw that they were controlling the pandemic and they go, all right, we need to wind down on the stimulus. And as that happened, the economy slowed. And then, a lot of other emerging countries actually started tightening the policy in 2021. In the case of a country like Brazil, the interest rate went from something like 2% a year ago to 10.5%, like in a year and they just raised rates 1.5% last night and they apparently are not going to raise that much now going forward. So, the stock market took a hit. But the beautiful thing in terms of the medium-term projection perspective is that a lot of these economies are going to be benefiting from the tight commodity market, tight energy market. The interest rate has gone up. The market has come down. And there's long secular trend stories, great quality companies trading on – I mean, it is a fraction of the valuation of what you can get in developed countries even after the NASDAQ fall. I mean, much cheaper than that even today. Jackson: Okay. Fantastic. Dr. Joseph, thank you for being here with us today. Dr. Lai: Thanks very much for your time. It's been fun.