Emerging markets to bounce back

Ray Prasad is a Boston-based senior global emerging markets portfolio manager at Batterymarch Financial Management. He joined Batterymarch in 1997 to perform emerging markets research and was promoted to portfolio manager in 2000. In 2005, he was named senior portfolio manager, with primary responsibility for Asian markets.

Prasad focuses primarily on the Asian markets within Batterymarch's emerging markets team, which manages around $3 billion in emerging Asian equities in both dedicated portfolios and broader mandates. Batterymarch, which has a quantitative and fundamental approach to investing, manages more than $23 billion in equity assets worldwide. He shares with AsianInvestor his views about emerging markets.

What is your weighting for emerging market equities within a global equities portfolio?

Depending on the specific investment mandate, the emerging markets exposure in our global equity portfolios is typically at benchmark weight or slightly above. We maintain exposure to emerging markets both for the return potential relative to developed markets and for the purpose of risk control.

How has your weighting for emerging market equities changed compared to one year ago?

Our weighting in emerging markets is smaller than it was a year ago. Emerging markets were outperforming developed markets and we took profits after 2007, thereby reducing the weight in the portfolio. We're currently maintaining a neutral to slightly overweight position against the benchmark, and we expect to stay at current levels unless emerging markets fundamentals deteriorate relative to those in developed markets.

Have you made any significant changes to your asset allocation in terms of markets or sectors in the past few months?

At Batterymarch, changes in our portfolios are incremental, taking into account shifts in the market environment. In the last six or seven months, we have reduced our cyclical and commodity exposures while increasing those related to domestic consumption and infrastructure build-out in the emerging economies. This means fewer materials stocks and more telecommunications and consumer-related names. At the country level, we have been adding to our position in China while decreasing our weight in commodity-related economies such as Russia and the Middle East.

How will flight to safety continue to affect emerging market equities?

Risk-averse investors often develop a get-me-out-of-here mentality at just the wrong time, and we have seen some of this in emerging markets. This presents a rare opportunity for the savvy investor to scoop up stocks at bargain-basement prices. For intermediate- to longer-term investors, buying emerging markets stocks during such periods has generally been a profitable venture.

What is your outlook for emerging market equities in the coming 12 months?

Emerging markets have historically bounced back from major downturns within a year of hitting bottom. While calling the trough can be difficult, this underlines the importance of being in these markets when they begin to turn back up. Looking ahead, the backdrop of attractively valued currencies, strong foreign reserve positions and policy initiatives, coupled with newly compelling valuations, superior growth prospects and solid balance sheets, both at the sovereign and the company level, lead us to remain confident in the capacity of emerging markets to outperform over the long run. In the short term, we need to be mindful of risk and volatility as the market digests the full extent of the slowdown.

Do you expect emerging market equities to outperform or underperform other markets in 2009?

Market predictions are always a challenge, never more so than in these unprecedented times. During periods like this, sticking to one's investment discipline and process goes a long way in delivering consistent returns over the longer run. Batterymarch's models remain cautious about the markets in general and at this juncture do not favor any particular equity asset class over another.

What are the opportunities available in emerging market equities at the moment?

Companies related to domestic consumption and infrastructure build-out are attractive in our model. Many of them have sold off dramatically despite good fundamentals and strong earnings on the back of rising domestic incomes. Infrastructure build-out in emerging markets might even accelerate to counteract the global crisis. We are also finding opportunities among very high-quality companies with strong market positions and very cheap valuations, namely banks and some of the technology names.

Which particular emerging markets do you favour?

We favor China, Brazil and Turkey as we are able to find attractive names in these markets. China has financial strength and flexibility in its policies on both the fiscal and monetary sides. This should help its economy stand up to the global slowdown. Over the years, Turkey's economy has become more resilient to global shocks through positive steps by its central bank to curb inflation. Furthermore, as a net commodity importer, Turkey's balance-of-payments position has been improving. The market has not yet given due credit to these changes. Turkey is one of the cheapest markets, trading at a 12-month forward price-to-earnings ratio of less than 5 times, with a dividend yield of around 6%. Brazil is also very attractive as it has been sold off due to perceived commodity-related exposures. 

Which emerging markets will you be avoiding in the coming months?

We are not avoiding any particular emerging market. At Batterymarch, our objective is to stay away from stocks that might be poorly positioned to weather this crisis. These are typically firms that indulged in too much capital expenditure at the top of the cycle and are now facing a sudden decline in demand. They may also be leveraged and could see funding constraints going forward.

Within emerging markets, which sectors are you bullish over?

Sectors with companies that seem to be well positioned in the current environment are in the telecom and consumer-related spaces. We are also finding selected stocks involved in building the transportation infrastructure across Asia. Finally, some of the bank names have very attractive valuations, having come down in sympathy with developed market banks.

Within emerging markets, which sectors are you bearish about?

We are underweight in sectors related primarily to commodities and real estate. Demand seems to have evaporated in these segments. Furthermore, in the last couple of years, substantial capital was spent to create capacity as everyone bought into the idea of unending demand from China and India. Companies in the real estate sector have also taken on substantial debt in order to win the growth competition, and this has now come back to bite them in a deleveraging world. Today cash is king and assets are plentiful -a turnaround from a few years ago when cash was worthless and assets could command any price.

What are the biggest challenges in finding suitable investments in emerging market equities under the current market conditions?

Our models focus on the fundamental value of a company and look for apparent mispricing relative to these fundamentals. Over the intermediate to longer term, our investment discipline and process have stood the test of time. The biggest challenge for us in the short term has been one of rationality. Correlations have converged for all names - until last year, if you overlaid a chart of a Brazilian bank stock with that of a Russian wireless stock, they would have looked the same. There was no differentiation by investors. Lately we have seen some semblance of rationality, and companies with better fundamentals are being rewarded.