The search for alpha in a low-growth world

Neal Smith, Portfolio Manager for SIM Global Emerging Markets Fund.

In current challenging markets, institutional investors have never been under greater pressure to look for alternative sources of returns to optimise their members’ retirement capital. Sluggish global growth, volatile markets, increased regulation and growing complexity mean making smarter asset calls is tougher than ever.

What should institutional investors do in this environment of lower growth and lowered return expectations? We believe the key is to focus on alternative investment strategies with strategic advantages … those that can thrive even in a low-growth world.

Where do the opportunities lie?

Emerging markets

Investors who jumped into emerging markets after 2008 experienced a bumpy ride with emerging markets significantly underperforming their developed market counterparts. We are now five years into an emerging market bear market and it would be fair to say that emerging markets are very much out of favour. Having said that, we believe that emerging markets are now significantly undervalued and are set to pick up their long-term trend of outperformance, says Neal Smith of renamed Denker Capital, a division of Sanlam Investment management. For institutional investors, now may be an opportune time to start allocating capital selectively.

Here’s why.

Emerging markets outperform developed markets over time

Sources: Bloomberg, Goldman Sachs Global Investment Research via Denker Capital 2015. All figures are daily USD total returns since 1970.

EMs have outperformed consistently since 1970 – but, returns don’t come in a straight line and carry volatility in the short term. It is significant that we are now 5 years into an EM bear market, and EM returns and currencies have done particularly poorly in this time. However we believe that the markets look ahead, and these severe moves have already priced in a significant amount of bad news.

Valuations are currently looking very favourable and there may be select opportunities for the clever bottom-up active manager.

Attractive historical annualised returns

While the MSCI EM index shows an absolute return of 11.3% per annum, the MSCI World index was almost half, at 6.6%. Compared to developed markets, EMs enjoyed a relative outperformance of 4.7%.

Had you invested $1 million into your investment fund back in 1970 in EMs, the value of that portfolio would now be $133 million; the same amount invested in developed markets would only be worth $16 million. That’s a whopping difference of $117 million.

Why we like emerging markets:

Powerful long-term growth drivers

? Emerging markets are attractively valued since they have de-rated considerably relative to developed markets, getting close to trough levels
? Emerging markets now have the dominant share of global GDP, according to the IMF, and have overtaken developed economies. It is interesting that the IMF expects emerging markets’ share of global GDP to increase at an ever faster pace going forward, with leading emerging nations such as China, India and Mexico looking set to contribute more, following structural changes and recent reforms.

Emerging markets account for the majority of global GDP

Source: IMF World Economic Outlook, April 2015

? As countries move up the development curve, we expect their stock markets typically to grow, to better reflect the importance of their economies. This results in a rising ratio of market capitalization to GDP. In other words, we expect emerging market stocks to continue their trend of outperformance going forward (Denker Capital, a division of Sanlam Investment Management, November 2015).

Amidst all the doom and gloom over the state of emerging market economies, could the worst now be behind us?

Positive demographics

Unlike their developed market counterparts where populations are ageing, emerging market economies are expected to have greater future growth prospects, as populations are typically much younger and faster growing.

The challenges associated with ageing populations relate not only to the number of older people, but also the proportion of older to younger people. Ageing populations pose strong headwinds to economic growth; they place a heavy toll on healthcare systems; economic growth begins a steady downward decline due to an older and shrinking workforce; heavy demands are placed on the public pension system along with increased social responsibility, medical costs and increased taxes. Ultimately this negatively impacts the workforce, results in skills shortages, and constrains overall economic growth.

If emerging markets can support their demographic advantage with good economic policies, access to education and healthcare, they can unlock what is popularly known as their “demographic dividend”, which would be a very powerful driver of future growth.

Rapid urbanisation

Established cities tend to dominate global economic activity, more so than their populations would suggest. Large cities are home to 38% of the world’s population but generate as much as 72% of global GDP. This means that disposable incomes and wealth is significantly higher in cities; for example average urban incomes are roughly 3 times those of their rural counterparts in China and India.

It all boils down to economies of scale, says Smith of SIM Global’s renamed Denker Capital. For example, it is considerably cheaper to deliver electricity and basic municipal services to densely populated cities rather than sparsely populated rural areas, leading to greater cost savings. The same holds true for businesses, such as retailers operating in big cities. Here they enjoy the considerable advantage of greater foot traffic, leading to much higher sales and profit levels.

These income and cost advantages allow cities to attract more skilled workers and productive businesses, which in turn supports strong economic growth.

Emerging markets also have an abundance of natural resources and boast the vast majority of the world’s population. This, combined with positive demographics and rapid urbanisation, should support strong growth in emerging markets going forward.

Optimal diversification benefits

Historically, emerging markets have been excellent diversifiers. Although emerging markets generally remain somewhat more volatile than developed stock markets, institutional investors should be able to achieve greater diversification benefits and improved risk return profiles by adding emerging markets to their portfolios (up to around 50% for optimal diversification benefits).

Adding up to 50% of EMs to a retirement portfolio can yield optimal diversification benefits

Sources: Bloomberg, Goldman Sachs Global Investment Research via Denker Capital 2015. All figures are daily USD total returns since 1970.

What about South Africa?

Many institutional investors believe that they already have exposure to emerging markets through their South African investments. However, in the available universe of emerging market options, South Africa represents a mere 0.9% of global GDP and 1% of global market cap, making it a relatively small investment destination. Moreover, South Africa is considered expensive compared to both emerging and developed markets. In spite of this, up until very recently, investors in the SA stock market have enjoyed strong relative returns due to a significant rerating. However, it is questionable how sustainable this is going forward. With a weak domestic growth outlook, expensive valuations and the rand not oversold relative to other emerging market currencies, this all implies that there is greater value to be unlocked offshore. Investing in South Africa alone restricts investors’ access to a multitude of opportunities that exist offshore (countries, industries, companies) that cannot be accessed locally.

Concluding thoughts

We believe that the tide has turned for emerging markets, valuations are attractive, and now is the time for retirement funds to start re-looking their asset allocation decisions. Globally, institutional investors are moving back into undervalued sectors as they seek out cheap valuations and alternative sources of alpha. Thanks to the long-term investment horizons of many retirement fund members, retirement funds can stomach the short-term volatility and reap the considerable long-term benefits of investing in emerging markets.

We believe the risks are arguably lower than many perceive them to be, current valuations represent extremely good value, and returns from emerging markets will outpace those of developed markets over time.

The opportunity for those institutional investors with an active management value bias, looking for higher returns, seems better than ever. The positive momentum of emerging markets, coupled with attractive valuations and fundamentals, gives long-term investors the opportunity to earn attractive risk-adjusted returns, while diversifying portfolios.

The focus should be on selective stocks that are undervalued and best positioned to benefit from the structural growth drivers that have long made emerging markets a compelling investment destination.