Mark Mobius: Making the case for emerging markets

There are few names as closely linked to
emerging markets investing as Mark Mobius. A pioneer in emerging markets since 1987, the executive chairman of Franklin Templeton made some time in his busy schedule to speak to the Cayman Financial Review about investment opportunities and the state of emerging markets as well as potential threats to their growth.

The world has changed dramatically since
Templeton started its first emerging markets fund in 1987 with $100 million. At
the time there were only six emerging countries in which the fund could invest. 

“If you remember the Andean Pact in
Latin America was designed to keep investment out, not bring investment in.
Then all these other countries had exchange controls, no developed stock market
etc,” says Mobius. “So we had to start going from country to country, building
up relationships, establishing custodial systems and so forth.”

Early on there were also no brokers and
analysts who covered emerging markets. Only when emerging markets began to show
significant growth, the brokerage community became more interested and started
to attract other fund managers. 

For much of the past 20 years emerging
markets have outperformed the developed markets of the US, Western Europe and
Japan, a fact that attracted significant funds into these markets. 

Templeton and, after the acquisition by
Franklin in 1993, Franklin Templeton never relied on broker research and had to
add researchers to the firm all over the world and now maintains 17 offices
globally with 82 professionals and 48 portfolio managers.

The economic success story of emerging
markets is also reflected in the $54 billion size of Franklin Templeton’s
emerging markets funds today.

But today the firm is no longer the only
game in town, says Mobius. “When we started it was just us, and International
Capital who had emerging market funds. Now there are hundreds and even hedge
funds are getting involved in emerging markets.”

However, the real revolution during the
past three decades, he adds, has taken place in communications.  

“I remember when I had my own business
in Hong Kong 35 years ago we were using the telex, there were no faxes and to
make a telephone call was damn expensive,” he reminisces with a laugh. 

“So we had to use call back systems,
then there was the telex, then you had PCs and email. This is all in less than
a lifetime.

“These days there are more people with
cell phones than people with bank accounts. This is an amazing development. So
you go to a place like Kenya and they are transferring money over the cell
phone.”

This is just the beginning, he notes,
and will lead to a lot of interesting, accelerated developments in these
countries as a result of the communication revolution.

Supply and demand

For investors in emerging market stocks,
the supply of IPOs and secondary offerings over the past 10 years has been an
important factor. The share of emerging markets in new issues worldwide climbed
from 10 per cent in 2001 to 50 per cent today.

2010 was in fact a record year with $450
billion raised in emerging markets and new funds raised in Chinese stocks
surpassing the US for the first time. For an emerging market investor this
development means more choice, says Mobius, but it follows also that more of an
investor’s portfolio should be invested in emerging markets. 

The market capitalisation of emerging
markets stocks represented about 8 per cent of the world in 1998 and 1999.
Today this share has increased to 32 per cent.

Because most investors have anywhere
between 3 and 8 per cent invested in emerging markets, individual and institutional
investors are severely underweight in emerging markets, says Mobius, who
advocates the allocation should be more in line with the 32 per cent share in
terms of market capitalisation.

Growth, debt and inflation

The attraction of emerging markets can
be summarised in one word, he says: growth.
This year emerging markets are expected
to grow 5.9 per cent on average compared to 1.6 per cent GDP growth in the
developed markets of the US, Japan and Western Europe.

China and India are the most exciting
markets because both have a population of more than 1 billion people and both
have economic growth exceeding 8 per cent this year.

At the same time emerging market
countries have learned their lessons from the debt crises of the past, says
Mobius. Since 2005 foreign reserves in emerging markets are larger than those
in developed countries and debt levels in relation to the GDP have come down.While this is also an effect of GDP
growth, debt levels are much lower than in developed countries.

Inflation has also come down
dramatically in emerging markets since the late 1980s and early 90s and
interest rates are generally lower, which of course is very good for
businesses.

Share prices are neither at the high or
low end of the valuations spectrum, if historic price earnings ratios and book
values are anything to go by. The average PE ratio of 11 is higher than the
2008 low of 7 but still well off the 1998 high of 28. The current price/book
value of 2 is right in the middle between the low of 0.9 and the high of 3.

“So we are still able to find a
significant number of bargains,” Mobius says, although it is not as easy as it
was during the subprime crisis in late 2008, when it was the best time to enter
the market.

Outlook

The outlook for emerging markets is not
easy to predict as stock markets tend to lead the economy, he notes, but one
indicator that is often helpful is the purchasing managers’ index.

The survey among purchasing managers,
who often have a very good idea of what their customers want, shows that an
economic recovery has taken place since early 2009. It is also one of the
factors that made a double-dip recession scenario one year ago very unlikely,
says Mobius.

A second important indicator is the
spread between emerging market debt interest rates and US treasuries. “If the
difference is low, people are confident and willing to invest in emerging
markets,” he explains. When the subprime crisis hit, money left the emerging
markets quickly to seek refuge in US treasuries. However, this trend now has reversed
again, Mobius points out.

Portfolio themes

Franklin Templeton’s investment strategy
has not changed over the years and Mobius makes it very clear that “we don’t
pick sectors or countries, we pick stocks”.

“We go after companies that are signed
below what we believe is fair value over a five year time frame and that has
not changed. But the scope of our work in terms of the number of companies that
we cover and the number of countries and sectors has expanded.”

With this caveat in mind it is, however,
still possible to identify two general themes in the portfolio. The first is a
focus on consumer products and services, based on the belief that populations
in emerging markets are bigger and that these markets are growing faster. 

While the GDP per capita in emerging
markets is generally much lower, recent years have shown a considerable
increase that is reflected in a rise of imports, which in addition to raw
materials also includes consumer goods. 

“We believe that because per capita
income is rising in these countries we should be exposed to consumers, whether
it be cosmetics or consumer banking, which is a big area for us.“ 

The potential for growth is immense,
Mobius says, in reference to statistics that show that China’s rural population
is starting to buy consumer goods. 

At the same time the share of these
products per household is still comparatively low as only 30 per cent of
China’s rural households own a refrigerator, 50 per cent own a washing machine
and computer sales have hardly taken off yet.

Meanwhile car sales in China have
surpassed those in the US last year, although car ownership per household is
still way behind the United States.

The second theme in Franklin Templeton’s
portfolios, Mobius says, is commodities. 

Investors should expect a lot of
volatility in commodities with corrections along the way, he believes, but the
overall trend is up for copper, aluminium, platinum, palladium, nickel, gold,
soybean, corn and sugar in addition to the oil and iron ore producers that
Franklin Templeton is invested in.

Emerging markets not riskier

The notion that emerging markets are
riskier than traditional developed markets is not justified at all, Mobius
says, adding that risk, which, for lack of a better system, is defined as
volatility by the investment community, is actually lower in diversified
emerging markets portfolio than in a US, German or UK portfolio.

This is even more the case for frontier
markets, a subset of emerging markets that are less well researched and
typically less liquid.

The reason for this, according to
Mobius, is that the diversity among emerging market and frontier market
economies, say for example Nigeria, Vietnam and Saudi Arabia, is much more
pronounced and therefore, when averaged out, results in a less volatile and
less risky portfolio.

Mobius concedes that the layman’s
understanding of risk is slightly different than volatility, in particular,
given the political turmoil that can be witnessed in North Africa and the
Middle East.

“This is the other side of risk,” he
says, but adds: “Our experience has generally been when there is political
turmoil, provided there is an underlying cultural political structure, we can
still invest and do quite well. For example, during the turmoil in Thailand in
the last few years we continued to invest and we did very well. Despite
demonstrations, killings, burning buildings the market continued to function
and the companies continued to function.”

The reason for the positive performance
was that stocks were undervalued and could be bought at a low price. 

“Then there are cases like Venezuela,
where as soon as Chavez got in, we were out.”

Mobius says in these scenarios he is
mainly concerned with two issues: the likelihood of the confiscation of assets
and the existence of exchange controls, which could prevent investors from
taking money out of the country.

When considering risk from this
perspective there are not that many risks in the markets where we are
investing, he says, but a full analysis has to be carried out on an individual
company basis.

Political turmoil can thus be an
opportunity to invest, he says, particularly in Egypt. “We continue to look at
that market and invest in some cases and we believe that down the road that
development is going to be positive. It may take a few years for the turmoil to
die down and a new system to be put in place, but generally speaking a more
open, transparent society is good for us, because that is what we are all
about.”

Developed markets on the other hand have
their own unique risk factors, such as regulatory risk of being hauled into
court in the US, he argues.

Challenges

This is not to say that emerging markets
do not have their own internal problems and continuous strong growth rates are
not automatically guaranteed by a large population.

Corruption, the rebalancing of the
economy and a lack of education for the wider population are only some of the
challenges that have to be overcome by countries like China and India in the
future.  

These issues are even having an effect
now, says Mobius and gives Tata Consultancy, an Indian outsourcing company
Franklin Templeton carries in its portfolio, as an example. As the firm is
beginning to run out of qualified employees, it is forced to expand globally,
for instance in Poland.

“There is a growing realisation in India
that they need to emphasise education,” he says. “And the private sector is
aggressively moving in that direction, so they are setting up schools and so
on.”  

In China the situation is similar. “So
there is a heck of a lot of work to be done in these countries. But if you have
a billion people who respect education highly you are going to get very
educated people. There is a lot of talent there,” he argues. 

Mobius does not buy into the view,
propagated in US media in recent months, that countries like China lack true
innovation and only rely on copying the products conceived in developed
economies.

“We used to think that about the
Japanese many years ago in the 60s. Then you got Sony and all these other
companies that were very innovative.”

Besides, nowadays everybody starts to
build on what existed previously. “The Americans built on what the British
achieved and copied what the British did during the industrial revolution.”

“Now the Japanese are saying the Chinese stole
their technology for high speed trains, but the Chinese trains are way faster,”
he says, laughing.

What you see now is the Chinese with a
vast supply of engineers will study what they find and then they will improve
it, he adds.  

“You see a lot of creativity in China
and all the other emerging market countries.“ 

Risks 

Still, from an investor perspective
there a number of risks that concern Mobius. 

First, the debt crisis in Europe and the
US is a concern because it can have an impact globally. “Sovereign debt in the
US, Japan and other developed countries is enormous and investors are now
scared of some of the developed countries,” he says, quoting credit default
swap rates that are higher for the sovereign debt of Greece than that of
Argentina and CDS rates for Portugal and Spain that are higher than Russia’s
and Brazil’s. Overall Western Europe CDS spreads are moving up whereas emerging
market spreads are moving side-ways, he concludes.

The lack of true bank and financial
system reform is another concern, says Mobius. “There have been cosmetic
changes but no real reform.” Basel 3 has not really made banks safer and
accounting rules have not changed and increased transparency, as banks still
mark-to-model. At the same time “too big to fail” has not been resolved. In
fact banks are even bigger now, because there are fewer of them, he says.

At 10 times the size of the global GDP,
the $600 trillion derivatives market is also very risky for a lot of companies.
“We always ask every company that we visit about the derivatives they have. And
if they say we’ve only got plain vanilla we get very suspicious, because so
many companies have gone bankrupt over these derivatives.”

In addition, the money supply and the
policy of quantitative easing has flushed a lot of money into emerging markets
and driven up prices.

“Generally speaking, if you are a stock
investor, inflation is good,” says Mobius. “Companies do better in an
inflationary environment because they can adjust, if you pick the right
companies of course. “ Likewise, therefore a sudden contraction of money supply
would be detrimental.

Asset bubbles?

Yet, Mobius is not concerned about asset
bubbles that appear, for example, in Chinese infrastructure and construction
projects. Are these investments really going to pay off?

“No,” replies Mobius. “But that’s OK
because the Chinese government owns the banks.”

“That is a big difference compared to
the West. You notice that they are already anticipating increased
non-performing loans by having massive increases of their capital. The reason
why the IPO and secondary issue market was so buoyant was to a great degree the
Chinese raising more capital for their banks to be sure that when and if these
non-performing loans rear their ugly heads they are well capitalised.”

If the situation gets too bad the
government will just set up an asset management company for these assets and
have an investment bank come in and sell it off, as they have done in the past,
he suggests. 

Mobius acknowledges that there is a
bubble, but it is not going to burst. 

In Shanghai, he says, he noticed
beautiful high rise apartment buildings overlooking the Huangpu River that were
half empty. “They are not selling. They have been empty for three years. They
just hang on until the prices go up to what the sellers originally thought is a
fair price.”

This is in fact similar to the Cayman
Islands, he says. All the apartments along Seven Mile Beach are not going to be
sold at heavily discounted prices, which is quite a different story from the US
where people are highly leveraged, he notes.

While in some ways it is a waste of
resources, that is the reality, Mobius says.

The best time to invest in emerging
markets is “when you have money”, he concludes, quoting the company founder Sir
John Templeton, because over time bear markets in emerging markets have lasted
for a very short time and tended to recover quickly, whereas bull markets have
lasted much longer.

In a bull and bear market comparison on
a dollar cost averaging basis, investors are going to hit a lot more bull
markets than bear markets, he says. 

Franklin Templeton’s regional manager for the Cayman Islands is:   

Christopher Lynch
Wholesaler – Americas
International Advisory Services Division
100 Fountain Parkway
Saint Petersburg, FL 33716

T:    (727) 299 4535
        (800) 233 9796 ext. 34535
E:    clynch@templeton.com
W:    templetonoffshore.com

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