Opinion: Emerging market stocks with a host of tailwinds are poised to outperform US equities

Investors poured a lot of money into emerging markets in April.

They added more than they have at any time in the past 10 weeks, Bank of America says. This continues a trend that began in late 2020.

It’s the latter, says Neal Dihora, who helps manage the Wasatch Emerging Markets Select Investor Fund WAESX,
alongside Senior Director Ajay Krishnan, who has been at the helm for over nine years.

Of course, they have a bias. They manage an EM fund. But their remarkable record tells me they are worth listening to. The Wasatch fund beats its Morningstar Diversified Emerging Markets category by 9 to 13 annualized percentage points over the past three to five years, according to Morningstar Direct.

Plus, they’re not the only ones bullish on emerging markets now. We’ll cover investing lessons we can take from the Wasatch team on how to beat the markets, and several favorite EM names. But first, here’s why emerging markets could outperform this year and beyond.

The dollar will lose its luster

If international tensions ease over the next few months, the dollar will lose some of its safe haven status. This will cause investment money to flow from the dollar to other parts of the world, supporting emerging market stocks, says Jim Paulsen, chief equity strategist at Leuthold Group. It favors emerging markets outside of China, which makes sense as many companies are moving their supply chains to other emerging countries.

Emerging markets will benefit from megatrends

Dihora cites five so-called megatrends: population growth; “financialization”, or the increased use of consumer credit; digitization, which means greater use of the internet for things like shopping and banking; and industrialization.

This means building supply chains in emerging countries, including Vietnam, Indonesia, Malaysia, Brazil and Argentina, among others.

Goldman Sachs agrees. The bank singled out emerging markets for their outperformance.

“An active emerging equity strategy may have the potential to outperform a US strategy over the next decade as emerging populations grow and innovation develops,” the investment bank says.

Inflation helps emerging markets

Many emerging economies are commodity based. A sustained rise in commodity prices will support gross domestic product (GDP) gains, improving the business tone for businesses across their economies.

Emerging markets seem relatively cheap

As investors fret over relatively high US stock market valuations despite this year’s weakness, emerging markets look about as cheap as they have for the past 20 years, according to Goldman Sachs.

The bottom line: While the iShares MSCI Emerging Markets ex-China EMXC ETF,
beat the S&P 500 SPX,
by about a percentage point since the start of the year, this could be the start of a medium-term trend of outperformance.

How to Outperform in Emerging Markets (and Beyond)

Given the outperformance of the Wasatch Emerging Markets Select Investor Fund over the past five years, it’s worth looking at how they achieve these returns, to see what we can learn.

Dihora offers three key tactics that he and lead manager Krishnan apply.

1. Lesson 1: Look for sustainable companies with comparative advantages. To see how it works, consider Mumbai-based HDFC Bank HDB,
which trades on the New York Stock Exchange (NYSE). The advantage of the business model is that the bank has developed a loan underwriting process which it strictly follows. This reduces loan cancellations. The bank also has a low-cost deposit base, partly because it is a trusted brand in India.

Also consider Mexican airport manager Grupo Aeroportuario del Pacifico SAB de CV PAC,
also listed on the NYSE. One of the reasons it’s a sustainable company is simple: it has exclusive agreements to run its airports in Mexico for decades. This gives him a long track to continue to develop his business by developing services such as parking, catering, lounges and hotel accommodation.

Lesson 2: Look for companies with large and growing addressable markets. Cynics claim that many companies cite fake research to overestimate their total addressable market (TAM), a popular investing meme these days. But owning companies with potentially large markets is key to winning investments, says Dihora. You can avoid pitfalls by thinking the numbers for yourself, as Dihora does.

Consider MercadoLibre MELI,
a sort of Latin American AMZN Amazon.com,
The popular online retailer (fourth quarter sales increased 74%) had 82.2 million users at the end of last year, in a region of more than 650 million people. It’s a big potential market.

The company benefits from a positive feedback loop of the network effect, which means that as more consumers buy from it, the platform attracts more merchants, which helps to attract more consumers, and so on. MercadoLibre also has a history of copying the tactics of successful competitors like Amazon.com’s use of fulfillment centers and Sea’s SE,
app gamification.

Another example: Globant GLOB,
which is an IT outsourcing company that helps companies improve the usability of their applications and websites and digitize their business. Customers include Walt Disney Parks and Resorts Online, part of Disney DIS,
The potential size of the market is significant given that IT outsourcing and online business migration still have a lot of room to grow.

Dihora also sees great potential in Globant’s internal business metrics. The company uses the “land and expand” model. That means it starts small with customers and then grows business with them over time, which is a big part of why fourth-quarter revenue grew 63% to $380 million.

For example, at the end of last year, the company had 12 customers spending more than $20 million a year, up from seven the year before. And it had 185 customers spending more than $1 million, up from 129 a year ago.

“I think that’s clear evidence of how we’re able to become more strategic in the type of relationships we have and that’s what gives us the confidence to increase our forecast,” the director said. financier Juan Urthiague on the fourth quarter earnings conference call.

Globant has around 1,100 customers, which suggests a lot more room for growth using this tactic, Dihora says. The company is based in Luxembourg but Dihora considers it an emerging company because it does a lot of business in emerging economies.

Bajaj Finance (500034 India: Bombay) is another example of a company with a large addressable market. The Indian consumer lending company has about 57 million customers. But there are around 300-400 million people in urban centers in India, where Bajaj targets customers.

Lesson 3: Do nothing. It sounds easy, but it’s not. The reason: As investors, we are bombarded all day with signals that we need to do something. The financial press, brokers, sell-side analysts and unexplained big moves in stocks are constantly pushing us to act.

“The world around us makes us want to do something,” says Dihora. “But what we’ve learned is that if we have businesses that have a sustainable business with a large addressable market, the best course of action is to do nothing.”

Some data confirms that this is a fundamental element of the fund’s strategy. According to Morningstar Direct, the fund’s annual portfolio turnover is only 20%, which is in the low range for mutual funds.

MercadoLibre has been in the portfolio since 2014. Bajaj Finance since 2015 and HDFC Bank since 2017. Globant is a newcomer, having joined the portfolio in 2019.

“You really have to think about the power of compounding. If you can avoid the pressure to “do something, do something!” it really pays off,” says Dihora.

Michael Brush is a columnist for MarketWatch. At the time of publication, he owned MELI and AMZN. Brush suggested DIS and AMZN in his stock market newsletter, Review actions. Follow him on Twitter @mbrushstocks.

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