Will Emerging Markets Outperform in 2001?

By Antoine W. van Agtmael
President and Chief Investment Officer
Emerging Markets Management
January 5, 2001

The essay below, dated January 5, 2001, was authored by Antoine W. van Agtmael, founder, president, and chief investment officer of Washington, DC-based Emerging Markets Management (EMM). EMM has performed admirably its role as lead manager of the TIFF Emerging Markets Fund since the Fund commenced operations in 1994. The firm's "generic" name is testimony to Mr. van Agtmael's pioneering spirit: he was one of the first investment professionals to draw attention to the opportunities presented by stocks of firms domiciled in developing countries (in the early 1980s), and his firm was one of the first to offer emerging market stock management capabilities to US-based institutions. The firm has added substantial value to emerging market indices over the years, applying value-oriented strategies that cause it to favor issues that tend to be overlooked by other institutional investors. The essay that follows summarizes EMM's outlook for emerging markets, which can be characterized as cautiously optimistic. To its credit, EMM anticipated many of the difficulties that emerging markets encountered in 2000, including the worldwide correction in TMT (technology, media, and telecommunications) shares. As noted in TIFF's Marketable Investments report dated March 31, 2000, big increases in their valuations in 1999 and the early part of 2000 caused TMT shares' weight in emerging market indices to soar to shocking extremes. EMM deemed these gains unsustainable, and its underweighting of TMT shares -- coupled with other profitable tactics -- enabled the firm to materially outperform the MSCI Emerging Markets Free Index (its TIFF-specified benchmark) in 2000.

Summary:

We predict that portfolio diversification will come back into vogue in 2001. The naïve hopes expressed by investors in 2000 toward technology, the Internet, growth and large cap stocks have "bitten the dust."

We believe that the conditions are ripe for emerging markets to outperform the U.S. and other major equity markets. Although it is evident that the global economy is slowing, it may not be as clear that many emerging markets and emerging markets stocks (particularly in Asia) seem to have over-reacted and already priced-in a “hard landing” scenario; one which we do not expect to materialize.

From a macro-economic point of view, the vast majority of emerging markets are in good shape, although growth is likely to be less strong in 2001 than last year. While it would be unrealistic to expect the tremendous turnaround in earnings witnessed in 2000 to be repeated this year, earnings are still expected to grow much faster in emerging markets than in the major markets. Emerging markets valuations are attractive, not only in comparison to industrialized peers, but also within their historic context (at a low for the decade). Risk premia are now less warranted as emerging market company balance sheets have improved and corporate governance receives more attention.

The likely catalysts for better performance by emerging markets include: (1) a lack of competition from high-performing technology stocks in major markets; (2) lower oil prices; (3) action by the major central banks to limit the global slowdown; (4) a weaker dollar; (5) a recognition of the comparatively stronger consumer demand in many emerging markets; and (6) continued outsourcing success.

Critical Issues:

Last year, our New Year’s letter focused on the Internet hype. We predicted that this mania would "burn out within the year or so." and that icons of the information age (e.g., Microsoft, Intel, Amazon.com and AOL) would face serious difficulties including competition from re-energized incumbents and new entrants. We expressed concern that even "winners" would not live up to investors’ high expectations and "losers? would disappoint severely. As you may recall from our quarterly financial report commentaries, we pointed out that the critical question in 2000 was when to get out of Internet and other over-hyped stocks and to, instead, focus on more ?boring? stocks.

This year, the critical issues will be:

Is the world facing a "soft" or "hard" landing?
Is spending on technology (i.e., everything from telecom infrastructure and software systems to PCs, mobile phones and PDAs) facing a brief respite or a long slump?
Will outsourcers exert greater (than normal) pressures on their suppliers in the face of their own profits being squeezed?
When will investors recognize that the time has come to better diversify their portfolios again?
Will a slowing U.S. economy derail domestic recoveries in emerging markets?

A Review of the Past Year:

The Year 2000 started with too much euphoria -- and ended with too broad disillusion. Investors now realize that the “bull market” in the U.S. and Europe was fairly narrow (i.e., TMT stocks) and was often based on unrealistic expectations. The “bigger is better” syndrome can now viewed within the context of the debt piles that it created. Investor confidence in technology plays and “dot.coms” has been replaced by skepticism about business models. The massive prices paid in Europe for third generation wireless licenses have turned out to be a poor allocation of resources. As the past has proven, when greed turns to fear, the “risky” assets are dumped first. 1999’s emerging market winners led the way in discounting a “hard landing” when the first signs of a slowdown became apparent and high oil prices began to strain current accounts.

Performance in 2000:

We were able to outperform the nasty 31% drop of the MSCI Free Emerging Markets Index. We did so by adding value in country allocation, selling software and telecom stocks that had run up too much (e.g., India and Eastern Europe), sticking to "cheap" technology, investing in attractive oil & gas plays, moving toward interest-sensitive financial institutions, and by focusing on companies with healthy balance sheets.

Watchwords for 2001:

Emerging Markets Investors Corporation / Emerging Markets Management, L.L.C. 2 Watchwords for 2001: We believe that “portfolio” diversification as well as “digital” diversification will become key concepts for investors this year. We also expect that corporate governance will begin to receive far more attention than it has in the past (and deserves) as we see greater investor support for pro-active involvement by managers.

Particularly because of the current “cheap” valuations, we have not lost our belief that technology stocks in emerging markets offer attractive opportunities and that technology will prove to be the most dynamic sector. While about half of all semiconductors produced globally are used in PCs, it is important to recognize that the other half is used in different applications that are growing much faster (e.g., cell phones, PDAs, set-top boxes or cable decoders, automotive electronics etc.). This growth could be called “digital” diversification and provides us with the hope that the current slowdown in technology spending will be short-lived. “Digital” diversification (in addition to the attractive valuations and healthy growth prospects of the technology companies in our portfolios) is also a reason why we, as investors, do not expect to leave the information technology sector. Longer term, we believe that growth will remain in this area, even if it is currently out of favor. The same is true for many telecommunications companies in emerging markets that are growing faster and are burdened with a much lower debt load than their US or European peers.

As discussed, the seductive attraction of high-priced growth stocks in the narrow field of technology has lost its luster. With growth in the industrial world now more subdued and earnings disappointing, technology out of favor, lower interest rates, and more interest in “quality value”, we believe that investors will (again) appreciate the merits of “portfolio” diversification and find their way back to emerging markets, which are currently cheap, healthy, growing and under-invested.

Copyright Emerging Markets Investors Corporation / Emerging Markets Management, L.L.C.

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