Foreign equity markets worth a serious look

Your clients should look beyond the U.S., and consider investing in foreign equity markets, specifically Asia and a few emerging markets.

It’s usually tough to break old habits but advisors may very well have do so if they want higher returns on their clients’ foreign investments. The first step is to look beyond the favourite U.S. market, which has tumbled for more than two years.

“People are going to seek out growth wherever they see it,” says Charles Bastyr, head of the international equity team at Toronto-based Altamira Investment Services Inc.

They’re not seeing it south of the border. Despite periodic glimmers of hope, the U.S. market remains plagued by problems. Among them: valuations remain relatively high, although they have been coming down as prices slump; corporate earnings have collapsed; and governance issues, ranging from accounting scandals to outright fraud, have shocked investors. And weaker-than-anticipated economic conditions, combined with the prospect of war with Iraq, add to the woes.

“The U.S. market is suffering from a lack of investor confidence,” says Chuk Wong, vice president and portfolio manager at Dynamic Mutual Funds Ltd. in Toronto.

Where should investors be searching? An examination of the Morgan Stanley Capital International (MSCI) price index returns for the one-year period ended Sept. 30 shows that emerging Europe and Asia have significantly outperformed developed regions of the world. The MSCI emerging markets European index, fuelled by the Czech Republic (+76.86%) and Russia (+49.45%), leads the pack with a return of 31.56% in U.S.-dollar terms. It is followed by the MSCI emerging markets free (EMF) Asia index with its gain of 18.66% in US$s, led by Sri Lanka (+151.67%), Pakistan (+72.71%) and Korea (+61.57%).

The MSCI EMF Latin America index is the only one of the emerging-market indices to produce a loss, down 23.28% in US$s.

“Latin America is beset by political problems and emerging Europe is too closely tied to the West,” says Bastyr. “Asia seems to be a good place now. Valuations are inexpensive and corporations, on average, have lower price/earnings ratios and better balance sheets than other emerging regions.

“Asia has already had its crisis,” he says — in 1997-99.

Evaluating Asia from a more macro level, Christopher Wood, global emerging markets equity strategist in the Hong Kong office of Credit Lyonnais SA, says: “The countries of Asia are discovering the will to become masters of their own destinies.

Fuelled by favourable demographics, strong reserves of savings and the new ethos that ‘tomorrow will be better than today,’ the region’s economies are poised to become the world’s economic drivers of the next 20 years.”

Wong also sees positive fundamentals in Asia. The region is in a different phase of the business cycle than the U.S., having endured a deep recession in 1998-99. Although economic growth is slowing, it will remain a healthy 5% next year. In addition, “interest rates are at multi-decade lows, valuations are at the bottom end of the historical range, debt/equity ratios are falling and free cash flow is rising.”

Wong, a bottom-up stock picker, invests in companies that are fundamentally sound and have good management and strong balance sheets. He likes companies such as Guoco Group Ltd., a Hong Kong-based financial services and property holding company that is trading at a 40% discount to net cash, 50% discount to net asset value and 14 times 2002 earnings. Another favourite is Mastek Ltd., an Indian IT services company that is a turnaround story. It is benefiting from increasing outsourcing from the U.S. and Europe. Mastek is trading at 10 times 2002 earnings and is expected to have a 30% increase in earnings-per-share growth this year.

Hana Bank in Korea and Cawachi Ltd. in Japan are two of his other stock picks. Hana Bank is merging with Seoul Bank to form the third-largest commercial bank in Korea. Its valuation is very attractive; it is trading at 1.1 times book value, 5.5 times 2002 earnings and has a return on equity of 25%. Cawachi is a drugstore chain that bypasses the wholesale distribution channel and is able to offer low prices daily. The company, in Wong’s opinion, is undervalued and not well followed. It is trading at 18 times 2002 earnings and is expected to see double-digit earnings growth this year.

Bastyr, who uses a combination of bottom-up and top-down strategies, looks at macro variables such as economic, social and political conditions, as well as stock-specific variables. He likes China, which is benefiting from vibrant exports, strong government, consumer spending and rising foreign direct investment. In Thailand, Malaysia and Indonesia, strong domestic consumption is fuelling growth, and Bastyr is keen on consumer-based stocks or what he calls “consumption plays” in those countries. But, he believes, Korea is overheating: “Going too far too fast.” He favours Indonesia’s Bank of Central Asia, which has a dividend yield of about 12%, a low loan-to-deposit ratio and a strong U.S. management team.

Dwarka Lakhan

Dwarka Lakhan is a pioneer in emerging markets journalism in Canada. His first emerging markets article, “Africa Joins Ranks of the Emerging,” appeared in Investment Executive, Canada’s leading newspaper for financial advisors, in September 1994. Since then he has written hundreds of articles on the full spectrum of emerging markets and has conducted more than two thousand interviews with emerging and frontier markets investment professionals.

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