From the March 2007 issue of Wealth Manager Web • Subscribe!

March 1, 2007

Safety Nets

After releasing third-quarter results during the last week of October, Telenor, the once stodgy Norwegian telecom service provider, saw its stock soar 13.2 percent on financials that are anything but boring. Revenues from the first nine months of 2006 were up 38.2 percent, operating profits were up 61.3 percent, operating margins rose from 18 to 21 percent, and EPS was up 66 percent. What's driving such remarkable growth?

According to Brian Younger, portfolio manager of Fidelity's Select Telecommunications Portfolio, it was the company's decision to expand into emerging markets. With virtually no such exposure a decade ago, 61 percent of Telenor's revenues and nearly 66 percent of its EBITDA are now being generated in Central and Eastern Europe and Southeast Asia. "The company has parleyed its expertise to fast growing markets outside of Scandinavia where costs are lower and margins are much richer," Younger explains.

Over the first three quarters of the year, sales in Malaysia were up 34.3 percent to 4.67 billion Norwegian kroner (Nk), with margins of 43.4 percent. Ukrainian revenue soared 62.5 percent to 7.93 billion Nk with margins of 37 percent. In contrast, home market mobile revenue was up 9.2 percent to 9.84 billion Nk, with margins of 36.5 percent.

These gains are attributable to more than just being in the right place at the right time. In Younger's opinion, the Scandinavian service provider negotiates effective contracts in emerging markets. This allows Telenor to uncover promising growth opportunities while managing the higher risks associated with venturing into less transparent and evolving markets.

The results have fueled phenomenal stock performance. Since Younger established his $3 million position at the end of 2005, Telenor's ADRs appreciated nearly 68 percent during the first 10 months of 2006. Over the past three years, its shares have nearly quadrupled. Telenor's experience suggests a potentially safer way for advisors to tap into fast growing emerging markets.

Emerging markets have been hot. Over the year ending Oct. 18, 2006, the benchmark Morgan Stanley Capital International Emerging Market index soared 34.23 percent in dollar terms. That's close to seven full percentage points better than MSCI EAFE--the international developed market index, ex- US. Three-year annualized returns were up by more than 29 percent, more than eight percentage points above EAFE. And over the past five years, emerging market total returns rose by an annualized rate of 28.57 percent--twice the returns of developed markets.

With such performance, it's easy to understand why so many investors and advisors have caught the emerging-market bug.

But the rub (and with numbers like these, there's always a rub) is that emerging markets are prone to periodic meltdowns that can quickly destroy capital. In the past dozen years, there have been four major quakes whose impacts have reverberated across the world's emerging markets. And they socked U.S. investors not only by the drubbing shares took on local exchanges, but in the precipitous decline in underlying currencies, which translated into further dollar-based losses.

Toward the end of 1994, Mexico found itself unable to sustain the peso's link to the dollar, which had contributed to severe fiscal imbalances. The currency subsequently declined by more than 50 percent, while the Mexican bolsa lost half its value in just three months. This sent shock waves across Latin American markets as foreign capital fled the region.

Several years later in 1997, Southeast Asia collapsed under the weight of currencies that were also unable to sustain their links to the U.S. dollar. Local stock markets, such as the Bangkok Stock Exchange, which had already been in decline, collapsed an additional 25 percent. Currencies lost up to half their value, and the once proud tiger economies were caught in a bear trap.

The following year, short sellers saw comparable weakness in the Russian ruble. With the government unable to defend the currency, the ruble proceeded to lose 85 percent of its value. Russia defaulted on its sovereign debt and suspended payments to foreign creditors. The stock market, which had already lost half its value since the previous year's peak, declined by another 85 percent during the third quarter of 1998.

And in 2002, Argentina followed suit, breaking the peso's peg with the dollar and watching its currency lose 75 percent of its value. The government defaulted on $93 billion in public debt, and the Merval borsa lost half its value in local currency terms during the six months leading up to the currency crisis.

The impact of these meltdowns--coupled with the post-2000 global market sell-off--is evident when looking at long-term returns of the MSCI Emerging Market index: That impressive five-year annualized return (28.57 percent) collapses to just 7.94 percent when you go back 10 years to the fall of 1996. That's just 66 basis points better than EAFE's 10-year returns of 7.28 percent and involved a lot more risk.

Because many emerging markets offer cheap labor, access to raw materials, more business-friendly regulatory environments, and GDP growth that's perennially two to three times that of developed markets, investors keep coming back in spite of the risks. Morningstar reports that since 2002--when the bear market was bottoming and investors were scrambling to safer havens--emerging market mutual fund assets have soared from $19.4 billion to more than $121 billion as of the end of September 2006.

But due to weak transparency, reporting standards, corporate governance, currencies and liquidity, and potential government interference by way of price controls and even re-nationalization of formerly public assets, a number of top-performing asset managers prefer gaining emerging market exposure through mature, developed market companies. The logic: These firms know a lot more than U.S investors about local markets, corporate operations, and macroeconomic and public policy risks.

Mauro Guill?n, professor of international management at the Wharton School and a specialist in Spanish multinationals, sees added protection in investing in developed market companies that have stakes in emerging economies. "Investors benefit," explains Guill?n, "not only by the due diligence involved in making the acquisition, but from the subsequent management and production synergies achieved in integrating emerging market operations into established companies."

Specific value-added moves include the introduction of proven management, superior information technology platforms, improved treasury risk controls, more efficient back-office operations, and enhanced marketing strategies. These changes can help a local operation leap-frog over its competitors, enabling the parent company to capture the benefits of faster growing markets with less risk.

A recent study by Alicia Garc?a-Herrero of the Banco de Espana and Francisco V?zquez of the International Monetary Fund, which reviewed 60 large banks from eight industrial countries between 1995 and 2004, found that "greater asset allocation to foreign subsidiaries, particularly [across a number of] emerging economies, enhances the risk-adjusted profitability of international banks."

David Riedel, who runs his own equity research firm in New York focusing on emerging markets, believes cursory evidence bears this out. He anecdotally compared a 52-week spread between stocks' highs and lows, along with their one-year total returns in local currency terms. Through the end of October, Erste Bank, Austria's largest bank--which generates 61 percent of its profits in Central and Eastern Europe [CEE]--saw its price swing 37 percent between its high and low, ending the year up 37 percent. At the same time, Romania's third largest bank, BRD, was more volatile, with a 54 percent spread between its high and low, and a return of 48.8 percent for the year. The Czech Republic's second largest bank, Komercni Banka, deviated only 30 percent. But its stock fell 2.4 percent.

Riedel then looked at the month between May 15 and June 15 of last year, when emerging markets severely corrected, and saw that Erste Bank was only sideswiped, falling 13 percent, while BRD was off 18 percent and Komercni plummeted 22 percent.

"While there hasn't been a definitive study that confirms what we suspect," says Riedel, "we do find this story frequently repeated, suggesting the merits of going through developed markets to gain less volatile emerging market exposure."

Paul Casson, portfolio manager of the EUR397 million Ivy European Opportunities Fund, which has soared nearly 25 percent over each of the past five years in dollar terms, has zero direct emerging market exposure. But he estimates that 13.8 percent of his investments are based on growth stories that are geared to emerging markets.

His 2 percent position in Spain's second largest bank, BBVA, is a play on both strong Spanish and Latin American growth. As of the end of the third quarter 2006, Latin America represented nearly 50 percent of BBVA's total revenue and more than 60 percent of its profits. Since the Argentine crisis in 2002, when bank earnings declined by 27.3 percent, BBVA profits have soared at an annualized rate of 35 percent. The stock has doubled in dollar terms during that time, pushing its market cap up to $82.66 billion.

Casson also ventures into smaller plays with growing emerging market exposure. German wood construction and products manufacturer Pfleiderer has a market cap of just $1.40 billion. But the company is enjoying rapid growth as it pushes into Central and Eastern Europe--especially Russia, where residential construction is surging along with demand for wood home furnishings.

Through the first half of 2006, 19 percent of sales and 28 percent of earnings came from CEE. Deutsche Bank projects Pfleiderer's 2006 EPS to rise 57 percent and 2007 profits to jump an additional 61 percent. This has helped fuel a 43 percent rise in the stock (in euro terms) over the past year through November 1, and encourages Casson to sustain his overweight position of 3 percent in Pfleiderer's shares.

Another smaller cap play that exploits rising emerging market demand through a familiar name is Coca-Cola Hellenic Bottling Company, Coke's Greek subsidiary. "It's hard to significantly increase penetration of Coke products in developed markets," Casson explains, "but in many emerging markets that sell soda cans off a hot shelf, introduction of refrigerated dispensing machines is fueling significant growth." Accordingly, more than 18 percent of sales are in Africa and the Middle East and 35 percent are coming from Russia and the Balkans.

"This may not be a sexy story," says Casson, "but it's a sound fundamental growth play." Casson has a 2 percent position in the company, and over the past two years, shares were up by more than 54 percent in local currency terms, pushing the company's market cap up to $7.79 billion.

As household earnings steadily increase, emerging markets are developing an increasing appetite for basic financial services. This has led Michael Sieghart, who manages EUR3 billion for Frankfurt-based asset manager DWS Investments, into shares of Wiener Staedtische Versicherung, a major Austrian life insurer. While its business was exclusively Austrian just a few years ago, 30 percent of the company's premiums are now generated in CEE. And growth rates in these emerging markets, which average 18 percent a year, are twice that of Austria.

In 2004, Sieghart established a 2 percent position in his DSW Invest European Equities fund at an average cost of EUR34.5. The stock has since enjoyed a substantial run-up, closing at the end of October 2006 at EUR50.40, contributing to the fund's three-year annualized return of 20.8 percent in euro terms. Sieghart expects the stock's strong performance to continue, given the currently low expenditures on insurance products across emerging Europe. Where Austrians spend an average of $2,160 per capita, Czechs spend $430, Hungarians $287, and Romanians just $48.

Finding multinationals that have significant exposure to emerging markets doesn't assure a profitable investment, however. Spain's giant energy concern Repsol-YPF struggled last year with a number of its Latin American deals. And a recent report by the global consultancy Deloitte found that developed market companies in Europe are frequently ignoring serious risks--such as bribery, corruption, and money laundering--in their rush to invest in new, fast-growing emerging market opportunities.

David Riedel believes periodic meltdowns will remain a part of emerging markets. "Despite improving government policies and corporate management," Riedel explains, "economies whose fortunes are geared to high growth rates, commodities, and volatile swings in foreign capital flows are inevitably prone to corrections. And thin liquidity exaggerates asset price swings."

But Riedel does believe the once difficult matter of contagion--where economies suffer unduly from the specific, unrelated problems of a troubled emerging market--is becoming less of an issue. "As their understanding improves, analysts are better able to differentiate between emerging markets," says Riedel, "and we are now seeing managers buying into declining, uncontaminated markets, which effectively contains regional fallout."

This means that buying into multinationals that have a track record of sound due diligence and profitable expansion may offer advisors and their clients the best way of investing in the inevitably choppy waters of emerging markets.

Eric Uhlfelder (Uhlfelder@hotmail.com) has covered domestic and international capital markets over the past 13 years for various brokerages and publications.

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