From the September 2011 issue of Investment Advisor • Subscribe!

Investing In Emerging Markets: The Opportunity in Asia

Advisors who want to take advantage of emerging Asian markets should look to small-cap stocks

In an abrupt historical shift, emerging markets appear stable relative to developed markets, which are suffering from political and economic issues that used to be the hallmark of emerging markets. Factor in robust growth relative to developed markets and it is easy to see why investor enthusiasm for emerging markets remains strong.

In spite of this relative stability and growth, issues that have traditionally plagued emerging markets have not totally disappeared. Increasing inflation has been forefront in the news, but more embedded limitations remain. Many markets impose trading restrictions on foreign shareholders. The rule of law, securities regulation and accounting transparency typically lags developed markets.

In addition, the large and liquid emerging stocks that dominate general and country-specific emerging market ETFs are oriented toward gyrations of the global economy rather than their local markets. Many of these stocks can be directly or indirectly influenced by their governments. The top five stocks in the iShares Emerging Markets Index Fund (EEM) highlight this point. In order, they are: Samsung, Gazprom, Petrobras, Vale and China Mobile, all of which have fortunes tied to the health of the general global economy or might not operate independently from government influence.

Advisors who are looking to gain access to the growth of emerging markets would be prudent to look at smaller market capitalization stocks that are more heavily geared towards growth in emerging markets. But these stocks are not readily available directly on emerging market exchanges, due to concerns about corporate governance, accounting, liquidity and, recently, valuation.

An Alternative Way to Invest in Emerging Asia
To combat these issues, advisors should seek out investment managers who can identify profitable companies with strong asset backing and limited leverage that might be underfollowed or misunderstood by the market. It is also important for the investment manager to purchase stocks below a reasonable estimate of net tangible asset value to protect on the downside while using a range of qualitative research techniques to determine how much upside an investment might generate. This investment style tends to provide strong downside protection in a declining market and upside participation in an ascending market.

This process has yielded an alternative and exciting way to invest in emerging markets. Smaller capitalization stocks listed on the well-regulated and established Asian bourses often times are directly or indirectly emerging markets stocks. Prime examples of these opportunities abound on the stock exchanges in Tokyo, Singapore and Hong Kong. Within these markets it is possible to find value securities that are heavily geared toward emerging market growth. These stocks are often unencumbered by government influence and led by entrepreneurial managers who have their “skin in the game” via stock ownership.

Researching these companies can be complicated. Some companies do not file their financials in English and many have limited sell-side research coverage. To conduct effective diligence on these names, investment managers should conduct on-site analysis of the company and also have the language skills and an understanding of cultural nuances to conduct a proper review of the company’s investment merits. These capabilities are essential to investing in a range of exciting stocks that should benefit from the growth of the emerging markets.

Indirect Exposure in Asia: Two Examples

Golden Meditech Holdings
Golden Meditech is a Hong Kong-listed company based in Beijing. It is a leading integrated medical devices and health care services company and is China’s largest blood-related devices manufacturer. It is also licensed to manage hospitals nationwide, and is the first medical insurance information management and BPO service provider in China. In addition, Golden Meditech’s subsidiary, China Cord Blood (NYSE:CO), controls the exclusive license to store cord blood in a number of China’s wealthiest and most populous provinces.

Golden Meditech’s small size, approximately $300 million market cap and limited sell-side research has kept it under the radar. As a result, in spite of a very strong balance sheet and attractive growth business in the Chinese health care sector, Golden Meditech trades at a sizeable discount to stated book value and an even greater discount to estimates of its net asset value. Golden Meditech is already quite profitable and trades at less than 10 times trailing earnings. In addition, the company should be relatively protected from increased inflation. The Chinese government is committed to providing affordable and quality health care to its citizens to limit social unrest. As a result, the government is likely to subsidize increases in health care services costs.

Chugoku Marine Paint
Chugoku Marine Paints (CMP) is a $550 million market cap, Tokyo-based industrial paint manufacturer with a leading position in the market for paints used on ships and containers. While CMP is a Japan-listed company, an investment in CMP is really an investment in globalization and emerging market growth. Most of CMP’s revenue is generated in rapidly growing neighboring Asian markets that are benefactors of globalization and highly geared to ship building and maintenance, such as China, Korea and Vietnam. Last fiscal year, CMP’s Chinese sales grew over 50% and now account for one-third of CMP’s total revenue. Despite CMP’s consistent 13% ROE, over 2% dividend yield and attractive prospects thanks to emerging market growth, the company trades at a very attractive valuation.

The key to unlocking the value of emerging markets is to gain exposure to high-quality companies that have excellent growth potential, are trading at big discounts and are listed on developed country exchanges—where they often go unnoticed. Right now these investment opportunities represent excellent value and have potential to see huge gains once investment analysts and investors “discover” them, causing the prices to reflect an emerging market premium.

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