There's Still Opportunity in Emerging Markets

In 1984, Julian Mayo was a trainee at Schroders, an investment bank, when he was sent to investigate a little-known automaker in a town called Ulsan on the southeast coast of Korea. The Asian “Tiger” nation was still under dictatorship, which meant army patrols swept the streets enforcing curfews, but the company impressed the analyst. Twenty years later, Korea is a democracy, Hyundai a household name and, in the past few weeks, Consumer Reports voted Hyundai Sonata “2004's most reliable car,” while downgrading Mercedes. Quips Mayo, “When I first saw the numbers, I thought they'd got it upside down.”

Mayo now is the London-based investments director at Charlemagne Capital, which subadvises U.S. Global Investors' Eastern European Fund and recently launched Global Emerging Markets Fund. (U.S. Global Investors is a mutual fund family known for providing unusual investment options, including funds specializing in gold, minerals and China.)

Eastern European Fund, launched in March 1997, has grown to over $700 million, largely on the strength of its spectacular performance. Over the past five years, the fund has averaged returns over 26 percent per year and garnered a five-star overall rating from Morningstar. In January, The Wall Street Journal designated Eastern European Fund “tops in 2004” after a 52-percent gain.

U.S. Global Investors/Charlemagne Capital's Global Emerging Markets fund, which debuted on Feb. 14, invests in places like Hungary, Korea, Russia, Mexico, South Africa, Poland, Chile and Taiwan. Geographically, the fund is weighted 49 percent to Asia, 18 percent to Latin America, 14 percent to Africa and 12 percent to Eastern Europe. We caught up with Mayo on his recent visit to New York.

Registered Rep.: What is your take on China now?

Julian Mayo: China is not about to stop growing. One feature of the Chinese economy that's still underappreciated is that each year almost 10 million people — a number equal to about one-third the workforce of the United Kingdom — are being let go by the state-run sector and driven into the private economy. That means the Chinese economy is going to remain competitive a lot longer than people think, simply because of the deflationary impact of these millions on the workforce. China's January and February industrial production numbers were up about 19 percent year-on-year, and that's been pushing input costs higher. Given that pricing power, you generally want to be closer to the producer than to the consumer.

RR: Where else are you putting your money?

JM: A lot of the companies we have in our emerging-markets portfolios are investors in China or buy things from China or sell things to China or do all three. One way to play China is through Russia, where Norilsk Nickel is a name that we have held off and on. In Latin America, you have the Brazilian iron ore company, Companhia Vale do Rio Doce, which just raised prices over 71 percent. Now, if you look at the production chain linking iron ore, steel, shipbuilding and the shipping lines, we believe the outlook for the shipping lines at the end of the chain is pretty bleak. The companies not to be investing in at this moment are the Maersks [units of AP Moller-Maersk]. But that iron ore price hike is being happily borne by some of the steel producers we invest in, who are saying they can pass it on to their customers.

That brings me back to Korea. Dongkuk Steel is the second-largest steel company in Korea and one of my favorite emerging-market stocks. Its major customers are the Korean shipbuilders, who recently achieved a record backlog of four years of orders. Even though iron ore producers get their price hike, Dongkuk can pass on every penny of the increase since shipbuilding demand is so strong. And those backlog numbers don't even include the recent ExxonMobil deal — a $10 billion variable cost order for LNG [liquefied natural gas] tankers. Dongkuk shares are trading under five times earnings and offer a solid dividend payout of about 5 percent.

RR: You mentioned Russia. Isn't that a bit precarious? Look what happened to Yukos. What are the risks?

JM: While we're very wary of political risk, the Russian economy has been growing 7 percent per annum for the past couple of years, there's a very strong current account surplus, government debt is being repaid very rapidly and the ruble, once a worry, is anything but on the upside. The government has been selling rubles and buying dollars. The only problem Russia has at the moment is a small amount of inflation, but it's a high single-digit amount, which is not bad for an emerging country.

In Russia, we're heavily invested in VimpelCom, the second-largest mobile-phone company. The story here is that mobile telephony take-up in Russia lags those of most other emerging markets with comparable income levels. We've analyzed the penetration rate take-up patterns. Last year we saw a very strong increase in penetration rates and expect another strong increase this year. In our view, we'll see top-line increases of 25 percent to 30 percent and 30 percent-plus profits increases.

RR: What are you finding in Latin America?

JM: In Mexico, the consumer sector is providing strong growth. Consumers aren't yet leveraged in the same way as they are in the states, and the savings rate is still very high. Plus, there's a shortage of homes. In recent months, the government policy about home-building has changed, making it easier to buy up land and develop property. Urbi Desarrollos Urbanos is a leading home-builder that is a major beneficiary of Mexico's newly liberalized policy. It's a name we like. The stock is trading about 11 times this year's earnings, and we're expecting 25 percent to 30 percent growth going forward.

RR: Can you summarize the case for investing in emerging markets?

JM: In one word: competition. You have to remember that, even though the guys running Hungary are former socialists, they want to be invited to sit at the top table in Brussels. The worst thing for Hungary would be to get invited to Brussels second in line after the Czech Republic. If you're a member of the Hungarian elite you know what you have to do. Get your deficits down. Get inflation down. And keep economic growth strong in a way that does not suck in imports and hurt your current account.

RR: How would you characterize your investing strategy?

JM: We aim to exploit inefficiencies. Volatility is higher in emerging markets and, therefore, the ability of a stockpicker to exploit inefficiencies is greater. Focus for us is very important; we concentrate our firepower on our best ideas and have less than 50 stocks in our portfolios. Our nuts and bolts is stock analysis. We meet management of every single company at least four times a year, generally on the ground. OTP Bank encapsulates what we're all about. It's the dominant Hungarian savings bank, with 60 percent of home mortgages. In general, banking-sector growth is a key driver in emerging markets, where typically the banking industry share of GDP is relatively low; in Hungary it's about 40 percent, whereas in the rest of Europe its about 110 percent. We expect to see those numbers converge. With Hungary joining the EU last May, a number of good things are happening. Wage rates are rising and interest rates are coming down. It all comes back to competition. The new EU entrants need to rein in fiscal spending to keep inflation down and that, in turn, means the markets will reward them with better credit ratings and lower interest rates. Over the past five years, eastern European bond yields came down to about 6 percent from about 12 percent. Now, OTP benefits from both consumption growth and lower rates, which cuts their funding costs and improves margins. So OTP is in a real sweet spot, as it gets both top-line and bottom-line growth. We see earnings growing 25 percent to 30 percent with shares trading about 10 times. So it's a very good story. And OTP shares still trade at a small discount to European banks, even with double the earnings growth.

RR: Aren't emerging-markets valuations getting a little bit ahead of themselves?

JM: The sector has had a good run the past couple of years, and some people are getting wary. But it was only last month that the MSCI Emerging Market Index exceeded the level reached in 1994. So there's no bubble in emerging markets; none whatever. And the fundamentals are still very strong. International reserves held in emerging markets have risen fourfold the past decade, to $1.6 trillion from $400 billion. At the same time, gross external debt has basically gone sideways. If you graph them, the two lines crossed in 2003, and for the first time emerging-market reserves exceeded debt levels. That means you have a series of cash-rich countries.

Also, if you combine current accounts and foreign direct investment, there has been a very strong increase from the flattish situation of much of the 1990s to the very strong surpluses the past four or five years. When emerging-market current accounts swing into deficit, it means the currencies are too expensive. What happens then is that net foreign direct investment deteriorates rapidly; global companies stay away and domestic investors start putting their money into Switzerland or Treasury bills. Contrast that with where we are at the moment, where all the emerging-markets areas are operating with very healthy surpluses.

RR: Are you saying that given the fundamentals, valuations are still within reason?

JM: I am. If you compare emerging markets with developed markets, valuations are not stretched. Emerging markets grow GDP at twice or three times the pace of developed markets and, according to UBS, the average emerging-market stock trades at 9.3 times next year's earnings, as compared to 15.5 times for the average U.S. stock. That's a 30 percent discount. It strikes me as being perverse that when the economic situation of emerging markets is better than ever, such big discounts remain. That, to me, is the opportunity.

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