The market’s focus on risks to EM from slower Chinese growth creates opportunities for stock pickers

Emerging Markets have experienced a broad sell-off that has accelerated in recent days, fuelled by a combination of Chinese growth fears, weakening emerging market currencies, the prospect of higher US interest rates and sliding commodity prices. China has been at the centre of the storm, with a declining mainland ‘A-share’ market (to which we have no direct exposure in either our Global Emerging Market or China portfolios) and a weak PMI data release having repercussions for Chinese companies listed in the Hong Kong and the US and across broader equity markets. In dollar terms, the MSCI Emerging Markets (total return) Index is down around 25% from its April high and trading at levels last seen in 2011.

In general, we believe the market is overly focused on the perceived risks to China and EM in general.

For evidence of this, one need only look at the very negative scenario that valuations are pricing in. The average price to book ratio for stocks on the MSCI EM index is now less than 1.3x – a level not seen since early 2009, when emerging markets were still reeling from the impact of the Global Financial Crisis.

And if we look at individual companies, many are trading at levels where declining valuations mean that cash sitting on their balance sheets has become a significant proportion of their overall value. Within the small cap universe, China Distance Education (CDE), a US-listed Chinese firm that provides online vocational training courses, has cash worth almost 30% of its market cap, while among the large caps, Samsung Electronics has 32% and semiconductor supplier Mediatek is sitting on cash worth 40% of its market cap [1].

Our investment approach is always to look at underlying company fundamentals, and looking at the medium and long term growth prospects of the companies in our funds and the valuations they trade at, recent market declines appear to us as more of a buying opportunity than a reason to sell.

China Distance Education, mentioned above, is an established business with decent growth prospects and its substantial scale within its sector constitutes a meaningful barrier to entry. That business is currently trading at 11x earnings and pays an 8% dividend in dollars. We see a very positive sign in the fact that when the firm announced its results, its management also announced that it would be buying back shares. That’s a move we’ve seen from a number of companies, including Baidu, ‘the google of China’. We believe that this is an important signal that the management of some of these companies see value in their stock at these price points.

Elsewhere, we are positive on Tata Motors, the parent company of Jaguar Land Rover (JLR), which has been impacted by slowing sales in China – an important growth market for the company’s luxury vehicles. We continue to like the stock for its strong new model pipeline, including a new Jaguar SUV to follow the recently Launched Discovery sport and Jaguar XE. These models offer class-leading fuel efficiency thanks to JLR’s newly developed in-house engines.

The impact of these positive changes has in recent months been overwhelmed by concerns about the slowdown in China and how this is impacting this year’s volumes and margins. However, the valuation is now at a level – less than 7x price-to-earnings – that we believe indicates an excessive level of concern about China and fails to reflect the company’s longer term growth potential.

For emerging markets, many roads do lead to China and it is understandable that declines in the domestic stock market and this month’s adjustment in the RMB exchange rate have focused investors’ attention on what could go wrong, as China attempts to shift away from its investment-led growth model and increase levels of consumption. However, as stock pickers, we have to consider what is already priced into stocks. We believe that in recent months and weeks, the market has become disproportionately focused on risk rather than opportunity and that, while China faces challenges, there are reasons to be optimistic. China is home to innovative companies that are driving or benefiting from positive structural change and the structural shift to higher consumption creates opportunities for those companies with the services and products Chinese consumers demand. In our view, recent market volatility has created an opportunity to buy into companies geared into some compelling longer-term dynamics at attractive valuations.