“If you remember the Andean Pact in Latin America was designed to keep investment out, not bring investment in. Then all these other countries had exchange controls, no developed stock market etc,” says Mobius. “So we had to start going from country to country, building up relationships, establishing custodial systems and so forth.”

Early on there were also no brokers and analysts who covered emerging markets. Only when emerging markets began to show significant growth, the brokerage community became more interested and started to attract other fund managers. 

For much of the past 20 years emerging markets have outperformed the developed markets of the US, Western Europe and Japan, a fact that attracted significant funds into these markets. 

Templeton and, after the acquisition by Franklin in 1993, Franklin Templeton never relied on broker research and had to add researchers to the firm all over the world and now maintains 17 offices globally with 82 professionals and 48 portfolio managers.

The economic success story of emerging markets is also reflected in the $54 billion size of Franklin Templeton’s emerging markets funds today.

But today the firm is no longer the only game in town, says Mobius. “When we started it was just us, and International Capital who had emerging market funds. Now there are hundreds and even hedge funds are getting involved in emerging markets.”

However, the real revolution during the past three decades, he adds, has taken place in communications.  

“I remember when I had my own business in Hong Kong 35 years ago we were using the telex, there were no faxes and to make a telephone call was damn expensive,” he reminisces with a laugh. 

“So we had to use call back systems, then there was the telex, then you had PCs and email. This is all in less than a lifetime.

“These days there are more people with cell phones than people with bank accounts. This is an amazing development. So you go to a place like Kenya and they are transferring money over the cell phone.”

This is just the beginning, he notes, and will lead to a lot of interesting, accelerated developments in these countries as a result of the communication revolution.

Supply and demand

For investors in emerging market stocks, the supply of IPOs and secondary offerings over the past 10 years has been an important factor. The share of emerging markets in new issues worldwide climbed from 10 per cent in 2001 to 50 per cent today.

2010 was in fact a record year with $450 billion raised in emerging markets and new funds raised in Chinese stocks surpassing the US for the first time. For an emerging market investor this development means more choice, says Mobius, but it follows also that more of an investor’s portfolio should be invested in emerging markets. 

The market capitalisation of emerging markets stocks represented about 8 per cent of the world in 1998 and 1999. Today this share has increased to 32 per cent.

Because most investors have anywhere between 3 and 8 per cent invested in emerging markets, individual and institutional investors are severely underweight in emerging markets, says Mobius, who advocates the allocation should be more in line with the 32 per cent share in terms of market capitalisation.

Growth, debt and inflation

The attraction of emerging markets can be summarised in one word, he says: growth.
This year emerging markets are expected to grow 5.9 per cent on average compared to 1.6 per cent GDP growth in the developed markets of the US, Japan and Western Europe.

China and India are the most exciting markets because both have a population of more than 1 billion people and both have economic growth exceeding 8 per cent this year.

At the same time emerging market countries have learned their lessons from the debt crises of the past, says Mobius. Since 2005 foreign reserves in emerging markets are larger than those in developed countries and debt levels in relation to the GDP have come down.While this is also an effect of GDP growth, debt levels are much lower than in developed countries.

Inflation has also come down dramatically in emerging markets since the late 1980s and early 90s and interest rates are generally lower, which of course is very good for businesses.

Share prices are neither at the high or low end of the valuations spectrum, if historic price earnings ratios and book values are anything to go by. The average PE ratio of 11 is higher than the 2008 low of 7 but still well off the 1998 high of 28. The current price/book value of 2 is right in the middle between the low of 0.9 and the high of 3.

“So we are still able to find a significant number of bargains,” Mobius says, although it is not as easy as it was during the subprime crisis in late 2008, when it was the best time to enter the market.

Outlook

The outlook for emerging markets is not easy to predict as stock markets tend to lead the economy, he notes, but one indicator that is often helpful is the purchasing managers’ index.

The survey among purchasing managers, who often have a very good idea of what their customers want, shows that an economic recovery has taken place since early 2009. It is also one of the factors that made a double-dip recession scenario one year ago very unlikely, says Mobius.

A second important indicator is the spread between emerging market debt interest rates and US treasuries. “If the difference is low, people are confident and willing to invest in emerging markets,” he explains. When the subprime crisis hit, money left the emerging markets quickly to seek refuge in US treasuries. However, this trend now has reversed again, Mobius points out.

Portfolio themes

Franklin Templeton’s investment strategy has not changed over the years and Mobius makes it very clear that “we don’t pick sectors or countries, we pick stocks”.

“We go after companies that are signed below what we believe is fair value over a five year time frame and that has not changed. But the scope of our work in terms of the number of companies that we cover and the number of countries and sectors has expanded.”

With this caveat in mind it is, however, still possible to identify two general themes in the portfolio. The first is a focus on consumer products and services, based on the belief that populations in emerging markets are bigger and that these markets are growing faster. 

While the GDP per capita in emerging markets is generally much lower, recent years have shown a considerable increase that is reflected in a rise of imports, which in addition to raw materials also includes consumer goods. 

“We believe that because per capita income is rising in these countries we should be exposed to consumers, whether it be cosmetics or consumer banking, which is a big area for us.“ 

The potential for growth is immense, Mobius says, in reference to statistics that show that China’s rural population is starting to buy consumer goods. 

At the same time the share of these products per household is still comparatively low as only 30 per cent of China’s rural households own a refrigerator, 50 per cent own a washing machine and computer sales have hardly taken off yet.

Meanwhile car sales in China have surpassed those in the US last year, although car ownership per household is still way behind the United States.

The second theme in Franklin Templeton’s portfolios, Mobius says, is commodities. 

Investors should expect a lot of volatility in commodities with corrections along the way, he believes, but the overall trend is up for copper, aluminium, platinum, palladium, nickel, gold, soybean, corn and sugar in addition to the oil and iron ore producers that Franklin Templeton is invested in.

Emerging markets not riskier

The notion that emerging markets are riskier than traditional developed markets is not justified at all, Mobius says, adding that risk, which, for lack of a better system, is defined as volatility by the investment community, is actually lower in diversified emerging markets portfolio than in a US, German or UK portfolio.

This is even more the case for frontier markets, a subset of emerging markets that are less well researched and typically less liquid.

The reason for this, according to Mobius, is that the diversity among emerging market and frontier market economies, say for example Nigeria, Vietnam and Saudi Arabia, is much more pronounced and therefore, when averaged out, results in a less volatile and less risky portfolio.

Mobius concedes that the layman’s understanding of risk is slightly different than volatility, in particular, given the political turmoil that can be witnessed in North Africa and the Middle East.

“This is the other side of risk,” he says, but adds: “Our experience has generally been when there is political turmoil, provided there is an underlying cultural political structure, we can still invest and do quite well. For example, during the turmoil in Thailand in the last few years we continued to invest and we did very well. Despite demonstrations, killings, burning buildings the market continued to function and the companies continued to function.”

The reason for the positive performance was that stocks were undervalued and could be bought at a low price. 

“Then there are cases like Venezuela, where as soon as Chavez got in, we were out.”

Mobius says in these scenarios he is mainly concerned with two issues: the likelihood of the confiscation of assets and the existence of exchange controls, which could prevent investors from taking money out of the country.

When considering risk from this perspective there are not that many risks in the markets where we are investing, he says, but a full analysis has to be carried out on an individual company basis.

Political turmoil can thus be an opportunity to invest, he says, particularly in Egypt. “We continue to look at that market and invest in some cases and we believe that down the road that development is going to be positive. It may take a few years for the turmoil to die down and a new system to be put in place, but generally speaking a more open, transparent society is good for us, because that is what we are all about.”

Developed markets on the other hand have their own unique risk factors, such as regulatory risk of being hauled into court in the US, he argues.

Challenges

This is not to say that emerging markets do not have their own internal problems and continuous strong growth rates are not automatically guaranteed by a large population.

Corruption, the rebalancing of the economy and a lack of education for the wider population are only some of the challenges that have to be overcome by countries like China and India in the future.  

These issues are even having an effect now, says Mobius and gives Tata Consultancy, an Indian outsourcing company Franklin Templeton carries in its portfolio, as an example. As the firm is beginning to run out of qualified employees, it is forced to expand globally, for instance in Poland.

“There is a growing realisation in India that they need to emphasise education,” he says. “And the private sector is aggressively moving in that direction, so they are setting up schools and so on.”  

In China the situation is similar. “So there is a heck of a lot of work to be done in these countries. But if you have a billion people who respect education highly you are going to get very educated people. There is a lot of talent there,” he argues. 

Mobius does not buy into the view, propagated in US media in recent months, that countries like China lack true innovation and only rely on copying the products conceived in developed economies.

“We used to think that about the Japanese many years ago in the 60s. Then you got Sony and all these other companies that were very innovative.”

Besides, nowadays everybody starts to build on what existed previously. “The Americans built on what the British achieved and copied what the British did during the industrial revolution.”

“Now the Japanese are saying the Chinese stole their technology for high speed trains, but the Chinese trains are way faster,” he says, laughing.

What you see now is the Chinese with a vast supply of engineers will study what they find and then they will improve it, he adds.  

“You see a lot of creativity in China and all the other emerging market countries.“ 

Risks 

Still, from an investor perspective there a number of risks that concern Mobius. 

First, the debt crisis in Europe and the US is a concern because it can have an impact globally. “Sovereign debt in the US, Japan and other developed countries is enormous and investors are now scared of some of the developed countries,” he says, quoting credit default swap rates that are higher for the sovereign debt of Greece than that of Argentina and CDS rates for Portugal and Spain that are higher than Russia’s and Brazil’s. Overall Western Europe CDS spreads are moving up whereas emerging market spreads are moving side-ways, he concludes.

The lack of true bank and financial system reform is another concern, says Mobius. “There have been cosmetic changes but no real reform.” Basel 3 has not really made banks safer and accounting rules have not changed and increased transparency, as banks still mark-to-model. At the same time “too big to fail” has not been resolved. In fact banks are even bigger now, because there are fewer of them, he says.

At 10 times the size of the global GDP, the $600 trillion derivatives market is also very risky for a lot of companies. “We always ask every company that we visit about the derivatives they have. And if they say we’ve only got plain vanilla we get very suspicious, because so many companies have gone bankrupt over these derivatives.”

In addition, the money supply and the policy of quantitative easing has flushed a lot of money into emerging markets and driven up prices.

“Generally speaking, if you are a stock investor, inflation is good,” says Mobius. “Companies do better in an inflationary environment because they can adjust, if you pick the right companies of course. “ Likewise, therefore a sudden contraction of money supply would be detrimental.

Asset bubbles?

Yet, Mobius is not concerned about asset bubbles that appear, for example, in Chinese infrastructure and construction projects. Are these investments really going to pay off?

“No,” replies Mobius. “But that’s OK because the Chinese government owns the banks.”

“That is a big difference compared to the West. You notice that they are already anticipating increased non-performing loans by having massive increases of their capital. The reason why the IPO and secondary issue market was so buoyant was to a great degree the Chinese raising more capital for their banks to be sure that when and if these non-performing loans rear their ugly heads they are well capitalised.”

If the situation gets too bad the government will just set up an asset management company for these assets and have an investment bank come in and sell it off, as they have done in the past, he suggests. 

Mobius acknowledges that there is a bubble, but it is not going to burst. 

In Shanghai, he says, he noticed beautiful high rise apartment buildings overlooking the Huangpu River that were half empty. “They are not selling. They have been empty for three years. They just hang on until the prices go up to what the sellers originally thought is a fair price.”

This is in fact similar to the Cayman Islands, he says. All the apartments along Seven Mile Beach are not going to be sold at heavily discounted prices, which is quite a different story from the US where people are highly leveraged, he notes.

While in some ways it is a waste of resources, that is the reality, Mobius says.

The best time to invest in emerging markets is “when you have money”, he concludes, quoting the company founder Sir John Templeton, because over time bear markets in emerging markets have lasted for a very short time and tended to recover quickly, whereas bull markets have lasted much longer.

In a bull and bear market comparison on a dollar cost averaging basis, investors are going to hit a lot more bull markets than bear markets, he says. 

Franklin Templeton’s regional manager for the Cayman Islands is:   

Christopher Lynch
Wholesaler – Americas
International Advisory Services Division
100 Fountain Parkway
Saint Petersburg, FL 33716

T:    (727) 299 4535
        (800) 233 9796 ext. 34535
E:    clynch@templeton.com
W:    templetonoffshore.com