An Interview With Arjun Divecha: Choosing The Right Emerging Market.
By Lawrence C. Strauss, Barron's | 27 July 2009
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Barron's: Let's start with your macro view of the emerging markets.
Divecha: I look at countries around the world as a spectrum. At one end are the countries for whom this is a secular crisis, such as the U.S., the U.K. and Spain, where there are going to be massive changes in the financial sector, and maybe in other parts of the economy, due to the current crisis. On the other end of the spectrum are a lot of emerging markets for whom this is really a very bad cyclical crisis, as opposed to a structural crisis. So the emerging markets got hit badly last year for two reasons, one being their dependence on exports. No. 2, a lot of them had become reliant on cheap foreign capital, which came out of the credit boom.
Just how much have emerging markets decoupled from developed markets?
I think of each of these emerging-market countries as being like a boat with two engines, one for exports and the other for domestic consumption. So when people talk about decoupling, they need to think about each of these separately. Clearly, the export engine cannot decouple. But the second part, the domestic-consumption engine, has been stimulated, and the stimulus in a lot of these countries has worked exactly as you would expect it to work. Consumers, because they were not overleveraged, can in fact borrow. So in places like Brazil, where interest rates have come down from 15% to around 9½%, car sales hit an all-time record.
What's driving these changes in Brazil and other markets?
There is a massive amount of latent demand in Brazil from people who love to buy cars. What has kept them from doing it has been, effectively, the cost of ownership. So the stimulus, a combination of an increase in government spending and lower interest rates, is actually working the way that you would expect it to.
The other thing that has changed in the past 10 or 15 years has been the demographics; there are a lot more younger people in the workforce now. And as a result, the savings rates in most of these countries have gone up quite a lot. So in India, for example, the savings rate 10 or 15 years ago was 8% or 10% of gross domestic product; today, it is over 30%.
…Which contrasts markedly with the U.S. and Europe, where the populations are aging?
That's correct. But it is more important for these countries, because they need to invest. In order to develop, India needs investment. So 10 years ago, it would have had to rely on foreign capital. Today, with a 30%-plus savings rate, India is not as reliant on foreign capital as it was.
What are some of the major changes you've seen in emerging-markets investing over your career?
The main thing in emerging markets is that getting the country right matters more than anything else. If you can pick sectors and stocks in the developed markets, that is what really matters. But in emerging markets, if you don't get the country right, it becomes much, much harder to add value.
In what countries do you see the best opportunities?
The countries that we are most positive on are actually ones we think will have the biggest recovery from the bottom. Our favorite four are Turkey, Russia, South Korea and Thailand. Some of our less favorite countries where we are underweight are China, South Africa and India. China and India have recovered a lot. Their stock markets have gone up a lot this year, and are much more expensive than other markets. And given that we are primarily value investors, we look for cheapest above everything else. Countries like Turkey and Russia are very cheap in terms of stock valuations.
When we spoke earlier this month, you mentioned that you were bullish on China short term, but much less so over the long term. Is that still the case?
I've changed my mind since we last spoke. We are negative on China short term as well. The reason is that the stimulus package there has been absolutely massive. As a percentage of GDP, it is three or four times the size of the U.S. stimulus. In this year alone, they've had new loans worth over $1 trillion, of which more than $250 billion was issued in June. It is massive.
What's your biggest concern about that?
I believe that a lot of this money is not going into productive investment. What we are hearing anecdotally is that a lot is being lent by the banks, which, remember, are government-owned. Who are they lending to? For the most part, this money is going to state-owned enterprises, which are not particularly efficient companies.
We know that they are buying real estate, and they are doing all kinds of things that we don't think in the long run is particularly productive investment. Now, in the short run, the stimulus works, because it puts money in the hands of people who are buying and consuming stuff. So therefore, car sales in China hit an all-time record last month.
What will be the consequences in China?
Two things are likely to happen. First, longer term, if the banks don't have a problem with bad loans now, they will almost certainly have a lot more bad loans two or three years from now. Second, from a short-term point of view, at some point the government is going to get really worried about having too much credit-creation; that leads to a credit bubble, just like you had in this country and everywhere else. As a result, they will start to withdraw liquidity by tightening the gates on money. I don't know when that will be. But I worry that it is coming.
A fair amount of the stimulus money has found its way into the real-estate and stock markets because China has a closed economy. So there is no way for money to leave the country. The stock market and real estate have had huge spikes. So when that liquidity is withdrawn, it seems inevitable that the stock market will take it badly.
What gives you pause about Brazil, which isn't at the top of your list?
It doesn't give us a lot of pause, and we are not negative on Brazil. It is just that other countries have become much cheaper. We still like the story there. We still think that the government has a lot of room to stimulate in Brazil, because interest rates at 9½% are still very, very high relative to inflation, which is about 2½%. So the ability to stimulate, if they need to, is absolutely massive.
Which emerging markets are you avoiding?
We are very wary about Eastern Europe, which, in many ways, resembles Asia during the crisis of '97. A lot of the Eastern European countries have too much debt denominated in foreign currencies. So if you have a problem with the currency, which they have, your debt suddenly balloons— because you have to pay it off in the foreign currency. [He's neutral on South Africa in part because of worries about its current-account deficit.]
Why is Turkey one of your top countries? Does it's not being in the European Union hinder its prospects at all?
I don't think anybody expects that is going to happen any time soon, although it may happen in 20 years. But quite frankly, they already have what I consider to be the most important part of access to the EU. They have a customs union, which basically allows them to ship exports with a zero tax rate.
What specifically do you like about the country's prospects?
Primarily, the Turkish stock market is as cheap as we have ever seen it, trading at seven or eight times forward earnings. We have increased our exposure to the banks there, because they tend to be the most highly leveraged part of the economy. So if the economy is going to recover, the banks tend to do the best in that kind of a scenario. And in most emerging markets, you don't have banks that lent too much money— whereas in the U.S. and the developed markets, one should be wary about the banks.
Is there anything else in particular that recommends Turkey as an investment opportunity?
At the end of the day, cheapness is what matters more. What you pay for something is the most important thing of all. If you can buy something really, really cheap, you are going to make more money on that than buying something that is really good. So Turkey is pretty well-positioned, because No. 1, unlike a lot of other countries, they are used to having crises. They have crises with great regularity. So they know how to get out of crises very well. And they definitely have done a pretty good job of being very competitive in various sectors like textiles, machinery, and auto parts.
Turning to Russia, one of the biggest concerns about investing there is corruption. What's your read on that country?
Everything that everybody says about Russia is true— that the corruption problems are really terrible. But at the end of the day, when you really get down to it, Russia is an oil play. It is really an energy play. And then really, it's about: What are you paying for that energy?
To give you a comparison, ExxonMobil (XOM) has a market value of about $345 billion, versus about $40 billion for Lukoil (LKOH.Russia). One of my favorite sayings is that you make more money when things go from truly awful to merely bad than when they go from good to great. Russia is [a place] where the situation is not particularly good. The economy is actually in pretty bad shape right now. But it is a question of being able to buy at a very, very low valuation, in this case six or seven times forward earnings.
Why do you think South Korea is a good investment opportunity?
Again, valuation is very cheap, under 10 times earnings. The most interesting thing about Korea is that the won has fallen 43% from its peak against the yen, and it has fallen 36% against the Chinese yuan. So relative to the two biggest competitors they have for exports, their currency has fallen massively, improving their competitiveness dramatically. As soon as you get any kind of a recovery in global exports, the Koreans are very well placed.
What about Thailand?
It's very, very cheap, trading at less than 10 times earnings. Part of the reason why Thailand is so cheap is because the politics there have been really quite awful for the last couple of years. You had the coup, among other turmoil. Our reading is that the politics is getting better, although I don't think it is reflected in the stock market.
How do the prospects for emerging markets look?
Longer term, we are quite bullish. The only issue is that we've had such a huge rally in the last four or five months. And one has to worry about a pullback, although I'm not predicting one. Still, I'm pretty sure that you are going to get good growth out of a lot of these countries. It is hard to make that case for a lot of the developed markets. It may happen, but the case is easier to make for emerging markets.
What are your biggest concerns about the emerging markets?
Things like protectionism coming out of the West. If the crisis was to get worse in the U.S. and in the developed markets, and that brought about a legislative or governmental response for greater protectionism and you start some kind of a trade war, that would clearly be very bad for emerging markets. And it certainly would be worse for the emerging markets than the developed markets.
Thanks, Arjun.
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