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Are we getting too excited about emerging markets?

Investors in global emerging markets are expecting great things in 2013 and while UBS sees opportunities - especially in the 'little GEMS' - it also spots several flaws in this generalistic view.

What's powering emerging markets?

GEM equities had a decent 2012, returning 18.6% and outperforming their developed world counterparts. This sentiment has continued into 2013, with region experiencing strong inflows.

UBS believes now is the time for investors to rotate from well loved, over-owned parts of the market, which have bcome the 'harbour of high expectations'. Instead, the investment bank suggests investors take advantage of the 'cheap' exposure in the large markets of China, Russia, India and South Korea. 'These markets are the rare few (except India) that trade at a discount to the GEM Index, and low valuations provide some protection,' UBS says.

UBS also has a preference for some of the ‘little GEMs’ – Indonesia, Thailand and Peru as well as South Africa and Turkey.

The banks highlights the following six charts from its 'GEM Inc' research as it asks the question 'Are GEMs losing their sparkle.

We advocate investors rotate from well loved, over-owned parts of the market that have become a harbour of high expectations. Instead we take advantage of cheap exposure in large markets of China, Russia, India and South Korea. These markets are the rare few (except India) that trade at a discount to the GEM Index, and low valuations provide some protection. We also have a preference for some of the ‘little GEMs’ – Indonesia, Thailand and Peru as well as South Africa and Turkey. We are overweight Financials, Energy, Consumer Discretionary and Utilities. We continue to add defensive characteristics through Quality and Dividends styles.

Emerging market equities have boomed over the last year, outperforming the developed world and they still attract inflows - but will this continue to be the case? UBS' global investment research team don't think it will - they attribute the increase in attractiveness primarily to P/E expansion after two years of stagnant growth across the emerging markets, and say that this won't last indefinitely.

Using a fictional firm, 'GEM Inc', the UBS team ask if global emerging markets are losing their sparkle?

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What's powering emerging markets?

GEM equities had a decent 2012, returning 18.6% and outperforming their developed world counterparts. This sentiment has continued into 2013, with region experiencing strong inflows.

UBS believes now is the time for investors to rotate from well loved, over-owned parts of the market, which have bcome the 'harbour of high expectations'. Instead, the investment bank suggests investors take advantage of the 'cheap' exposure in the large markets of China, Russia, India and South Korea. 'These markets are the rare few (except India) that trade at a discount to the GEM Index, and low valuations provide some protection,' UBS says.

UBS also has a preference for some of the ‘little GEMs’ – Indonesia, Thailand and Peru as well as South Africa and Turkey.

The banks highlights the following six charts from its 'GEM Inc' research as it asks the question 'Are GEMs losing their sparkle.

We advocate investors rotate from well loved, over-owned parts of the market that have become a harbour of high expectations. Instead we take advantage of cheap exposure in large markets of China, Russia, India and South Korea. These markets are the rare few (except India) that trade at a discount to the GEM Index, and low valuations provide some protection. We also have a preference for some of the ‘little GEMs’ – Indonesia, Thailand and Peru as well as South Africa and Turkey. We are overweight Financials, Energy, Consumer Discretionary and Utilities. We continue to add defensive characteristics through Quality and Dividends styles.

Emerging market equities have boomed over the last year, outperforming the developed world and they still attract inflows - but will this continue to be the case? UBS' global investment research team don't think it will - they attribute the increase in attractiveness primarily to P/E expansion after two years of stagnant growth across the emerging markets, and say that this won't last indefinitely.

Using a fictional firm, 'GEM Inc', the UBS team ask if global emerging markets are losing their sparkle?

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Inflated earnings expectations

UBS points out P/E expansion has been almost exclusively responsible for driving these returns after two years of stagnant earnings growth across the emerging markets.

This cannot continue indefinitely and we believe earnings will have to play a bigger role in 2013. Consensus earnings expectations look too high, assuming a rebound to 13-14% growth this year. In our own UBS GEM Inc, expectations for our non-financials universe are even higher at 20.9% growth.

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The role of profit margins

This graph highlights how GEM profit margins have been in decline since 2005 because of lower global GDP growth and lower commodity prices, in what has become a worrying trend. Last year the GEM Inc net profit margin made a new low of 7.8% -lower than the 2008 nadir of 7.9%

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Depressed sectors

Profit margins are particularly depressed in the capital-intensive resources sectors of energy and materials as well as telecoms. UBS says for GEM profit margins to expand, they must rebound in these sectors in particular. It pointed out other sectors already have little room for further margin expansion, given that they are already at decade highs in many sectors, including healthcare, consumer discretionary and consumer staples.

'Without strong improvement in GDP growth or another super-cycle in commodity prices we believe it could be very difficult for margins in aggregate to expand sufficiently to drive double digit earnings growth,' UBS explains

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A ‘wake-up’ call

UBS says another way to boost emerging market equity returns would be through stricter capital discipline.

'GEM Inc has continued to invest for growth and has not yet adjusted to the realities of today’s lower global growth environment. GEM Inc’s capex was twice its depreciation last year, close to record highs. At the same time its return on investment (ROIC) remains well below the pre-crisis level. In spite of these lower returns, capex budgets continue to grow. This is having an adverse effect on GEM Inc’s ROE, which has fallen in all from 18.2% in 2004 to 12.3% in 2012,' UBS says.

'GEM Inc is also under-levered and can use its balance sheet more efficiently. Management could reduce cost of capital and increase ROE through cheaper debt financing while paying out excess retained earnings that many companies have been hoarding as defence against volatile capital markets.

'We should like to see GEM Inc increase its payout ratio in line with the developed world and return more cash to shareholders. Dividends historically have made up a third of GEM total returns and remain very important in a world of low capital gains and high volatility. A higher dividend payout would support ROE and lift GEM equity valuations.

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The best payout potential

GEM Inc highlights the health care, consumers, technology and telecoms sectors as having a wide spread of free cash flow yield (FCF) over dividend yield, indicating the potential to lift payouts.

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