Forbes - Emerging Markets Investments 1o5k3q

Forbes International

INVESTMENT

REPORT

Special Feature

6

Emerging Markets Investments for the LONG RUN

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merging market stocks have had a rough ride since the start of the year. After a 36% gain in 2007, Morgan Stanley Capital International’s Emerging Markets index is off 27% since the beginning of 2008. But these numbers don’t tell the whole story. Individual stock markets in emerging countries don’t move in lockstep. While China and India have both lost more than 30% this year, some smaller markets like Colombia and Israel are actually in positive territory. And more than a dozen emerging markets, ranging from Qatar to the Czech Republic, have outperformed the U.S. on a relative basis in the most recent downturn. With this sort of volatility rearing its ugly head, many investors are starting to bail out of emerging markets. For longterm investors, this is a big mistake. It’s often said that the four most dangerous words in investing are “this time it’s different.” Anyone who bought Chinese stocks at their peak last fall is learning that lesson the hard way. So I’m not going to tell you that things are different this time. Emerging markets are still a risky investment class, as Russia’s war with Georgia reminds us all too well. But the case for investing in these countries remains compelling, and the recent pullback is a great opportunity to start looking for bargains again. For starters, emerging markets continue to offer a rare combination of growth and value. Usually investors need to choose between one or the other. But the beauty of emerging markets is that you can have your cake and eat it too. If you’re a value investor, emerging markets are hard to resist. Emerging markets are now selling for about 11 times next year’s earnings forecasts. That compares to a price-earnings multiple of 16 for the U.S. market. If growth is your thing, emerging markets look just as tempting. The International Monetary Fund expects the gross domestic product of emerging markets to grow at a 6% clip in the next five years, or twice the developed world’s pace. According to consensus forecasts, that will help drive 15% to 20% growth in corporate profits in emerging markets. It’s not uncommon to find high-quality emerging markets firms that are delivering sales and earnings growth of 50% or more on a regular basis. A second reason to be optimistic is that the economic funda-

$35,000 $30,000

mentals in emerging markets are the strongest they have been in years. After being tested under fire in the Mexican peso crisis in 1994, the Asian meltdown starting in 1997, and the 1998 Russian debt default, these markets are in fighting shape, even though commodity prices have softened of late. In many cases, current and budget surpluses have replaced deficits, interest rates are low, and inflation is under control. Third—and perhaps best of all—there are more world-class companies to choose from in emerging markets than ever before. There are more than 300 developing market companies with market caps in excess of $1 billion, versus just two dozen or so back in the 1980s, according to Antoine Van Agtmael, the money manager who first coined the term “emerging markets” in 1981. In his excellent book, Emerging Markets Century, Van Agtmael notes that companies such as Korea’s Samsung Electronics, Mexico’s Cemex and India’s Infosys Technologies, represent a new generation of blue-chips. Despite their emerging market roots, these are truly global companies. Above all, it’s important to keep things in perspective. All investing, whether it takes place in Boston or Bangladesh, is based on a fundamental trade-off between risk and reward. There is no such thing as a free lunch. If you want to enjoy the 30%+ returns that emerging markets have delivered, you must be willing to stomach a few nasty corrections like the one we’ve seen this year. The good news is that over the long haul, investors have been well paid for taking that risk (see chart), but not if you bail out at the first sign of trouble. Emerging markets now for about half of the world’s economic output and more than 80% of its population. And yet, stock markets in the emerging world still for less than 15% of the total global market capitalization. There is a lot of upside left before these markets reflect their true contribution to the global economy. Bottom line: Don’t give up on emerging markets just because we’ve seen some volatility this year. But you do need to pick stocks carefully. This special report features 6 emerging market investments from Forbes International Investment Report model portfolios that I believe will be long-term winners despite the market’s short-term pessimism.

Growth of a $10,000 Investment in Emerging Markets over 5 Years

$25,000 $20,000 $15,000 $10,000 $5,000

N

Au

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3 ov -0 Fe 3 b0 M 4 ay -0 Au 4 g0 N 4 ov -0 Fe 4 b0 M 5 ay -0 Au 5 g0 N 5 ov -0 Fe 5 b0 M 6 ay -0 Au 6 g0 N 6 ov -0 Fe 6 b0 M 7 ay -0 Au 7 g0 N 7 ov -0 Fe 7 b0 M 8 ay -0 Au 8 g08

$0

Data source: MSCI Barra.

1

Net Serviços de Comunicação Brazil, Cable Television

BUY

Brazil’s Net Serviços de Comunicação (nasdaq: NETC) is the Net Servicos (NASDAQ: NETC, $10) largest cable television company in Latin America, reaching 2.5 million subscribers and 1.4 million broadband Internet customers. The company has a 46% market share in cable television and 15% share in broadband. But NETC has barely even scratched the surface. Less than 10% of Brazil’s 190 million population has access to cable television, and the so-called “triple play” bundles of internet, telephone and cable TV services that are common in the U.S. are just now becoming affordable for many Brazilian consumers. Net Serviços is an early pioneer in this area. Last year, NETC reported full-year revenue growth of 29% to $1.5 billion on strong subscriber growth. The company’s cable television subscriber base grew 16% in 2007, and its broadband subscriber base surged 65%. EBITDA (earnings before interest, taxes, depreciation and amortization) grew 26% to $410 million. NETC should continue to benefit as the penetration rate of cable television and broadband services rises in Brazil. Plus, there’s also room to get its existing customers to spend more. Many of the services that have driven revenue growth for developed market cable operators are just getting started in Brazil. For example, High Definition (HD) services are still in their infancy. Source: Prophet.net As demand for these services catches on, as it has in more mature markets, NETC should be a prime beneficiary.

HDFC Bank India, Banking

BUY

While India’s technology outsourcing boom has been well HDFC Bank (NYSE: HDB, $92) chronicled, its banking sector has gotten considerably less attention. This is unfortunate, because banks offer one of the best ways to tap into the growth of India’s booming middle class. HDFC Bank (nyse: HDB) is the country’s leading mortgage lender. It also offers credit cards, auto loans, and investment products, which will all be in demand as India’s middle class continues to grow. Retail lending s for more than half of the bank’s lending portfolio and that proportion is rising. The real attraction is HDB’s strength in home lending, which the bank pioneered in the Indian market. The potential for growth here is simply enormous. Consider mortgage balances as a proportion of GDP. At a mere 3%, India has one of lowest mortgage penetration rates in the world. Granted, it will take a very long time for India to catch up to the 50%+ threshold that is the norm in the U.S. and Europe, but there’s no reason India can’t quickly close the gap with a market like Thailand, where mortgages are 9% of GDP. HDFC reported outstanding results in its latest quarter, which ended in June. Net revenues rose almost 50% compared to the same quarter a year ago. The bank’s net interest margin of 4% compares favorably to the banking industry standard of about 3%. Non-performing loans were a scant 0.5% of customer Source: Prophet.net assets. The bank currently operates 1,229 branches in 444 cities in India. Short-term, HDFC will remain vulnerable to volatility in emerging market stocks and general concerns about the financial services sector worldwide. But if you believe in India’s massive growth potential and the development of its middle class, HDFC is an essential long-term emerging markets holding.

2

BUY

T. Rowe Price Africa & Middle East Fund Middle East & Africa, mutual fund In the past year, there has been a surge of interest in so-called frontier markets. The T. Rowe Price Africa & Middle East Fund (ticker symbol: TRAMX) is one of the few actively managed mutual funds that invests in this exciting new asset class. Launched in September 2007, the fund has a broad mandate to invest throughout Africa and the Middle East. The fund owns stocks in countries ranging from Nigeria and South Africa to oil-rich Gulf states such as Qatar and the United Arab Emirates. The $650 million fund (assets) is run out of London by Chris Alderson and a team of some of the most experienced emerging market fund managers and analysts in the business. One of the biggest arguments in favor of investing in frontier markets is their lack of correlation with the rest of the world. While Middle Eastern and African stocks may move in tandem with other global markets in the short run, over longer periods the correlation of the Middle East to the S&P 500 has been less than 10%, whereas global emerging markets are about 70% correlated with the S&P 500. A second argument is valuation. It is not uncommon to find high-quality companies in the Middle East and Africa selling at multiples of 10 to 12 times earnings, depsite excellent long-term growth prospects.

Philippine Long Distance Telecom Philippines, telecom

T. Rowe Africa and M.E. (TRAMX, $11)

Source: Prophet.net

BUY

If China is Asia’s ultimate growth story, the Philippines must surely qualify as the region’s biggest turnaround story. Long plagued by political instability and disastrous economic policies, the Philippines is finally getting its act together. President Gloria Macapagal Arroyo, an economist by training, has taken a series of bold steps to overhaul the country’s economy since her election in 2004. By closing egregious tax loopholes and introducing a sales tax, Arroyo has helped bolster the country’s finances. Economists expect GDP growth of nearly 7% this year and foreign investment capital is pouring into the country. Inflation is well below 3% and the country is running a current surplus of close to 6% of GDP. Once considered the “sick man of Asia”, the Philippines now looks surprisingly robust. Philippines Long Distance Telecom (nyse: PHI), which trades on the New York Stock Exchange, is one of the easiest ways for investors to get broad exposure to the local economy. But don’t be thrown off by the “long distance” part of the name. The company provides a full range of telecom services, and is Philippine Long Distance (NYSE: PHI, $57) the leading provider of wireless telecom services in the Philippines with nearly a 60% market share. Its mobile subsidiary Smart Communications has nearly 30 million mobile subscribers. At a recent $57, PHI is trading at 11 times estimated 2009 earnings and less than 7 times EBITDA. Investors in PHI also enjoy a dividend yield of more than 5% as an added bonus. Wireless penetration rates in the Philippines are among the lowest in Asia, suggesting considerable room for future growth before the market becomes saturated. Roughly half of the Philippine population owns a mobile phone, compared with penetration levels of more than 90% in countries like Singapore and South Korea. There’s an even bigger opportunity for PHI’s broadband business, which s for just 5% of the company’s revenue at the moment. PHI has just 500,000 broadband customers, in a nation of 90 million people. Source: Prophet.net

3

Wimm-Bill-Dann Foods Russia, Food and Dairy Products

BUY

Winston Churchill’s famous description of Russia as a “riddle, wrapped in a mystery, inside an enigma” rings hauntingly true today. The events in Georgia are a grim reminder that political risk cannot be ignored when investing in emerging markets. But as risky as Russia may seem in this respect, investors have been rewarded for accepting those risks. In the past ten years, Russian stocks have risen more than 1,000%. Obviously it wasn’t something to bet your life savings on, but for a small part of your portfolio it was worth taking a calculated risk. There is no question that Russia can be a difficult, indeed dangerous, place to do business. And the situation in Georgia is heartbreaking from a humanitarian and diplomatic perspective. But those are not reasons to avoid all Russian stocks. Investors who focus only on the bad news coming out of Russia are missing out on some high-quality companies with excellent growth opportunities. Wimm-Bill-Dann Foods (nyse: WBD) is a case in point. In report in March, the Boston Consulting Group a research Wimm-Bill-Dann (NYSE: WBD, $xx) named Wimm-Bill-Dann Foods (nyse: WBD) as one of just three Russian companies on an exclusive list of “Local Dynamos.” BCG’s list includes emerging market companies with a dominant presence in their respective markets, and a history of successfully competing head-to-head against much bigger multinational rivals. WBD is Russia’s largest food and beverage company. It has a whopping 76% market share for dairy products like milk and yogurt. It is the #3 player in beverages, mainly fruit juices, and it has the #1 market share for baby food in Russia. In developed markets, selling baby food and fruit juice is a mature, if not mundane business. But in Russia, these can still be considered relatively attractive growth opportunities. Last year, WBD’s full-year revenue rose 38% to $2.4 billion. EBITDA, also up 38%, came in at $301 million. Net income for the year was $140 million, a 29% increase. The momentum Source: Prophet.net continued into the first quarter of 2008, with revenue up 35%, driven by a +67% surge in baby food sales. Despite good fundamental performance, shares of WBD are off nearly 50% since January. Concerns about high prices for milk, WBD’s most important ingredient, and the conflict in Georgia have weighed heavily on the stock. While I can’t predict commodity prices, and I certainly can’t predict what the Kremlin will do next, I’m pretty confident that demand for WBD’s products will remain strong for many years to come. It’s not often that you find a company delivering nearly 40% growth in a low-tech business like baby food. In my mind, the long run opportunity in WBD outweighs the short-term panic over Georgia.

Cellcom Israel Israel, Mobile Communications

BUY

As is the case with most countries in the Middle East, Israel rarely comes up in discussions of global “safe havens.” But so far this year, Israel has been a pretty good place to hide from Wall Street’s woes. Israel is one of the few markets in the world that is in positive territory since the start of the year. Israel is also a unique case in the sense that it straddles the increasingly hazy line between “developed” and “emerging” markets. The world according to MSCI—the mavens who calculate the most widely used set of global indexes—says that Israel is an emerging market, although it is being considered for an upgrade, possibly next year. Rival index provider FTSE takes a somewhat more enlightened view, putting Israel in the developed market column, but that decision was made only last year. Whatever the index purveyors may say, it’s clear that a nation with nearly $30,000 per-capita GDP and dozens of world-class technology firms doesn’t quite belong in the same bucket as Sri Lanka or Colombia. , this is the same place where Warren Buffett made one of his biggest foreign acquisitions, the $4 billion purchase of Iscar Metalworking. Investors like Buffett know that labels like “emerging” or “developed” should never stand in the way of a great opportunity. Putting stereotypes about risk aside, Israel offers a lot of interesting opportunities, even for fairly conservative investors. Cellcom Israel (nyse: CEL) is a prime example. The company is Israel’s largest mobile phone service provider, with sales of $1.6 billion in 2007. Since February 2007, the company has had a dual listing on both the New York and Tel Aviv stock exchanges. Discount Investment Corp. Ltd., one of Israel’s largest business groups, owns just over 50% of the company. With 3.1 million subscribers, Cellcom has a 34% share of Israel’s mobile telecom services market. Roughly three-quarters of Cellcom’s subscribers are individuals, and the remaining 25% are corporate customers. Israel’s mobile

4

telecom market is fairly well developed, with a penetration rate almost 125%. In other words, there are more than 9 million mobile phone s for a population of 7.2 million people. Furthermore, spending on telecom services in Israel s for 4.4% of GDP. That’s a higher proportion than even the U.S. and Europe. But here’s the strange part. Despite the relative maturity of the industry, Israeli mobile phone s spend the bulk of their money on “voice” services, or plain old phone calls.Value-added content (more expensive stuff like messaging, e-mail, ringtones, etc.) s for less than 10% of Cellcom’s revenue. In Europe, the norm is closer to 20%. As a result, Cellcom’s Average Revenue Per (ARPU) runs about $40 per month versus more than $50 in European markets with similar levels of mobile phone usage. Part of this is due to Cellcom’s history as a low-cost alternative to other carries. Cellcom was also somewhat late in rolling out these servSource: Prophet.net ices. But that’s changing. Cellcom’s content-related revenue surged nearly 50% last year, albeit from a low base. This was in part due to a marketing strategy that draws heavily on Cellcom’s position as the leading provider of music-related content. With EBITDA of $550 million in 2007— a 35% margin— Cellcom throws off tons of cash. It has also done a good job keeping expenses under control. And at less than 12 times earnings, and less than 8 times EBITDA, the valuation looks very reasonable.

Cellcom Israel (NYSE: CEL, $13)

Forbes International Investment Report Published monthly by Forbes Inc. 60 Fifth Avenue, New York, NY 10011 Copyright 2007 by Forbes Inc. Editor: John H. Christy III, CFA Forbes Newsletter Group Vice President and Editor: Matthew Schifrin To subscribe on the Web visit Forbes.com Investment Newsletters ( www.forbesnewsletters.com) or call 1-877-733-7876. Editorial e-mail: [email protected] Forbes International Investment Report is not a market timing service nor an actual portfolio. Our model portfolios are shown purely for informational purposes and do not constitute personalized investment

advice. There is no guarantee that companies mentioned in this newsletter will produce profits or that they will equal past performance. Although all content is derived from sources and data believed to be reliable, accuracy cannot be guaranteed. Price data is provided for reference purposes only. Some stocks, especially those that trade over-the-counter, may trade at wider than average bidask spreads due to limited liquidity. Prices shown herein reflect the best available information at the time of publication, but their accuracy cannot be guaranteed. of the staff of Forbes International Investment Report and their families may hold positions in some or all of the stocks listed and discussed in this publication.

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