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Solving the emerging market conundrum

When investing in emerging markets, which countries are the most attractive and which ones are best avoided? And, which is the best strategy to adopt – a direct and or indirect approach?

Historically, emerging markets have been seen as a risky investment and not without good reason. One only has to recall the Asian currency crisis of 1997, which rocked stock markets around the world, followed by Russia's loan default in 1998, Argentina defaulting on part of its external debt at the beginning of 2002 and the bursting of the real estate bubble in Dubai at the end of 2009.

However, as Gordon Grant Curtis, portfolio manager and executive director of CI Investments Family Office, points out, things can quickly change.

Just look at the dramatic turnaround of the Brazilian economy, which is now growing again at an annualised rate of 5%. The country's inflation rate of 4.2% is a far cry from its peak of 2,489% in 1993. Meanwhile, in 2009 it maintained a healthy trade surplus of $25.3 billion despite the global downturn and since 2008 its government bonds have been awarded investment grade status by the main credit rating agencies. Foreign direct investment rose by 30% in 2008 – a big vote of confidence in its future.

Emerging economies have benefited most from the commodities boom (leaving aside Canada and Australia) and, this boom could well continue to be of benefit to these countries for some time yet if Jim Rogers, a former partner of George Soros of the Quantum Fund, is correct. Back in 2006 he voiced the view that "If history is any guide, this bull market [in commodities] is going to last between 2014 and 2022 and everything is going much higher". Indeed, the long-term economic prospects for emerging markets are now generally accepted by the global investment community to be rosier than for most developed countries.

That said Curtis views some geographies as being off-limits. He is, for example, uncomfortable investing in Russia, citing the difficulty of enforcing common law principles there. In general he shies away from countries where corruption is rife and where political instability adversely impacts a country's economic drivers. In order to operate in a country there must be a stable business environment.

One country that does pass muster is Vietnam. Horst F Geicke, who established a manufacturing plant for his family business in the country before founding asset management, investment banking and real estate consulting firm VinaCapital, argues that the best approach is to invest in businesses that offer slow-but-steady growth based on meeting long-term demand trends.

He believes that Vietnam is an excellent example of a country, which although subject to great volatility over the past two years, still maintains very strong fundamentals for long-term growth. Vietnam has a very young population (50% under 30); high literacy and a trainable workforce; rich and diverse natural resources; political stability; and a rising middle-class that is rapidly becoming a brand-conscious mass consumer base. While one or more of these factors can change, together they point to substantial long-term growth in a pattern very similar to South Korea or Taiwan 20 years ago.

In a market like Vietnam, Geicke says that investors can find companies that are almost bound to see substantial growth over the long term. For example, Vietnam's consumption of dairy products sits at just 9kg per year compared to 24kg and 60kg for China and Europe, respectively. It is proven in countries around the world that people increase their consumption of dairy products as incomes rise. This is why VinaCapital invested in Vinamilk, Vietnam's top dairy firm. The company has strong management, the top brands and a nation-wide distribution chain. VinaCapital has seen a substantial investment return and still have a substantial holding in Vinamilk, five years after first investing in the firm.

However, Curtis' single family office investment mandate limits him to seeking direct investment opportunities over a much shorter timeframe. In essence he looks for unique situations, where projects or tangible assets lack the one or two essential ingredients to realise their true worth. When making such an investment Curtis says that it is important to know who wields power and to have government associates and partners on board.

One common investment theme revisited by CI Investments is the utility sector. According to Curtis the emerging middle class in Asia, Latin America and India increasingly see basic utility services, such as purified water, electricity, sewage and gas supply, as essential.

Here, Curtis believes that there is a psychological element. Once people have become middle class they will fight to maintain that status and there are political ramifications. He says that this backdrop provides attractive opportunities for direct investment.

In Ecuador, for example, electricity supply is the number one issue. The problem is so sensitive that governments can be forced out of office over it. One solution open to family offices is to build micro-power units. Key elements of an attractive deal involve setting up a local company as part of the grid infrastructure and then trading with a local utility company that buys electricity from you on attractive tariffs.

Another major problem in countries such as Peru and Argentina is the availability of potable water. Short of implementing reverse osmosis membranes, alternative water purification technology is relatively cheap to install. Curtis believes that this market opportunity in water is immense and not being fully exploited.

For Geicke, the decision whether to invest in a fund or make a direct investment into an emerging market is a very important one. He made his first direct investment into Vietnam 15 years ago, which at the time was very much a frontier market. Direct investment is time-consuming, headache-inducing, and dependent largely on the quality of your local partner and network. It is also, when it works out, very rewarding.

Indirect investment, typically in a fund focused on one or more countries, on the other hand, does not give you nearly as many headaches. If you carefully select a skilled general partner or investment manager, they are the ones who deal with the issues in return for their fees.

Investors benefit from the experience of the manager and their local connections, which can and should extend all the way up to the highest levels of the private and public sector. Typically, there is the ability to withdraw your capital more easily from an indirect investment, particularly if it is a listed fund. For most emerging market investors, indirect investment therefore is a wiser decision. The money you pay in fees is money well spent if the manager is skilled.

However, as Curtis points out, when deploying capital into an emerging market the selection of management for any project still requires a high level of due diligence to review their past track record and any prior deals that they may have concluded. And, as part of the overall plan if the sole objective is to grow one's capital, then one should look to hire someone with the relevant transactional experience together with perhaps a predefined exit strategy.

One possible downside when going through a third party, such as a hedge fund or private equity fund, may be the level of fees involved and if the family office does not have significant size or expertise access, then this may be unavoidable.

Other considerations include political ones and the contacts that an investment manager may have or perhaps the need to seek out a fund or manager that specialises in investment in a particular area, such as public entities. If there are ancillary benefits, such as socially responsible motives and or perhaps carbon offsets or carbon credits involved, this would require yet further investigation into relevant expertise in such a genre.

When investing in companies that predominantly acquire their products from overseas - most notably China - there can be inefficiencies in the market place and costs associated with overhead in those companies that are variables that are difficult to ascertain. Again, this may be avoidable where a family office has the ability and expertise to achieve direct investment into a specific project.

According to Geicke, direct investment should be limited to those family offices that have particular sector knowledge or connections where they have an advantage in managing the investment themselves. A family office that focuses entirely on the hospitality sector, for example, may feel adequately prepared to own hotels in emerging markets around the world. Without access to their own hospitality expertise, however, other investors should find a REIT or LP that will manage the investments for them.

The choice he has seen many make is to blend the two approaches – invest indirectly in most cases, with small or selective direct investments in areas your office has particular knowledge or experience.

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