Shou-Pin Choo
Portfolio Manager - Asia & EM Equity, UBS Asset Management

How are we navigating the headwinds?

Emerging markets (EMs) have faced a myriad of headwinds over the last two years, including heightened geopolitical tensions and a strong US dollar as well as China’s zero-COVID policy and changing regulatory environment. As the paradigm shifts, so too do our investment theses covering various companies, sectors and markets.

Performance has been challenging since 2021. While 2021 was marred by Chinese regulatory tightening in certain sectors, Russia’s invasion of Ukraine and a troubled Chinese real estate sector affected emerging markets in 2022.

This year, although some of the drag factors have subsided, China’s uneven economic recovery and rising temperature in the China-US relations became major drags on EM equity markets. The increasing competitive intensity in the Chinese ecommerce sector and pressure from seed investors reducing their stake on select large technology companies also weighed on investor sentiment.

Long-term potential

As the overall environment stays tough, we are continually reviewing and challenging our long-term assumptions for EMs. We have also enhanced our sector review format enabling more structured review and comparison of long-term assumptions for the companies in a sector. Having done this,  we are still able to identify significant upside to fair value in several areas using our long-term intrinsic value approach.

We expect the consumption-led recovery in China to continue at a measured pace and expect consumers with higher income to be willing to pay more for better quality products and services. Here, we think the dairy sector is well positioned, and companies that produce minimally processed, pasteurized, low temperature milk and dairy products have a long runway for growth given low market penetration levels. What is more, premiumization and distribution enhancement in lower tier cities should help sustain and drive further market share gains, at the expense of smaller players for high quality bigger players.

Despite the headwinds of intensifying competition for e-commerce companies in China, there are signs they are taking the appropriate steps to unlock shareholder value. By improving profitability, capital allocation and balance sheet structure, these companies are focusing on creating value for the longer term, which we believe is the right approach. Even though these names continue to selloff, we like their long-term prospects. In fact, some have low single digits price-to-earnings (P/E) ratios, offering a solid potential upside to fair value and putting them in a better position for a rebound.

For information technology (IT) hardware, we think the industry cycle may bottom out in the next few months given the industry glut and order cuts. Through our findings from recent research trips, we believe our investment theses remain intact and have gained greater confidence in our long-term industry assessment. Interestingly, the industry dynamics have improved during this period of depressed market sentiment. Geopolitical tensions and technology export controls weighed on Chinese IT hardware manufacturers, but at the same time weakened competition at the forefront of technology. Particularly in the semiconductor memory segment, normalized margins and normal growth could be enough to lead to upward revisions, given the inevitable consolidation that would follow the current downturn. We believe the semiconductor industry presents an opportunity.

Elsewhere, we find structural growth sectors in India attractive. We like a leading company in energy, retail and digital service that is active in organized retail, ecommerce, digital media and clean energy – areas that offer 10-year double-digit compound annual growth rate (CAGR) with a large total addressable market. Fundamental and discounted cashflow valuation metrics  show the current stock price is not reflective of the strong moat the company has built in these structural growth sectors.

Taken together, even though the landscape has become more difficult in the past years, we believe in-depth fundamental research will help us identify attractive investment opportunities in different sectors and countries. There still appears to be a lot of potential to be realized in EM equities.

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