Arjun Divecha
GMO Emerging Markets Funds
by Marla Brill
MFI Publisher
Emerging Markets Make A Comeback
After years of sagging returns,
emerging markets are back in the spotlight. Arjun Divecha, manager of the GMO
Emerging Markets Funds, says that’s no flash in the pan.
Many financial advisors have come to
view emerging markets as a more rollicking version of the NASDAQ, and their
feast or famine performance in recent years has done little to shake that
reputation. In 1999, for example, the IFC Investable Composite, a bellwether
emerging market benchmark, rose 67.14 percent. The following year, it lost
nearly one-third of its value.
Since the early 1990s, the downs have
far outweighed the ups. Despite some short-term rallies, the benchmark has seen
negative returns in five of the last eight years, and has a five-year average
annual total return of –5.05 percent. .
But last year, when emerging market
stocks rallied 28.5 percent in the fourth quarter of 2001, the fog finally
looked like it was lifting. The market had been so downtrodden until then that
the spike, the strongest quarterly performance since 1993, only brought the IFC
into slightly positive territory for the year. The jumpstart has continued into
2002.
The question now is whether emerging
market stocks and the funds that invest in them will fizzle or fly in the coming
months. In either case, the recent rally has given Arjun Divecha, manager of the
Grantham, Mayo, Vanotterloo (GMO) Emerging Markets Fund, a new familiarity with
the financial press. “In the last few years, I’ve hardly had any calls from
journalists,” he says. “In the last few days, I’ve gotten five or six. People
are always interested in what’s doing well now.”
Skeptics have long argued that
widespread press coverage for a fund is a good sign that the easy money has
already been made, but Divecha thinks that dirt-cheap valuations will continue
to give his fund an edge over those investing in US securities. “Eighteen months
ago, emerging market stocks were trading at just ten times earnings. Today they
are priced at 12 times earnings, which is less than half the valuation of the
S&P 500. There’s still plenty of room to grow.”
Stocks in the GMO Emerging Markets Fund
are even cheaper. The portfolio is priced at a penurious 9 times earnings,
reflecting a focus on small, largely neglected companies in emerging markets.
The median market capitalization of the portfolio is $1.4 billion, well below
the $3.4 billion of the median market cap for the benchmark.
“Smaller emerging market stocks have not
been this attractive since I began managing the fund in 1993,” he says. “And
smaller does not mean junkier. The return on equity of the small companies in
the portfolio is actually higher than that of the benchmark.”
The small company focus worked against
the fund late last year, when its 20.8 percent return lagged the fourth quarter
performance of its benchmark by 7.7 percent. Divecha attributes at least some of
the gap to the fund’s underweight position in Korea and Taiwan’s technology
giants, which led the rally. But with a total return of 9.78 percent in 2001,
GMO Emerging Markets fund still managed to finish first out of 180 emerging
markets funds tracked by Morningstar, and has ranked in the top decile of all
emerging markets funds for the past one, three, and five years.
Divecha’s firm believes that emerging
markets will out-perform most other asset classes in the coming years. Its
prognosticators predict an average annual return of 9.4 percent for the group
over the next seven years, compared to –1 percent for US large company stocks,
2.2 percent for US small company stocks, and 5.2 percent for small company
stocks trading in established international markets.
Weighing against such optimism is a
post-September 11 world in which political instability—which has sent emerging
market funds reeling many times in the past-- seems almost routine. Even before
that day, the world bore witness to market-shaking debacles such as the Asian
currency crisis, Russia’s massive debt defaults, the devaluation of Brazil’s
currency, and, most recently, the Argentine debt crisis.
Divecha acknowledges that while some
emerging market country economies are on shaky ground, many are stronger than
they were just a few years ago. “Most emerging markets have gone through a
crisis and are in recovery mode,” he says. “There is strong domestic growth and
low reliance on exports that makes them less dependent on the state of the
economy in developed markets.”
Besides, he argues, maintaining a
position in emerging markets is a sensible asset allocation strategy because
they do not correlate as closely with the US as developed markets in other parts
of the world. “A lot has been said in the last few years about how emerging
markets have not fulfilled their promise of providing diversification, and were
simply a high beta version of the NASDAQ,” he says. “But correlations in daily
price movements are irrelevant. The true test of diversification is how much
money you make or lose in relative terms over a number of years.” Many of the
firm’s clients, he says, have between 15 percent and 20 percent of their
international equity holdings in emerging market countries.
And over the last three years in
particular, emerging markets have been an effective tool for pulling up sagging
portfolio returns. During the period, the IFC Investable Composite had total
return of 16.1 percent, while the S&P 500 Index, NASDAQ, and the MSCI EAFE Index
all fell into negative territory.
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