Returns beyond the dazzle of GDP

Michael Godfrey, the manager of M&G Global Emerging Markets, argues that investment returns in China bear no relation to its economic growth. He prefers to focus on valuations.

He is a major global emerging markets investor who does not hold a single stock in mainland China. He reckons that the ­Chinese banks have been “incredibly shoddy” in their lending practices and have contributed to a seriously overvalued property market and stockmarket; that there may be ­opportunities in China, but at these prices they are relatively few.

Michael Godfrey, who runs M&G’s £416m Global Emerging Markets fund, has a view on China that is rather different to that of Fidelity, currently peddling its £170m C share for Anthony Bolton’s China Special Situations. Fidelity’s prospectus says that “the long-term prospects for investing in China are compelling” and waxes extensively about its fast-growing GDP. Bolton himself says: “The Chinese economy has not been slowing down as fast as earlier expected and this will probably happen in 2011. However, I continue to believe that the growth rate in China will still be attractive relative to the growth rates being seen in the developed world.”

But over at M&G, Godfrey reckons that investors who are dazzled by GDP growth numbers are likely to be sorely disappointed when it comes to returns on their investments. “If you look at value creation, the investment return you achieve in emerging markets has nothing to do with economic growth,” he says. “Over a 20-year period there is a negative correlation between economic growth and equity returns. It makes us scratch our heads why that number [GDP] is so picked over by investors.”

“There is a negative correlation between economic growth and equity returns. It makes us scratch our heads why [GDP] is so picked over by investors”

I do not doubt Godfrey’s figures, but if you look over the last five years there has been a rather significant relationship between China’s growth and returns for investors. The average China fund has gained 138% over that period, while the average UK All Companies fund has managed only 25%.

Godfrey says: “If you look at economic growth on a yearly basis, in many emerging markets you see growth of 6%, 7%, 8% and so on. But you also see a huge amount of volatility in equity returns, so you still can’t tie together the GDP figure and equity returns. It all comes back to valuations, rather than relying on growth alone. Companies in emerging markets have been poor at capturing value.”

Investors should ignore GDP figures and focus on return on capital, he says. “That’s the measure that gives you the bare bones of what a company is doing with your money.” (article continues below)

Many other investors in emerging markets (especially the domestic Chinese) are not interested in the long-term fundamentals of a company, being traders rather than investors, he says. “On the Shanghai market the average investment is held for six weeks. We tend to be holders of stocks for around four years and can take advantage of other investors’ boredom. For example, you can’t justify the valuations put on consumer companies in China and India. But it means that investors are forgetting about industrial stocks.”

Godfrey eschews top-down macro asset allocation in favour of fundamental analysis, yet in any global emerging markets fund it’s always interesting to see which parts of the globe the cash goes to. At present Brazil takes the biggest segment of the fund, partly the result of a significant holding in Vale. China is listed as the second largest area, although that’s because Godfrey holds stocks listed in Hong Kong, although none on the mainland.

The surprise after that is that South Korea is just over 10% of the fund, and that Samsung is the fund’s biggest holding. It’s an oddity of emerging market investing that Korea is still in the MSCI Emerging Markets index when it has a higher GDP per head than many European countries. “We are not index constrained so I don’t have to hold any Korea or any Samsung stock,” says Godfrey. “But I see it as a global stock, which has come out of an emerging market and become one of the world’s best consumer electronics businesses.”

Another surprise is the number of banks Godfrey holds, despite what he says about the perceived recklessness of Chinese bank lending. Financials are 18.5% of the fund, although he is 5% underweight in the sector. He holds the simple and safe banks rather than major integrated players. “They have to have a tangible asset base. The banks we have are very simple. They have large franchised branch networks, they take deposits and then lend it out and charge fees. It’s not rocket science.”

Commercial International Bank in Egypt is one of his favoured holdings. “It’s a tremendously well-run bank in a hugely under penetrated banking market.”
Resources also feature prominently among Godfrey’s top 10 holdings, led by Vale, and Lukoil of Russia. It was interesting that last week, as fears grew about how the authorities might dampen China’s property bubble, it was resources stocks that were hit. All that iron ore is not going into building factories, it’s going into offices and apartment blocks that might be left empty if the bubble bursts. Yet Godfrey is confident that over the longer term the structural demand story continues to underpin resource stocks.

The fund was launched only in February 2009, but it has gone straight into first quartile, ranked 17 out of 41 GEM funds over the past year. It benefited from a relatively large number of positions in Thailand, which during political rioting fell strongly out of favour with investors. “I was in Thailand in February last year and saw some fantastic companies that had become cheap. They were operating completely independently to what was happening on the political level.” Krung Thai bank in particular helped performance of the fund, with its shares doubling over the past year.

At the other end of the scale, the fund suffered indigestion from Chaoda Modern Agriculture, a Hong Kong-listed stock that exports a variety of vegetables. A $400m (£252m) capital raising was greeted poorly by the market and its shares are trading at half their peak level over the past 12 months.

Given concern about asset bubbles in China, many investors are cautious about committing more money to emerging markets. But Godfrey is optimistic. “As people get worried, we get excited, he says. “The China market has had a shaky year and we are beginning to see some rather attractive valuations.”