For the fourth quarter of 2013, the Wasatch Emerging Markets Small Cap Fund gained 1.45%, slightly ahead of its benchmark, the MSCI Emerging Markets Small Cap Index, which gained 1.26%.
Details of the Quarter
After a more volatile third quarter for emerging markets, there was some normalization in the quarter. The strongest contributors by country were India (up 14.5%) and Taiwan (up 8.5%). Many of the countries in which we were invested had modestly positive performance for the quarter. The countries that detracted the most from the Fund’s performance were Thailand (down 7.5%), Brazil (down 7.7%) and Indonesia (down 8.7%). The top-contributing sectors were consumer discretionary, financials and industrials where performance was between 4% and 4.5% for the quarter. The strongest individual contributors to the quarter were Mahindra & Mahindra Financial Services Ltd., a leading lender to rural India; Biostime International Holdings Ltd., a provider of pediatric nutrition and baby care products in China; and Promotora y Operadora de Infraestructura, a toll road operator in Mexico. A number of our holdings in Taiwan featured strongly including Merida Industry Co. Ltd., Taiwan FamilyMart Co. Ltd. and Airtac International Group. Detractors in the quarter were led by names in the weakest markets including Minor International Public Co. Ltd. and Home Product Center Public Co. Ltd. in Thailand and Tegma Gestao Logistica in Brazil.
In reviewing 2013, the performance of emerging markets has clearly diverted from that of developed markets. The performance gap is the largest since the Asian financial crisis, which began in 1997 and went through 1998. And it is reasonable to expect that the gap may continue for a while. It is not reasonable to expect that emerging markets will follow the U.S. and Europe when there have been very different cycles of recovery. Part of the argument for investing in emerging markets is that it is an asset class based on different countries at different stages of economic development, representing a huge part of world gross domestic product (GDP)†† and that this asset class does not correlate strongly with developed markets. If the emerging markets asset class truly offers different equity exposure compared to developed markets (including the U.S.), then there will be periods where it really differs in performance and behavior. We believe we are in such a period.
The emerging markets asset class (we can include equities and fixed income here) has shown strong performance in the past decade driven by inexpensive valuations,‡ improving credit quality, strong GDP growth and other positive economic factors. The equity and debt markets of the asset class have broadened as well as deepened, as we should expect over time with the right conditions. In the last two years, we have seen some slowing of positive changes and previous high rates of growth. Concerns about the macro side of emerging market economies have come more to the forefront and that will remain for some time—some of the valuation discrepancy between more opaque emerging markets and developed markets is justified. However, we do not think emerging markets are going back to where they were in the 1990s. Sovereign and corporate credit in emerging markets is in much stronger shape and central bankers are more aware of the risks, and have more tools at their disposal.
In 2013, we saw outflows from emerging market equities globally, which contrasted with strong inflows into the developed market equities. We also saw a significant slowdown in flows into fixed income markets in emerging markets, which has a direct impact on the current account deficit in countries like South Africa, Indonesia, India, Turkey and Brazil. In addition, some of these countries were hurt by a slowdown in their hard currency earnings driven by commodities.
In considering the outlook, emerging markets seem to be narrowing, meaning that investors are starting to differentiate more between countries and considering emerging markets less as one entity. As such, we expect to see continued divergence between regions and countries, say between North Asia and Latin America and so on, or between countries that are strong exporters (e.g., China and Korea) and those that require foreign financing (e.g., Indonesia).
In the past, emerging market equities have been treated as an asset class. The period when emerging markets expanded into investors’ portfolios coincided with the rise of indexing. This is less true of the regions of Europe and Japan. They have not been indexed into the developed market asset class in the same way. This suggests, as we look forward, investors may make increasing distinctions between emerging market countries—between South Korea and Brazil, for example—and may look to make allocations to countries individually rather than to emerging markets as a whole, similar to the way investors regard Japan. Emerging markets managers will also need to be more discerning, as returns become less broad based. Some countries like South Korea will likely graduate to developed status. It can also be said that the fact that emerging markets embrace so many countries and political systems means there is more noise around the category (whether individually, say Turkey or China). As this is aggregated into “EM,” noise is more conspicuous when it leans to the negative. In a way, we saw a similar situation in Europe three years ago—investors were not making the distinctions between German stocks (or Germany) and Spain, when Germany was clearly on much stronger economic footing than Spain. In fact, the Eurozone was almost seen as a regional basket case. It has only been in the last two years that we have seen significant flows back into Europe.
We can see the “narrow market phenomenon” with China. Some years ago, investors did not discriminate between Chinese equities (whether they were listed in the U.S. or in Hong Kong). Today, investors make finer distinctions, the market is narrower, and quality companies can show good stock performance. For investors, it has become less about being in “a market” and more about identifying the right companies and the right sectors where possible.
The emerging markets universe is expanding strongly in the range of companies it contains—both small and large. We see continued scope for our quality-focused approach to find strong names that represent the potential for sound earnings growth.‡‡ The valuation disparity between emerging markets and the developed world has widened. We see the present period as a time to build a solid portfolio for when investors do return to emerging markets.
We thank you, our shareholders, for your continued support and wish you a bright 2014.
Roger Edgley and Laura Geritz
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††Gross domestic product (GDP) is a basic measure of a country’s economic performance and is the market value of all final goods and services made within the borders of a country in a year.
‡Valuation is the process of determining the current worth of an asset or company.
‡‡Earnings growth is a measure of growth in a company’s net income over a specific period, often one year.