Managing Risk in Emerging Markets

Cindy Sweeting, CFA¹
Executive Vice President Director-Institutional Portfolio Management
Templeton Global Equity Group

Investors may have heard that emerging markets companies may provide greater return potential than those companies in developed markets due to higher earnings growth potential. Nonetheless, these firms also have a downside-they carry potentially greater risk, including currency instability, lack of transparency in financial statements and/or poor corporate governance. In addition, regions experiencing higher rates of economic growth do not necessarily provide the best equity investments, as competition for market share is fierce, often driving down profitability, and valuations can become excessive due to the optimism of investors. That is why quality research and effective risk management is so important.

As long-term value investors, we use valuation to manage risk. In analyzing stocks, we look for those trading at a generous discount to our estimation of the fair value of the company's business. This valuation discount provides a potential "margin of safety." Fair value is difficult to accurately compute, so a substantial margin of safety provides room for error.

The greater the discount to underlying business value, the more attractive the risk/return characteristics. This is particularly important in emerging markets, where unexpected factors can significantly impact an investment. To compensate for the heightened risk profile of emerging markets, we seek larger valuation discounts in these investments. While we might be satisfied buying a Western European multinational for 80 cents on the dollar, we may demand 50 cents on the dollar to buy a Latin American telecom. Our goal is to buy value at an adequate enough discount to compensate for greater risk and uncertainty.

Directly investing in local companies is not the only way to access the potential of these regions. Building emerging markets exposure through investments in foreign multinationals can be cheaper than direct investment, and this strategy can potentially increase the margin of safety for our investors while reducing a portfolio's overall risk profile. Many international companies located in developed markets are tapping into faster-growing economies around the world and, according to our analysis, are currently valued at less of a premium and with possibly less risk. Political turmoil that may only cause a minor problem in the operations of a foreign multinational might well be fatal to a domestic operation. On the other hand, a domestic emerging market stock will generally outperform a foreign multinational in a strong regional bull market. The most important factor, in our view, is the price you pay for the stock.

We have other ways of managing risk while seeking opportunities in emerging markets. In-depth research helps us manage country- and region-specific risk. Along with our industry experts, the Templeton Global Equity Group has country analysts who study the stability and growth prospects of various regions, with the goal of finding bargains in those markets. We want to know if a country might default on its debt, debase its currency, raise or lower interest rates or tax rates, depose a sitting government, go to war, nationalize industry sectors or any other factors that could affect our investment. This due diligence is an important part of our risk management and analytical process, and it provides the framework for our individual company analysis.

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Footnote

1. CFA® and Chartered Financial Analyst® are registered trademarks owned by the CFA Institute.