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  • Emerging Markets Equity

    Many Reasons To Be Cheerful About 2018

    David Semple, Portfolio Manager
    January 24, 2018
     

    Continuing Strong Performance in 4Q'17

    During the quarter, VanEck's emerging markets equity strategy returned 8.26% (measured by VanEck Emerging Markets Fund, Class A (GBFAX), excluding sales charge). On a relative basis, the Fund outperformed its benchmark, the MSCI Emerging Markets Investable Market Index (MSCI EM IMI)1, which gained 7.74% in the fourth quarter of 2017.

    We are pleased to report that 2017 was a banner year for both the emerging markets and Fund investors. The Fund rose 49.70% during the year, outperforming the MSCI EM IMI which rose 37.28%. Gains were driven by improved corporate earnings and a supportive macro environment both globally and in emerging markets. After multiple years of underwhelming results for emerging markets companies, the asset class regained its gloss and was able to outperform its developed markets counterparts for the second year in a row. Growth outperformed value in 2017, reversing the underperformance from the previous year. Small caps, on the other hand, failed to outperform large caps for the second year in a row. We are excited about the prospect for 2018 as we believe we are in the midst of a multi-year earnings up-cycle coupled with a conducive macro environment and reasonable valuations.

    As for the fourth quarter of 2017, there were some signs of "digestion" of the large gains in some of the biggest companies in emerging markets such as Alibaba Group Holding Limited, Tencent Holdings Limited, etc. There was some profit taking towards the end of the year. So while these companies did very well over the first three quarters, they had a more mixed performance in the fourth quarter.

    Although we see China slowing a bit and addressing the excesses in its financial system, tightening seemed to level off during the quarter with the strong bits of the country continuing to be strong. In Brazil, social security reform appears to have been pushed back, but not necessarily shelved. This is causing a bit of a hiatus in that market's performance. In South Africa, it was all about the African National Congress (ANC) election. Cyril Ramaphosa won and we think this could be an encouraging sign. On the other hand, the Steinhoff debacle2 does constitute a blot on an otherwise clean landscape in terms of the management capability displayed by the country's leading companies.

    South Africa was the best performing country in emerging markets for the quarter, along with Greece and India. India was able to salvage some performance in the last quarter of the year, after an extended period of underperformance in 2017 due to high valuations and elevated financial risk in the country. On the negative side, Pakistan and the United Arab Emirates suffered. On a sector level, healthcare rebounded after a shaky first three quarters and performed best during the fourth quarter. Utilities and telecommunication services, conversely, lagged in the quarter.

    Emerging Markets Equity Strategy Review and Positioning

    Growth and small-caps outperformed value and large-caps, helping the Fund's relative performance versus the MSCI EM IMI. Stock selection in the financials, information technology, and consumer staples sectors also helped relative performance, while stock selection in the healthcare sector dragged on relative performance. On a country level, the Fund's largest overweight, China, contributed most to its outperformance in the final quarter of the year. China continues to be one of the most exciting places for long-term structural growth opportunities. Taiwan and Russia also helped. On the negative side, South Korea and India detracted from relative performance in the fourth quarter.

    Top Performers/Detractors

    The top performing stock was Chinese company Tencent, which further strengthened its operations during the quarter. The top five included another two Chinese companies: Ping An Insurance (Group) Company of China, Ltd. ("Ping An") and China Lodging Group, Ltd. ("China Lodging") In addition to executing and beating earnings expectations, Ping An also benefited from giving greater transparency into its fintech business and improving its corporate communications. China Lodging benefited from a successful capex program, including acquisitions, which saw its operating leverage "kicking in". South Africa-based Naspers Limited not only continued to benefit from its substantial holding in Tencent, but also engaged in corporate activity to realize value. South Korean electronics manufacturer Samsung Electronics Co., Ltd. continued to benefit from the supply in its industry becoming more concentrated, while the uses become more broad-based and significantly reduce cyclicality.

    The five greatest detractors from performance during the quarter were from around the globe. While still executing well, Chinese company, TAL Education Group gave up some of its extraordinary gains from earlier in the year. Brazilian car rental company Movida Participações SA continued to suffer both from unexpectedly high losses in its operations due to damaged and stolen cars and slower than expected improvement in its car resale business. Taiwanese company Basso Industry Corp., a leading manufacturer of pneumatic tools, experienced slower than expected sales recovery due to U.S. dollar depreciation. Another Brazilian company Biotoscana Investments S.A., which develops, manufactures, and distributes pharmaceutical products, suffered as a result of both changes in management and a slowdown in its Brazilian business. As a consequence of the country's challenging economic environment, Colombian bank Banco Davivienda S.A. experienced both a deterioration in the quality of its loan book and disappointing growth.

    Outlook

    Looking back over the year, there has definitely been enhanced interest in the emerging markets equities asset class. Since the asset class has underperformed for a number of years, positioning in it remains still relatively light. Previously there were better and less risky alternatives offering better returns. We believe that now the pendulum has swung the other way and returns appear to overwhelm any perception there may be of enhanced risk. However, while there may be less risk, certain countries are still struggling and there continue to be issues with others.

    The big one remains China. People are now much more relaxed about the country. We see neither the capital outflows nor the pressure on the renminbi, which everyone has been concerned about. While debt is still increasing, it is doing so at a much slower pace and the government has demonstrated that it is addressing the issues, particularly the excesses (generally in the financial system). While the move towards better quality growth has not yet really impacted the overall level of growth (it is going to take a long time before it becomes apparent), the quality of the financial system is gradually improving.

    Although Russia may not be a "happy hunting ground" for us in terms of what we can buy there, we appreciate the work that it has done in terms of inflation control and orthodox monetary policy. We have a holding in Sberbank of Russia OJSC. In general, the company consistently generates great returns on equity and benefits not only from the prevailing fiscal orthodoxy, but also the continued pruning of the banking system. Since the governorship of the Russian Central Bank was taken over by Elvira Nabiullina in 2013, more than 340 banks have lost their licenses. Sberbank continues to thrive and has many new avenues of opportunity, including mortgage lending and asset management.

    In India, the government recently announced a substantial recapitalization of banks which it is hoped will provide the motivation for them to resolve the issue of their bad debts. Concerns remain, however, not only about how long this is going to take, but also whether it will then provide enough capital for growth in the banks thereafter. Our judgment is that it will not. We believe that, across the system, there are going to be hidden exposures to which the banks have not confessed, with public-sector banks being particularly affected, and that things are going to get a little worse before they get better. In our opinion, this all bodes well for private-sector banks and especially the best credit quality banks (for example, HDFC Bank Limited, which we hold) at the least risky end of the banking spectrum. They will be able to continue with their structural growth and taking of market share.

    Mexico faces presidential elections in 2018 and many people are still trying to figure out just who is who and what is happening. While Andrés Manuel López Obrador, known as AMLO, remained in the lead at the end of the year, we are just going to have to see how things turn out. The country's economy remains, we believe, on a reasonably firm footing. While the risks going forward are the political risks of the election cycle, the Mexican companies we have in our portfolio seem to be doing absolutely fine.

    Our largest holding in Brazil is Fleury S.A. a high-end medical diagnostics company. In good times and in bad, people are going to continue to have their blood drawn, have MRI scans, etc. We see Fleury as a "self-help" company with an individual story in an economically insensitive space. It is an idiosyncratic investment and we are not trying to play the economy getting either better, or worse. In South Africa, we continue to be defensively positioned relative to currency risk. Our holdings in the country are not large, but what we do have, most of it Naspers, has very little local income. Our considerations are enduringly political considerations and we remain concerned with the country's fiscal situation.

    Download Commentary PDF with Fund specific information and performance.
    For a complete listing of the holdings in VanEck Emerging Markets Fund (GBFAX) as of 12/31/17, please click on this PDF. Please note that these are not recommendations to buy or sell any security.