TheAdvisory

INVESTMENT PERSPECTIVES FROM BROWN ADVISORY 1 OVER STORY C COMPELLING OPPORTUNITIES IN EMERGING MARKETS 5 ROM BORING TO BOOMING F THE BEAUTY OF DIVIDEND STOCKS 6 MBRACING THE IDIOSYNCRATIC E PRIVATE EQUITY AND YOUR PORTFOLIO

COVER STORY

MARCH 2012

Big Spenders
The rise of the middle class in emerging economies will drive growth for decades. Here are some interesting strategies to benefit from this trend.

he numbers are so large that its difficult to comprehend: According to the IMF, 800 million people in emerging market countries are expected to move from the lower class to the middle class over the next 10 years; 70% of global growth will come from emerging economies in that time; and G7 economies (the U.S., France, Germany, Italy, Japan, the U.K. and Canada) are estimated to slip from 65% of global GDP to-

day to 25% by 2034. The knee-jerk investment conclusion would be to over-allocate funds to emerging markets from developed markets, believing that such powerful economic growth will lead to strong investment returns over time. But our conclusion isnt quite so simple. Contemplating investments in emerging markets reminds me of my experience covering technology stocks during the dot-com frenzy
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Getting Cheaper
The collapse in emerging-markets stock prices in the last year has been largely the result of declining price/earnings ratios.

BY PAUL CHEW, CFA

23 21 19 17 15

Head of Investments

MSCI Emerging Markets Index Trailing P/E Ratio Long-Term Median

COVER STORY CONTINUED

in the late 1990s. Then, the markets 13 were mesmerized by the potential of the Internet to change our lives, which of 11 course it did. While there were many 9 casualties of the Internet bubble (re7 member Pets.com and their sock pup2001 2003 2005 2007 2009 2011 pet commercials?), other companies delivered on their potential. Amazon.com, SOURCE: BLOOMBERG for example, wowed investors with a business model that allows customers to shop from the comfort of their homes. Today, everyone knows that Amazon should have a meaningful allocation on emerging market consumers. Its has been a smashing success. What peo- that includes both large- and small-cap much more of a bet on the future price ple forget is that it took Amazon shares stocks, hedged exposure through long/ of oil, which is largely determined by 11 years to climb back to the heights short managers, and emerging-market economic activity in the U.S. and Euwhere they were trading at the end of corporate debt. Here are the details. rope rather than developing countries. 1999. The question in Amazons case In order to capitalize on the emergwas never growthit was valuation ATTENTION ASIAN SHOPPERS ing-market middle-class theme, we beand price. The rise of the emerging-markets con- lieve that it makes more sense to invest Just as the Internet brought trans- sumer is a well-known trend, yet ETFs, in smaller companies that offer a purer formational change to a variety of mar- index funds and many of the largest exposure to the high-growth consumer kets, the rise of the middle-class con- emerging-market mutual funds provide sectors and niche markets. These busisumer will reinvent emerging markets little actual exposure to the consumer. nesses tend to develop after the larger over the coming decades. This repre- The development of financial markets state-backed firms are established, and sents a great long-term opportunity, but in various emerging economies follows they are a more direct play on domestic we believe that taking advantage of it a familiar script, with the first public economies. As one indication of this will require a more thoughtful approach companies being government spin-outs potential, if consumption expenditures than just investing in an index fund or in industries such as financial services, continue growing at historical rates, throwing darts. That was clear in 2011, energy and materials. Thus, it is not developing-Asia consumers alone will when the MSCI Emerging Markets in- surprising that the MSCI Emerging account for 43% of worldwide condex fell more than 18%. The bright side: Markets Index is dominated by banks sumption by 2030, spending $32 trilThe price decline has caused valuations and export-focused energy and materi- lion annually, up from $4.3 trillion in to become quite attractive, as the chart als companies, as shown in the table on 2008. The consumer is therefore likely above shows. page 4. to be the engine of overall growth. Rather than a simple one size fits Take Petrobras. An investment in all approach, we believe that investors this Brazilian company is hardly a play CONTINUED ON PAGE 4
2 THE ADVISORY MARCH 2012

Finding Opportunities Across the Liquidity Spectrum

Timely, opportunistic additions to portfolios can make a significant difference in overall returns. Identifying ideas like the ones listed in the table below represents only the first half of our process for finding opportunistic investments. Identifying the correct vehicle to capitalize on that opportunity is just as important. We look for the right vehicle across the liquidity spectrum, which runs from money market funds to private equity with a 10-year lockup. Greater liquidity allows portfolios to be more nimble when entering and exiting the opportunistic investment, while less-liquid investment vehicles can offer a wider range of strategies to capitalize on the opportunity. For example, in early 2009, Brown Advisory identified smallcap growth companies as a compelling opportunity based on attractive valuations, the chance for rapid growth despite sluggish overall economic expansion, and the tendency of small-cap stocks generally to outperform coming out of a recession. In that case, the optimal vehicle was a direct investment in small-cap growth stocks with significant liquidity. At the other end of the spectrum, in 2011, with historically low interest rates and depressed property prices, Brown Advisory recognized a significant investment opportunity in income-producing real estate. High-liquidity options, like real estate investment trusts (REITs), offer some exposure to this asset class, but share prices are largely tied to swings in the equity market. Less liquid vehicles, such as private real estate partnerships, provide a more precise way of capitalizing on this investment opportunity. Other opportunistic investments have involved using multiple investment vehicles at different points along the liquidity spectrum. In late 2008, for example, Brown Advisory identified an opportunity in credit markets after yields relative to Treasury bonds spiked to historic levels in the wake of the financial crisis. To capitalize on this opportunity, we invested directly in relatively liquid corporate bonds as well as credit-oriented private funds with relatively little liquidity. Thus, different opportunities along the liquidity spectrum can meaningfully improve the long-term risk/return profile of a portfolio.

ASSET CLASS

OUR PERSPECTIVE

INVESTMENT OPPORTUNITY

FIXED INCOME

Low yields create unattractive risk/return in much of the fixed income universe; one exception is emerging-market corporate bonds. The U.S. economy is improving and valuations are attractive but risks remain from U.S. political and European financial uncertainty. The eurozone situation is becoming more stable but growth prospects remain poor. Some emerging economies have also slowed but long-term opportunity remains. Inflation appears subdued, but with global central banks aggressively providing stimulus, a resurgence in inflation is possible. Low interest rates and reasonable prices make for a buyers market. Real estate can provide income diversification and low correlation to other assets.

U.S. dollar-denominated emergingmarket corporate bonds Low-beta, income-oriented stocks Domestically focused small-cap stocks De-emphasize developed international stocks Favor small-cap emergingmarkets stocks Maintain a small allocation as an inflation hedge

U.S. EQUITIES

INTERNATIONAL EQUITIES

COMMODITIES

REAL ESTATE

Cash-flowing developed properties below replacement costs Multifamily with strong rental income growth

Whither the Consumer?

The top 10 holdings of the MSCI Emerging Markets index, which account for 17% of the total market capitalization, are dominated by huge, export-oriented corporations. Companies in highlighted rows are state-backed firms. MSCI EMERGING MARKETS INDEX TOP 10 CONSTITUENTS SAMSUNG ELECTRONICS CO TAIWAN SEMICONDUCTOR MFG CHINA MOBILE GAZPROM (RUB) PETROBRAS PN AMERICA MOVIL L CHINA CONSTRUCTION BK H ITAU UNIBANCO PN VALE PNA PETROBRAS ON MARKET CAP (BILLIONS) $101.5 61.6 58.8 56.8 48.4 45.5 41.9 41.6 40.6 36.7

SECTOR Technology Technology Telecom Services Energy Energy Telecom Services Financials Financials Materials Energy

ing markets. A portfolio of such funds can be designed to reduce the peaks and valleys but still participate in the attractive returns offered by emerging markets over a full market cycle.
THE DEBT OPPORTUNITY

SOURCE: MSCI. DATA AS OF 12/31/11.

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Further, many of these smaller, emerging-market companies are poorly covered or in many cases completely undiscovered by Wall Street analysts, creating opportunity for fund managers willing to commit the time and energy to exploit these market inefficiencies. Because emerging-market small-cap companies are less closely followed than their large-cap brethren, they typically trade at lower valuations, allowing diligent, research-driven fund managers to invest in companies with significant and sustained earnings and revenue growth at value-oriented prices.
IMMATURE FINANCIAL MARKETS

If the best way to play the rise of the middle class is through small-cap consumer stocks, how should you get exposure to the other industries in emerging markets? The first answer is
4 THE ADVISORY MARCH 2012

carefully. Emerging markets today are dominated by foreign, institutional investors since many countries have not yet developed a local investment culture. These immature financial markets tend to have highly volatile prices, as liquidity movements drive stock prices up and down to a far greater extent than fundamentals do. A recent example is 2008, when most emerging countries were able to maintain strong economic growth but the markets sold off more than 50% because of the financial crisis. We recommend that investors maintain sizable exposures to emerging-markets equities but recognize that the volatility in these markets makes that allocation difficult to stick with during market downdrafts. To help alleviate the stress of market swings, we recommend for qualified purchasers a collection of long/short hedge funds specializing in the emerg-

The final component of our recommended allocation to emerging markets is exposure to U.S. dollardenominated emerging-market corporate bonds, for three primary reasons. The first is attractive absolute yields: dollar-denominated investment-grade emerging-market bonds yield more than 7% today, similar to high-yield (junk) bonds. The second driver is the likelihood of favorable monetary policy coming from the U.S. and central banks in emerging economies. In 2010 and 2011, central bankers in many emerging nations were forced to aggressively tighten monetary policy in an effort to fight inflation, causing GDP growth in many countries to slow. In fact, Brazils GDP even turned negative in the fourth quarter. With growth and inflation now falling, we expect to see many countries cut interest rates to restimulate growth. The final catalyst is the possibility that various credit rating agencies will upgrade many corporations in the emerging markets. To date, the agencies have tended to hold the debt rating of many companies at or below the level of the country in which a company is located. As these well-run corporations further improve their balance sheets, ratings agencies are relaxing their informal standard and upgrading these companies. In sum, the emerging markets will remain the growth story for years to come. Investors need to make sure that their portfolios are actually positioned to benefit.