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As governments emerge from the global economic crisis, emerging markets have been on a bull market run. Although there have been major gains in 2009, we believe there is still significant growth potential for the asset class and that emerging markets companies will continue to offer above-average earnings growth potential over the next five years.
Patricia Ribeiro, vice president and portfolio manager for the American Century® Emerging Markets Fund, believes the emerging markets asset class offers short- and long-term growth prospects and diversification benefits at attractive market valuations. In a recent interview, Ms. Ribeiro shared her views on the current state of emerging markets, what lies ahead in 2010, and how her investment team is selecting equities for the fund.

Why did emerging markets rebound so quickly from the global economic crisis of
2008-2009 compared to developed countries?

While the shakeout in global markets has left few countries unscathed, the emerging markets asset class was well positioned to weather the global economic crisis. Sound macro fundamentals and stimulus measures helped emerging market countries address the global financial crisis. Unlike the U.S. and other developed countries, consumers in emerging economies did not take on the huge amount of debt and financial institutions in emerging markets did not have exposure to toxic assets such as subprime mortgages. Emerging markets have also been shielded from the problems of the developed world by years of conservative fiscal policy resulting in higher savings rates, increases in business and infrastructure investment, strong domestic economies, and job creation. Another key point is that growth in emerging markets has become less reliant on demand from developed countries and being driven by the emergent consumer classes. For instance, the economies of Brazil and India are being driven by an emerging consumer class with buying power.

Are emerging market economies becoming less reliant on developed economies such as the U.S. and Western Europe to set the pace for growth?

One of the misconceptions about the asset class is that emerging market countries are reliant on exports to developed markets for growth. In reality, however, the rise of a middle class in emerging market countries is fueling domestic consumption. Moreover, emerging market economies have become much more economically disciplined and that is raising the income level of their populations. When it comes to domestic consumption, consumers in emerging markets such as China, India (see table below) and Brazil are just getting started.

As China is poised to overtake Japan as the world’s second-largest economy, the country’s swift economic rise has not been without costs, however; China’s emphasis on exports—which most experts believe cannot be sustained indefinitely—is causing both economic and social dislocations. As a result, China’s leaders are committed to placing the country on a new footing by moving toward a consumer-oriented economy where domestic consumption will be the engine for future growth. Some of the main by-products will be significant improvement in the country’s standard of living (ranging from income to health care to education), import-led reductions in China’s huge current account surplus, which has fostered trade friction and heightened risks of protectionist measures by trading partners, and far less vulnerability to fluctuations in global demand for the country’s products. For the rest of the world, a consumer based economy in China holds positive implications for many companies abroad as they view Chinese demand as their ticket to growth and profits in a post-recession world.

Led by its manufacturing and mining sectors and public spending, India’s surging economy expanded at its fastest pace in over a year. Stimulus measures and lower interest rates have driven demand for automobiles, steel, and cement.

On the other hand, emerging market countries are also creating growth opportunities for themselves by exporting their goods not only to developed counties but to other emerging economies as well. For example, Taiwan-based Mediatek, largest seller of handset phones, has seen its business grow because of increased demand in other emerging market countries, instead of the U.S. and Europe. In Korea, 70% of exports are to other emerging market countries.

Emerging economies are also seeking a more prominent role in global financial markets. In a joint statement released at an inaugural summit held June 2009 in Russia, representatives of the BRIC countries (Brazil, Russia, India and China) agreed that “the emerging and developing economies must have greater voice and representation in international financial institutions, and their heads and senior leadership should be appointed through an open, transparent, and merit-based selection process.”

How did emerging markets perform thus far in 2009 as an asset class?

Stocks from the emerging market asset class surged in 2009 as investors who were seeking to recoup the losses of 2008 sought higher yielding assets perceived to have few links with battered developed economies feeling the pinch from the global economic crisis and subprime market meltdown (see chart on the next page). Within the MSCI Emerging Markets Index and the Emerging Markets Fund, every sector posted either double- or triple-digit returns year to date. On the other hand, many benchmark countries and portfolio countries recorded either double- or triple-digit returns.

Despite the run-up in the value of the asset class, is there still room for growth in
emerging markets? What factors are making the asset class attractive?

Over the past 10 years, the asset class has been more dynamic and faster growing than the developed world (see table below). Looking ahead, I believe there are certainly more growth prospects for investors who are prepared to accept the risks and invest for the long term. Maintaining growth and stability is certainly a top priority for emerging market countries. Compared to when emerging markets funds were first listed some 20 years ago, the asset class is also better regulated and offers more transparency due to improvements in the legal and financial systems. Many economies such as China, Russia, and Brazil have also built up their foreign exchange reserves, which allows them withstand market turbulence from developed economies.

Another key point is that stocks in emerging markets often have had attractive valuations relative to developed markets. According to MSCI Barra, the forward price-to-earnings ratio for the MSCI EM Index has averaged 11.8 since June 1994, compared to 17.8 for the MSCI World Index.

Where are you seeing investment opportunities in emerging markets?

In emerging markets, we are focusing more on companies in the financial sector. Financial institutions in emerging markets have been a good source for growth because they were not as impacted as those in developed markets and did not have exposure to toxic assets such as subprime mortgages. In addition, consumers in emerging economies didn’t take on the huge amount of debt compared to consumers in developed markets. We have also found growth opportunities in the consumer discretionary sector. As purchasing power improves in emerging market countries, consumers are spending more, either on firsttime purchases or on upgrades.

Governments around the globe have tapping reserves and implementing stimulus packages. At some point these governments will have to wean their economies off of such stimulus measures. What are the ramifications?

At this point we believe that most emerging countries are economically sound, so weaning themselves off of their stimulus packages will not have much of an impact. The majority of the emerging market countries entered the global economic crisis with far healthier economies than developed world economies, allowing them to spend more money as needed. On the other hand, the consumer debt levels of many emerging market countries have been lower than that of developed countries. And since emerging market banks have been in much better shape than Western banks throughout the global financial crisis, they have been able to continue to grow their loan portfolios. Over the next five years, emerging market economies will be driven not only by export demand from the rest of the world, but by growth in domestic consumption, including health care, technology, infrastructure, and finance. This will create huge opportunities for companies doing business in these sectors, among others.

What is the outlook for emerging markets for 2010?

Emerging markets have been able to withstand the greatest economic crisis since the Great Depression. There’s no doubt that 2010 will continue to be a challenging year for global markets. However, the emerging markets asset class will continue to offer above-average earnings growth over the short and long term. The global economy will start growing again in 2010 but the emerging markets will accelerate at a much faster rate than the U.S. and Europe. The global economic crisis has shown emerging market countries have managed their economies well over the past several years.

BRIC countries have been among the fastest growing economies in the world. We believe the outlook is positive for BRIC countries heading in 2010 and they offer excellent mid- and long-term investing opportunities. Domestic consumption holds the key to future growth as the four BRIC markets account for about 50% of the world’s population. Brazil and India are better positioned for near-term growth because they are not as dependent on global exports as China and Russia. As the global economy improves, resource rich nations such as Brazil and Russia will benefit from higher demand and rising prices for oil, steel, aluminum, copper, and other commodities. A key issue for China is whether its economy can continue to expand independent of a U.S. recovery. While it may be a long and bumpy road, we think China understands the importance of paving the way for an economy based more on domestic consumption. For investors, a consumer-based economy holds positive implications because many global companies view potential Chinese demand as a ticket to growth in a post-recession world.

What is American Century’s investment philosophy in the emerging market asset class?

Our philosophy of growth investing is centered on the belief that accelerating growth in earnings and revenues, rather than the absolute level of growth, is more highly correlated to stock price performance. This philosophy often directs us to research different companies than other growth managers, as we do not require an absolute threshold of earnings or revenue growth. We believe this philosophy allows us to take advantage of both the normal price appreciation that results from a company’s earnings growth and the market’s re-rating of a company’s price-to-earnings multiple as the earnings acceleration becomes visible. Our goal is to construct a portfolio of emerging market stocks that are experiencing accelerating growth that we believe to be sustainable over time.

Are there any takeaway points for investors?

Emerging market equities have traditionally provided investors with exposure to dynamic growth opportunities and diversification benefits, while delivering strong, yet admittedly volatile returns over time. Despite the volatility, I also think that the emerging markets asset class remains an appropriate investment choice, especially for clients with fully diversified portfolios and a long-term investment horizons.

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