Eaton Vance's Rees-Moog Sees Tremendous Values in Emerging Markets

When one travels to distant locales, it's advisable to secure the services of a trusty and knowledgeable guide.

The same holds true for investing in emerging markets, where one may encounter such potential pitfalls as problematic accounting, banks laden with bad debt, concerns about terrorism and economic woes (this is overseas we're discussing, right?). You would have to travel far to find a surer guide than Jacob Rees-Moog, manager of the ( EMEMX) Eaton Vance Emerging Markets fund.

Since Rees-Moog assumed the helm of the fund in May 2000, the value-minded Briton has turned in a most impressive performance. The fund's 7.28% one-year return puts it in the top 3% of all emerging-markets funds, according to Morningstar. Its three-year annualized return of negative 5.87% ranks among the top 13%.

Rees-Moog makes a convincing argument that emerging markets offer extremely cheap buying opportunities, thanks to reforms enacted after the global crises of 1997 and 1998 as well as burgeoning middle classes within the borders. How cheap? He is finding many stocks with price-to-earnings ratios below 10 and dividends near 5%.

Rees-Moog takes readers around the investing world in 10 Questions -- from Russian oil companies and South African mining stocks to Brazilian tobacco makers and Chinese insurance outfits. Armed with characteristic British wit and an encyclopedic knowledge of emerging-market economies, we think you'll find it a most valuable trip.



Jacob Rees-Moog

Eaton Vance Emerging Markets Fund
Tenure: Manager since
May 1, 2000
Assets: $18 million
Three-Year Average Annual Return: -5.69% (Top 13% of Peers)*
Top Three Holdings: Harmony Gold Mining (S. Africa), Gold Fields (S. Africa), Sindoricoh (S. Korea)**
Fund Information: Web site or 1-800-225-6265
*Performance through 11/30/2002. **As of 9/30/2002. Source: Morningstar, Eaton Vance

1. What is the outlook for emerging markets in the next 12 to 18 months?

It's a mixed picture. Emerging markets obviously have significant dependence on the major markets. What we're seeing is that domestic markets are strong, but that exports to the U.S. and Europe are weak. We are more invested in domestic consumer-based stocks rather than export-driven businesses.

Where we're positive and why we're very optimistic about emerging markets at the moment is on valuation grounds. I'm seeing many stocks with P/E ratios under 10 and dividend yields approaching 5%, which is almost always a good basis on which to invest.

Why are valuations so low?

The emerging markets went through a crisis in 1997-1998 and it was across the board -- Russia, the Far East, Latin America as well. Since then, there's been quite a lot of consolidation and reorganization, the banking systems have been reformed, credit has improved dramatically.

We've seen extremely low levels of earnings bounce back surprisingly quickly. I wouldn't categorize it as fundamental growth, rather a rebound after a couple of years of extremely difficult trading. In a way, we're back on trend.

That's one side of the equation. On the other side, there is domestic growth. Emerging markets have large consumer markets within them where the people are getting steadily richer -- a growing middle class, if you will.

2. Your largest weighting by country is South Korea. Are you confident in its economy?

The MSCI Emerging Markets index weighting is 22%-23%, so we're underweight. We're not index investors, mind you, but we're a little bit light relatively speaking.

What we like in Korea, again, is primarily driven by valuation. Our biggest holding is a office-equipment company called Sindoricoh, a subsidiary of Ricoh Japan, which has a sizable holding.

Sindoricoh has a dividend of about 4%, it has 25% of its market capitalization in cash on the balance sheet, and a P/E of 9. It is also benefiting from a technology transfer from its Japanese parent. It has a strong domestic market, as well as some export business -- not just in the U.S., but also to the Asian region.

That's an example of what we're looking for. The more stocks I can find with these characteristics, the happier I would be -- a combination of growth, competitive advantage and low valuation. It's not quite perfect (laughs), but stocks like that are very good finds.

We've bought into the banking sector in Korea recently.

Are you concerned about rising consumer debts in Korea?

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Yes. Credit card debt has been a worry, and credit card delinquencies have become surprisingly high. That was actually one of the reasons for buying banks. There's been quite a large sell-off in these shares, which made valuations more attractive. The banks themselves are less directly affected. It's not a risk-free investment.

But Korea has changed. When I was first investing in Korea, it was all about exporters. Korean very much fits in to the broad theme of looking more for domestic demand.

3. As of Sept. 30, your two largest holdings were South African gold companies -- Harmony Gold Mining (HMY), and Gold Fields (GFI). Why do you like these companies, and have you lightened up at all?

No. Actually, we have taken little bits of profits because gold stocks have done very well to make sure we weren't even more exposed than we are. But we haven't sold since the end of September.

Why do I like gold, and why do I like South African gold? I like South African mining stocks because they have become much more focused on profitability since South Africa has become a more open economy. The old gold companies used to be very profitable, but they would use their money to buy vineyards and all sorts of extraneous investments because they couldn't move their money out of the country.

Now, they are investing in Australian gold mines, Russian gold mines -- they're clearly focused on gold. And they're managing their money more tightly to maximize profits.

Also, the gold price has been greatly undervalued. In a period of market uncertainty, gold is a great place to put your money.

Look at the major global currencies. If you look at the euro, the underlying economies are in a bad way. The stability pact has been called "stupid" by European Commission President Romano Prodi -- not a very productive comment, but it happens to be true. The euro is not where you want to put your money. The yen is backing the Japanese economy, which is in long-term doldrums. The dollar requires $2 billion a day to keep the U.S. trade deficit funded.

If you look at the world's three major currencies, there's good reasons to believe all of them were going down. They can only go down against each other. I think this remains very positive for gold. (Laughs.)

If it were just that alone I wouldn't invest in gold stocks, because I could be wrong about the gold price. It's hugely helped by the fact that the companies are improving their management techniques and are very aggressive in increasing productivity and profits. Add to that a gold price that is very stable, plus a positive macro view, and they remain good investments.

4. You have a number of holdings in China. Would you provide your perspective on the country?

We have quite a big exposure to China. It is an enormous area of growth -- 10% annual growth rates for more than a decade. The numbers are so staggering that when you talk about the Shenzen and Shanghai areas, you're talking about a population the size of the United Kingdom. And the country has a billion more people in the poor hinterland.

So, you're getting pockets of China that are really almost "first world" already, but we've got a huge pool of low-cost labor so they can carry on growing through there. You hear stories of factories moving lock, stock and barrel 50 miles inland and halving their costs. That brings more people in to the manufacturing systems and prosperity and wealth. It's a great virtuous circle.

But the caveat: Every body knows that story. Every fund manager is fully aware of that. Therefore, you periodically see great spikes in the value of Chinese stocks. Sometimes these stocks get hopelessly overvalued. So we have to be careful to take profits when everybody gets overexcited, and that we look beyond the China Mobiles ( CHL) of the world, which everybody is fully aware of to find stocks that haven't been discovered so much.

A lot of individuals here in the U.S. are very interested in tapping into the emerging Chinese market. How can investors separate the wheat from the chaff in terms of Chinese stocks?

They shouldn't invest in any company with China or dot-com in it's name. (Laughs.) Well, I'm half-serious; there are some perfectly good companies with China in their names. Some of the lesser companies with China in their names have done very well.

We do hold China Insurance; they have a big stake in the Chinese insurance market, which is growing rapidly. Other global insurers are finding life very difficult; the competition that China Insurance expected to find hasn't materialized. They've got a first-mover advantage and it's going on longer than expected. Their results keep coming in way above expectations.

Investors looking to tap into China should look for companies listed on the Hong Kong exchange rather than the Chinese exchange. They should invest in companies that don't have a large ownership by the Chinese government, because of the concerns about overhand. Invest in family companies -- your interest and the family's interests are tied together.

But it is difficult, because some families treat outside investors very bad. Other families, conversely, value the capital that they've raised from outside investors and treat them very well.

Be very cautious. You have to minimize your risk if you're brave enough to go on your own. Of course, you can always let someone like me do it for you -- I suppose I should say that, shouldn't I?

That's certainly advisable. Continuing on China: How is the recent changeover in leadership going to affect the nation for the short and long haul?

If you take a broad, historical sweep of how countries emerge, a lot of them have appeared to be getting rich and it's all appeared to be working. The one thing that stops it is political catastrophe.

If you look at China and Russia in the 1900s and 1910s. Both had been viewed as great emerging market opportunities that were halted by political catastrophes. If you look at European economies in the 19th century, a series of revolutions made investments there very unsuccessful.

What made the U.K. and the U.S. a great investment is that the political systems worked. But we look back on our political systems and think that because they worked, it's destiny. But I don't think that's right, I think we were very lucky that they worked. If a few things had gone the wrong way, it could've been a different story.

The key to the long-term success of any emerging market is that the political system hangs together -- that you don't have a revolution. What has happened in China is that we have avoided a revolution for another political generation. It is smooth and has been accepted. Jiang Zemin remains but is slightly behind the scene, as did Deng Xiaoping before him. It is an orderly, regulated procession.

It's not a political system that you and I would choose; we enjoy greater democratic freedoms. But nonetheless, it allows for stable investments to be made and for further development to take place. And so, to tempt fate, I don't think we need to worry too much about China's government until the next hand over, which perhaps will be in another 10 years.

It's very important; it's very good news. But taking a long-term 50-year view, politics remain the biggest investment-risk in China. What do you think?

I think Americans rightly have concerns about China from a human-rights perspective, but they also don't fully appreciate how much progress China has made in such a short period. They have gone from an agrarian society to a modern society in a hurry.

China has squeezed into 20 years what the United Kingdom did in 200. The Industrial Revolution in the U.K wasn't really completed until you had tractors on the farms; and that took about 170 years. That process took 20 in China; it's an amazingly rapid industrialization.

The thing about new emerging markets is that they can leap frog. They don't need to go through every stage of development. They don't need steam power; they can go straight to electricity.

You see that much more significantly with the extension of mobile telephony ahead of fixed wire lines and because it's so much easier to install in remote areas.

5. Let's talk about Russia, where you have a stake in Yukos (YUKOY) and a few other holdings. What do you like about the country?

Most of our exposure to Russia is in the energy field, where they have huge resources and major companies.

I think the election of Vladimir Putin was hugely important. Since their crisis in 1998, the banking system has been reformed. You've seen an increase in property rights. Once you have property rights, you can have mortgages, once you have mortgages you can have people setting up businesses because they have property to put up as capital.

This is leading to a good deal of development, which is currently being paid for by a reasonably robust oil price. The hope is that if it were to go down to $15 a barrel, by that point the economy would manage to get sufficient debt out of it to carry on growing.

Putin has also been very successful on tax matters. Tax levels used to be extremely high, which of course no one paid. He has instituted a flat tax at 13%, and tax revenues are at record levels. Income-tax collection at the flat 13% rate has doubled from the higher, variable levels.

6. Speaking of oil, let's talk about the possibility of military action in Iraq. What happens to your oil investments if Iraq becomes the 51st state, as it were?

From a political standpoint, I'm one of the small number people in Europe -- fortunately part of a greater number here in England -- who actually believes your president is absolutely right. It's very important for all investors. If we have lunatics dropping bombs all over the world, it's quite dangerous for all of us.

I think we're going to have to play the oil situation very carefully. As long as tension remains, the oil price will remain in the $20s.

What if we have a 24-hour war -- a swift and total victory. We get the Iraqi economy back going full steam -- what's that, a couple million barrels a day of extra production? You could see a drop in the oil price, depending on what the Saudis do. If the war lasts a week, you'd see a spurt in the oil price until the war was over, because people would get nervous. It's not clear cut what will happen.

We're going to hold on to our oil positions in the meantime, in the hopes that between now and everything being settled we will get a better price. It may be that we're being too clever by half.

7. Let's move to Latin America, where you have about 14% of your assets -- a bit underweight. What do you see in that part of the world?

I'm underweight in Latin America, particularly in Brazil.

Brazil is really difficult. Argentina was easy. We took money out a year before the currency devalued on the basis that it was clearly going to devalue.

Brazil may still go completely bust. I have very little confidence in Lula Brazilian President Luiz Inacio "Lula" da Silva, who has no experience. He has made a series of fairly random statements over the past year, some of which are reassuring, some of which are decidedly not. They have problems collecting tax, they have a large structural deficit after paying interest.

On the other hand, the IMF is being very supportive, and the stock valuations are among the lowest in any of the markets I examine. If the currency went back to something under three, it might all hold together. In which case there's great value and you could make a lot of money.

Then again, Lula could say one stupid thing about defaulting, the real could collapse overnight and then they'd have to default. I honestly don't know which way it's going to go.

It looks like your only major holding in Brazil is cigarette-maker Souza Cruz.

Souza Cruz, yes. If there's a catastrophe, people will smoke even more. (Laughs.) They've got some export earnings from their tobacco leaf, which help. They pay out 90% of earnings in a dividend. They have a P/E of 6; it's a great value-company.

Also, they're not going to get sued. They do have legal actions against them, but they won't have a U.S.-style legal payout.

They have over 80% of the domestic market. The legal market, I should say. That's actually quite helpful. The government is trying to stop the illegal market, so it's keeping tax rates on tobacco extremely low. The government knows if they raised rates, the black market would get much stronger.

8.How do you factor in the vagaries of U.S. economy on investing in emerging markets?

That's a good question. It varies county by county.

From 1995 to 2000, if I spoke with U.S. investors about emerging markets, they would have had no interest because they could make so much money in their domestic market. It was much easier, more understandable. What's the point of doing extra work to invest in a specialist area?

Since 2000, it hasn't been so easy to make money in the U.S. market. If a very, very small amount of money moved into global emerging markets, they would take off like a rocket. If U.S. mutual funds put another $20 billion into global emerging markets -- a pittance, a bagatelle -- it would have an enormous positive effect.

But if the U.S. were to have a recession, it's very tough to read. The last U.S. recession benefited China exports because Americans were buying less-expensive items at Wal-Mart and the like, and cheap imports are often made in China. But Korean car makers, for instance, did poorly because people held on to their cars for another year.

Some markets will do surprisingly well, and others will do quite badly. You have to consider it market by market, really.

9. If you had to pick two or three companies that you would hold up as solid longer-term investments, what would they be?

This is the curse. Whenever one recommends particular stocks, they inevitably perform terribly going forward. But I'll stick my neck out and hope for the best.

On value grounds, I would buy Telecom Indonesia. The company has a P/E of under 5 and a dividend yield of over 6%.

I'd buy on the grounds of huge growth Kimberly Clark de Mexico ( KCDMF), because the use of paper products in Mexico is very low. It has an 11.5 P/E and again a dividend yield of about 6%.

I'd buy gold stocks because if everything else goes wrong, you'd still make money. I'll pick Harmony Gold because it has a fantastic management.

Lastly, I'd put a little money in Sindoricoh, because of the reasons I explained. It may not be perfect timing at the moment.

Wow, you offered four.

Now, if all four stocks encounter disasters, you'll know who to blame.

10. One last question: You invest in some hot-spot areas, such as Indonesia. Are you concerned at all about the risk of terrorism on your holdings? Is there any way you can possibly factor this into your investing?

I live immediately behind the American embassy in London, so I'm surrounded by armed police, barricades, you name it. So it's certainly on my mind. However, I think you can't invest or live on the basis that you or your stock is about to get blown up. You're not.

The odds of any stock you're investing in having damage are so slim. And when these things happen, which they inevitably will, these stocks fall off so dramatically that it becomes a great time to buy.

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