NEW YORK (TheStreet) -- Emerging market stocks are cheap but against a backdrop of sluggish global growth, investors have been reluctant to jump in.
That scenario may be beginning to change.
China, the world's second-largest economy and the undisputed heavyweight among emerging markets, plans to allow for changes in its financial sector that could help to reshape the economy. Over the weekend, Chinese policymakers said qualified private investors would be able to establish small-to-medium-sized banks that would compete with state-owned financial institutions.
News of the plan, among other proposed reforms, lifted the MSCI Emerging Markets Index for a second day, it's largest two-day advance since Sept. 10. Nonetheless, the MSCI EM Index has lost 4.7% this year against a 27% gain for the MSCI World Index and a 26% increase for the S&P 500 Index. In defense of emerging markets, the MSCI EM Index has gained 6.9% since June 30.
The relative poor performance of emerging market stocks to developed markets has forced fund managers to more carefully chose their investments. Rather than picking a basket of stocks within a particular country, fund managers are having to select individual names.
"I no longer look at emerging markets as an asset class, the countries and their components are so different," Colin Bell, Auerbach Grayson vice-president of global emerging markets said in a phone interview. "We're undergoing a shift now, where countries that can fund themselves [their own current accounts] will perform relatively better [that those with large current account deficits]."
On a valuation basis, emerging markets certainly look attractive. Emerging market stocks trade at around 1.6 times book value - the value above their assets - against 2.5 times for U.S. stocks. Countries such as Russia and Hungary trade around 0.8 times book value. But many seemingly cheap countries are described as "value traps" by fund managers -investments appearing to present value that is unlikely to eventuate.
There are two key reasons for this. The economic slowdown in many emerging markets is structural rather than cyclical, requiring a combination of government and monetary reforms to kick-start growth. For example, India has slowing growth, a widening account deficit and high inflation. The country's central bank has raised rates to fight inflation but this has crimped growth - with similar scenarios faced in Brazil and Indonesia.
Secondly, economies with large current account deficits such as Indonesia, South Africa, Turkey, Brazil and India have been fueled by cheap capital inflows from developed nations like the U.S. That scenario is likely to end with the anticipated wind-down of Federal Reserve stimulus, which is seen as potentially triggering capital outflows from speculative investment in emerging markets.
Fund managers say a key theme for much of the year has been to avoid emerging economies with deteriorating current account and fiscal deficits - a trend they expect to continue.
"Countries that leveraged off cheap capital inflows from developed markets (such as the U.S.) to fund their national deficits may be challenged when that goes away," Bell said.
He noted this could change if Federal Reserve stimulus is maintained at current levels for the medium-term. Countries that fall into this basket - including Turkey, Indonesia, Brazil and India - have seen their markets lose between 3% to nearly 15% in 2013.
Excessive credit growth is another risk factor. Societe Generale's head of global research Patrick Legland warned clients last week that private sector debt had built up rapidly in many emerging Asian countries, with a fast rise in household debt in Malaysia and Thailand.
"More worrying is the leverage in China's corporate sector, now one of the most indebted in the world (at about 150% of GDP)," Legland wrote. A prolonged economic slowdown could trigger a jump in bad loans in emerging markets with high debt levels, he added.
A 60-point plan announced by Chinese authorities late last week would see sweeping economic and social change, though several economists have said it is unlikely to significantly boost GDP or the stockmarket. The changes include state-owned enterprises being required to pay higher taxes to government, with private firms encouraged to play a greater role in the economy. Private investors will be able to set up banks, along with moves to liberalize the labor market.
But John Rutledge, chief investment strategist at Safanad, said any moves by the U.S. Federal Reserve to cut back its bond purchases would be far more consequential for emerging market stocks than the Chinese reforms.
"The Chinese reforms are very positive but they come at a time when the structure of the Chinese economy is changing - emerging markets used to be driven by the resource demands from China and its infrastructure," the New-York based fund manager said in a phone interview. The more consumerist slant of China's economy meant any impact would now be substantially reduced for other emerging markets, he said.
Instead, Rutledge said emerging markets would be far more sensitive to the potential for huge capital outflows amid any backdrop of rising U.S. interest rates.
A greater emphasis on consumption in the world's second largest economy also has implications for other emerging markets. As Chinese growth has slowed from over 10% to around 7.7% over the past few years, its need for commodities has fallen and emerging markets that produce these materials have been hit. China is also buying fewer manufactured products from other developing Asian markets like South Korea. "China has a reasonable growth rate but it's not enough to bring Latin America and other economies along with it," Derek Sasveld, head of asset allocation at ING Investment Management said at a press briefing this week.
At a company level, many corporations in emerging markets have high cost structures and have not used foreign capital inflows wisely, Sasveld added. "We need to see an increase in profitability - these companies are often good at asset turnover but poor at generating a return on equity," he said.
Given these challenges and the huge diversity of emerging market economies, many fund managers emphasize the need to take an individual company approach to investing.
Van Eyk Emerging Markets Fund portfolio manager David Semple invests in China via the Hong Kong Stock Exchange and likes companies such as Tencent, an internet conglomerate that runs one of China's largest social-media platforms. He also backs specific Russian stocks that include an industrial state developer, a supermarket and an oil company. But he warns that the bounce in some emerging market sectors and stocks (the MSIC emerging markets index has gained 12.2% since June) is likely to be a reprieve rather than reprisal of strong growth. Sasveld agrees.
"Emerging markets are often thought to be attractive on valuation grounds but when you dig deeper, it is somewhat illusionary," Semple said.
-- By Jane Searle in New York