The first quarter was weak for emerging markets in terms of economic activity and corporate earnings, but valuations offered a bright spot as price-to-earning and price-to-book ratios came in at a large discount to historical levels. In this environment, we believe two countries warrant particular attention: China and Brazil.
China's reforms are slowing economic activity - for now
The Chinese government is continuing to correct the excesses in the economy and missteps of the last administration. As an example, the government appears to be keen on slowly letting out some of the steam from the unofficial shadow banking system. (Shadow banks include financial intermediaries and activities not subject to regulatory oversight.) In March, the government allowed its first-ever corporate bond default when it refused to bail out a local solar panel maker, which we believe is a way for the government to educate depositors about the risk of high-yielding wealth management products that rely on less formal channels.
While we believe these initiatives are positive for the long run, we are seeing a reduced level of economic activity now. One year ago, the street was looking for 2014 gross domestic product growth of 8%, while today expectations are closer to 7.4%. Given Chinese companies' cheaper valuations, we are finding pockets of interest.
Brazil's market improved dramatically
Brazil started off the year as one of the worst-performing markets, as investors lost hope in economic improvement as current President Dilma Rousseff was expected to win re-election in October despite weakening economic fundamentals. But in mid-March the market rebounded on cheap valuation and on a hope that the result of the election may lead to positive changes in the country. Brazil is now suffering from one of the worst droughts it's had in decades, and power rationing appears to be likely. Given the increasing chance of power rationing, presidential popularity is falling. This has raised low expectations of a political change, which could mean positive changes in economic policies.
As Brazilian stocks got cheaper during the quarter we added Brasil Foods, Brazil's dominant processed food manufacturer, as it hit attractive valuations (0.22% of Invesco International Growth Fund as of March 31, 2014). We also added to financials in Brazil, for example, BM&F Bovespa (2.86% of Invesco Developing Markets Fund as of March 31, 2014). The company runs the largest securities and derivatives exchange in Latin America. It had a strong profit margin and free cash flow generation, and has announced a share buyback. We believe the valuation was compelling and its stock offered a nice dividend yield.
The EQV view
Our EQV criteria focuses on earnings, quality and valuation. In our opinion, valuations in emerging markets look cheap, but we are seeing only of pockets of opportunity in high-quality companies with long-term earnings power and efficient capital allocations. On the bright side, we are glad to see many of the companies we own increasing dividends, which we view is a sign of capital discipline in an environment of slow growth.
Invesco Developing Markets Fund and Invesco International Growth Fund
Depositary receipts involve many of the same risks as a direct investment in foreign securities, and issuers of certain depositary receipts are under no obligation to distribute shareholder communications to the holders or to pass through to them any voting rights.
Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks. An investment in a derivative could lose more than the cash amount invested.
An investment in emerging market countries carries greater risks compared to more developed economies.
The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified funds.
Growth stocks tend to be more sensitive to changes in their earnings and can be more volatile.
The investment techniques and risk analysis used by portfolio managers may not produce desired results.
Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.
Invesco Developing Markets Fund
Preferred securities may include provisions that permit the issuer to defer or omit distributions for a certain period of time, and reporting the distribution for tax purposes may be required, even though the income may not have been received. Further, preferred securities may lose substantial value due to the omission or deferment of dividend payments.
Invesco International Growth Fund
Many countries in the European Union are susceptible to high economic risks associated with high levels of debt, notably due to investments in sovereign debts of European countries such as Greece, Italy and Spain.
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