Cabot Explorer Issue: September 29, 2022

The Smart Way to Play Emerging Markets Right Now

The drama surrounding Britain’s economic plan is worth following and offers some lessons for America as we chart a path forward.
At the start of Thatcherism and Reaganomics, both the U.K. and the U.S. ran small current account surpluses, had manageable debt levels and high marginal tax rates, and highly regulated markets and interest rates.

In other words, there was plenty of room and political support to boost debt, consumption, and de-regulation.

At the start of a new economic plan called “Trussonomics,” Britain has a record current account deficit and, like the U.S., a national debt above 100% of GDP, making it difficult to jumpstart the economy.

Another problem is politics. Margaret Thatcher had a strong mandate to push through unpopular policies such as big cuts to government spending.

This is no longer the case and the same goes for U.S. In addition, America’s national debt as a share of our GDP has gone from about 30% to 50% under Bush 43, to 80% under Obama, to 100% under Trump and Biden. Some of this is due to the pandemic, of course, but the key takeaway is that debt limits flexibility to spur economic growth.

Emerging markets have less leeway on managing debt and spending, which may in the end be a blessing in disguise. They have underperformed in the last decade but still represent a big part of global growth and output, not to mention are trading at a huge discount to well-developed markets.

This week I offer the smartest way to play this opportunity.

New Explorer Recommendation: WisdomTree Emerging Markets High Dividend Fund (DEM)

Stocks have pulled back sharply this year for multiple reasons including interest rates rising, but a key reason is that valuations were stretched a bit far relative to earnings, book value and dividends.

This was not the case for many international markets and the strong U.S. dollar has made them extremely cheap. Sir John Templeton, the dean of international investing, called this sort of market situation a sign of “maximum pessimism,” and a good time to buy.

This brings us to the WisdomTree Emerging Markets High Dividend ETF (DEM), a basket of high dividend stocks based in Latin America, Eastern Europe, and Asia.

Emerging markets make up about 80% of the countries in the world, representing 77% of the world’s landmass and 85% of its population.

These countries now represent roughly 60% of total global GDP while just two decades ago they accounted for only 23%.

Every day, approximately 150,000 people in emerging markets move from the countryside to cities in search of better opportunities. From education to health, infrastructure to financial markets, these nations have made major strides. Companies, domestic and international, are making a lot of money meeting the wants and needs of these 6.6 billion people, as they become an upwardly mobile world middle class.

Yet it seems that most investors have zero or little direct exposure to these dynamic markets while I recommend that you have about 10% of your equity portfolio in emerging markets.

WisdomTree Emerging Markets High Dividend ETF covers 17 different emerging markets and gives broad exposure to large caps, mid-caps and small caps in these countries.

This ETF has a clear income and value strategy. The stocks in its basket tend to be conservative, defensive companies with low valuations and high dividends.

And WisdomTree makes adjustments to the portfolio every year to make sure the companies in the ETF basket are in the top 35% of emerging market companies by dividend yield. Furthermore, this ETF holds some of the cheapest quality stocks in the world with an average price-to-earnings ratio of 5.5 (vs. 12 for the MSCI Emerging Markets Index and about 20 for the S&P 500).

And its average stock holding trades at only 1.2 times book value and yields 7.7% (versus 1.4% for the S&P 500).

To sum it up, the stocks in this ETF could more than triple in value and they would still be cheaper than the S&P 500.

The fund, while down 16% so far this year, was up 11.7% in 2021 versus negative-2.5% for the MSCI Emerging Markets Index.

It does take a leap of faith to be a contrarian and buy assets like these that are out of favor and largely ignored. But that is how smart investors often earn higher returns with less risk.

Also keep in mind that blending emerging market stocks with U.S. stocks actually reduces your portfolio’s volatility since the two asset classes don’t move together. Emerging markets beat to their own drummer.

In my opinion, emerging market equities are the world’s most undervalued asset class. BUY A HALF POSITION

Portfolio Changes
None

Updates

Centrus Energy (LEU) shares were up 8.8% yesterday and for the week rose from 41 to 43. This nuclear fuel supplier’s deployment-ready centrifuge enriches uranium for utilities in the U.S. and abroad.

Centrus’ net income margins are above 50% for the year, and revenues have grown by double-digit margins while its stock trades at just 2.2 times forward sales estimates. In addition, the company recently announced that it has secured new nuclear fuel sales contracts and commitments worth an estimated value of $270 million so far this year.

Based in Bethesda, Maryland, Centrus supplies nuclear fuel and services for the global nuclear power industry. Nuclear power provides 20% of the power for our electricity grid and more than 50% of U.S. emission-free energy, according to the Department of Energy. Centrus stock is still trading way off its 52-week high and at just over three times earnings. BUY A HALF

Fanuc (FANUY) shares were off a bit this week to 14, in contrast to Fanuc’s robot orders in the latest quarter, which rose 23% from the previous quarter, driven by strong demand everywhere and especially the U.S.

Fanuc’s robot division has grown to be its biggest revenue contributor, accounting for nearly 40% of its total sales, but machine tool sales were weaker to China in particular.

Jefferies estimates that Fanuc is the world’s leading manufacturer of industrial robots. FANUY offers us a high quality stock with a strong balance sheet with plenty of cash. This stock is testing our patience but holds its ground in weak markets. BUY A HALF

Ford (F) shares were off a point to just over 12 and as the company unveiled its redesigned F-Series Super Duty product lineup this week. CEO Jim Farley stated that parts supply issues persist and labor markets remain tight and lithium prices remain elevated. For 2022, the company projects that adjusted operating results for the third quarter would fall between $1.4 billion and $1.7 billion. Ford stock will benefit from recently approved $7,500 EV subsidies and is still a buy as it trades at just over four times trailing earnings. BUY A HALF

Infineon Technologies (IFNNY) shares gave back a point this week though many other semiconductor stocks are under more pressure as the company’s core market is the auto sector rather than consumer electronics. The company’s EPS is expected to grow 38% this year and cash flow growth is strong. Infineon is a leading broad-based European chipmaker founded when the company was divided from its Siemens parent in 1999 and is focused on auto markets rather than consumer electronics. This is still a buy given its markets and sales and earnings momentum. BUY A HALF

Kraken Robotics (KRKNF) shares fell from 0.31 to 0.28 this week on low volume. This maritime/defense micro-cap is among the first Canadian companies qualified to sell directly to the Government of Canada without competition and was this week in Scotland demonstrating the capabilities of its flagship KATFISH High Speed Towed Synthetic Aperture Sonar System. The company recently signed a follow-on contract to supply additional KATFISH™ for the NATO Navy’s new mine hunting vessels. Kraken Robotics has also landed a major contract to provide new sonar systems for the Royal Danish Navy.

Based in Newfoundland, Kraken Robotics is a marine technology company providing ultra-high resolution, software-centric sensors and underwater robotic systems. Kraken is a well-run company in a strategic area of growth and a prime takeover candidate but please keep in mind that it is an aggressive play offset by strong management. BUY A HALF

MP Materials (MP) shares dipped from 31 to 28 as the company’s market value gets closer to $5 billion and its shares trade at 25 times forward earnings, which is about half of where the metric sat a year ago. I recently moved this stock to a hold primarily because rare earth concentrate prices have pulled back sharply, which is not good for business.

This stock is a way to play clean tech, defense, semiconductors, and other advanced and emerging technologies through some of their basic inputs. HOLD A HALF

Oracle (ORCL) shares drifted lower, from 66 to 63, despite a strong quarter reported last week. The company reported solid results in its first fiscal quarter – without foreign currency effects, its cloud infrastructure revenue increased 58% year over year, and cloud application revenue was up 48%. In addition to the impressive cloud business growth, Oracle’s founder and chairman, Larry Ellison, noted that Oracle can save cloud users money and offer a better product than Amazon’s AWS. “We expect next quarter, we’ll be announcing some brands and companies moving off of Amazon,” he said.

Oracle also announced this week the launch of Java 19, its latest version of the world’s number one programming language and development platform.

One key advantage for Oracle is that its cost structure is fairly fixed so each additional dollar of revenue earns more profit than the last. This cost structure also enables Oracle to offer big enterprise clients a discount for bundling services. Despite all these strengths, Oracle’s shares lack an uptrend and are therefore a hold. HOLD A HALF

Sociedad Química y Minera de Chile S.A. (SQM) shares tumbled from 104 to 95 this week and I’m digging into whether lithium prices may have peaked, which is why the stock is a hold. Lithium prices and fertilizer prices are key drivers and Chile’s political risk is a bit of a drag on performance.

SQM’s dividends are sizable with the annual dividend yielding 11.9% and an impressive five-year annualized dividend growth rate of 12%. SQM is a double play as the company is also the largest producer of potassium nitrate used for fertilizer so the stock offers two drivers of revenue and profits. We need to watch this stock closely, and make sure you have a trailing stop-loss in place. HOLD A HALF

Taiwan Semiconductor (TSM) shares went from 76 to 72 this past week as Apple, a key client of Taiwan Semiconductor, announced that it is reducing production of its iPhone 14 product family by as many as 6 million aiming to produce 90 million handsets for next year, roughly the same level as the prior year.

A Needham analyst recently stated that it expects TSM will grow top-line revenue 15% in 2023 despite an expected fall in industry sales. TSM trades at a very reasonable 16 times earnings as the stock has retreated from a 52-week high of 145 in early January.

While nobody right now can compete with America’s software programmers, semiconductor designing, and equipment, most advanced chips come from Taiwan, an island with a population of 24 million about 100 miles away from the Chinese mainland. Meanwhile, America buys 70% of its most sophisticated chips from Taiwan. BUY A HALF

The next Cabot Explorer issue will be published on October 13, 2022.

JUST PUBLISHED — New book from Chief Analyst Carl Delfeld