Break Through Preconceptions to Reap Emerging Markets Stock Rewards

Long a source of potential reward as well as perceived risk, emerging markets can represent an attractive asset class for investors seeking returns and diversification. BlackRock's emerging markets experts discuss opportunities, misconceptions and ways of incorporating the asset class into your portfolio.

• The long-term economic and demographic backdrop within emerging market countries should provide tailwinds for emerging markets equities for years to come.
• While investors in multinational stocks gain some emerging markets exposure, they must pay a higher multiple. Investing in a portfolio of emerging markets stocks can offer higher earnings growth at more attractive valuations relative to developed markets stocks.
• Long-only and long/short strategies both offerpowerful ways to access emerging markets equities.

For a long time I've heard the story that emerging markets stocks offer greater investment upside. Is that still true?

The reality is that investors in emerging markets("EM") have been rewarded more than investors in developed markets over the past decade (see chart at right). We believe this will continue to be the case for a number of reasons, including that emerging markets have faster growing economies and more rapidly growing companies. For example, the real GDP growth of emerging markets economies is considerably higher than developed market GDP growth rates (see chart on next page). In addition, emerging market economies are not experiencing the same kind of extraordinarily high debt-to-GDP levels and financial system crises that some developed market economies are right now. While these factors don't equate to stronger stock returns necessarily, they certainly do help.

Another key factor to our long-term outlook is demographics. It's pretty well documented that the US and other developed countries generally have an aging population, with a sharply rising number of people retiring over the next 5 to 10 years. But in emerging markets, the pattern is the opposite. Over the next 20 or more years the working population in emerging markets will be expanding. More workers earning incomes means more spending and consumption, which translates into stronger levels of economic growth.

Ultimately, however, what drives stock performance is corporate earnings growth and valuation of stocks. Indeed, over the longterm, companies in emerging markets have grown their earnings more rapidly than developed market companies (see chart below). At the same time, we believe that investors gain more upside potential in buying emerging markets stocks as opposed to buying more expensive multinational stocks with some emerging markets exposure.

I thought emerging markets stock markets were less efficient and more volatile. Has that changed?

Not really. Emerging markets stock markets are still less efficient and more volatile, with less good-quality data. But we find this environment to be very attractive from the standpoint of an active investor, as we believe there are more opportunities and more upside. Investing in emerging markets involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. Indeed, we believe there is a huge opportunity to generate excess returns in emerging markets equities through stock picking. The chart on the opposite page shows that stock-specific risk dominates other risks in EM. One of the key advantages of our platform here at BlackRock is our ability to apply disciplined and methodical approaches to equity investing.

What are the benefits of a long-only equity approach to emerging markets?

The benefits of a long-only equity approach to emerging markets are that an investor gets a portfolio built from the bottom up with a methodical approach to stock selection, and gains exposure to positive longer-term market trends. In this approach, we take a stock-picking focus that accounts for most of the risk exposure. However, we will also take country and sector views when we have very strong conviction, though such views will contribute a lower amount of the overall risk exposure.

For example, within China we are cautious on the macroeconomic backdrop and thus cautious on a lot of financial stocks. But there are great opportunities, such as certain companies in the Chinese Internet sector that we believe have strong business plans and growth prospects. It is stock-specific, rather than dependent on the Chinese economy. We believe the best approach is to disaggregate what is happening to the economy versus the company-specific opportunity. In each emerging nation there are opportunities like that.

How do you construct a long-only portfolio?

Our portfolios are constructed around specific stocks, so we use a methodical, consistent and focused process in researching and ranking investment opportunities. The process focuses on determining the key drivers of growth, analyzing valuation and assessing a target investment's governance profile. Thereafter, we rank each company with respect to these qualitative and quantitative assessments, and derive a weighting of how that investment would (or would not) fit within the portfolio. This deliberate ranking process, combined with the risk analytics that the investment team employs, produces the team's highest conviction stock ideas, and in turn, high conviction portfolios.

How does a long/short strategy differ from long-only?

A dedicated long/short approach is an efficient way to access emerging markets excess returns because it allows us to manage market risk. The long/short investment strategy means that we buy (long) stocks that we believe will appreciate in price, and at the same time sell (short) those stocks we believe will go down in price. So this strategy is not about hitting home runs every once in a while. It's about achieving a continuous succession of singles that ultimately brings the investor attractive returns with minimal risk. See table below for a comparison.

How do you construct a long/short portfolio?

Our methodology to building a long/short portfolio is a bottomup stock picking approach that we implement systematically. Because emerging market stock-specific risks (relating to a single company stock) are essentially the same as developed market risks, we prefer to look deeper at the specific stock level to make investments. We rely on three main measures of value in picking stocks to own or to sell short: earnings quality, sentiment and relative valuation. Our process is agnostic in terms of having favorite countries or favorite industries. With all these factors, we get a comprehensive view of how likely it is that a given stock is going to outperform or underperform its peers over the next three to 12 months. The portfolio management team uses that output to construct portfolios.

One part of our disciplined approach is to scrub and clean the data to prevent a "garbage-in, garbage-out" scenario, which could hurt a manager with lesser resources. The inefficiency of the market in recognizing new data means that information is priced in slowly across emerging markets, which can be a big advantage for sophisticated investors. For example, information is factored into equity prices in developed markets, such as the US or Japan, in a matter of minutes or hours. In emerging markets, it can take days, weeks or even months for information to be priced into securities. Our portfolio management team is immersed in market and security research and can often capitalize on an event before the market prices in its realization. That's a powerful example of the potential inefficiency in this market that makes us very excited about investing in emerging markets.

How much of an equity portfolio should be allocated to emerging markets?

While the "typical" investor's portfolio has increased the allocation to emerging markets, it still holds only 5% in emerging market equity according to Lipper, considerably underweight the 12% that EM represents in world market capitalization (see pie charts). However, we believe that allocation is even too low, given the attractiveness of emerging markets from a fundamental and growth perspective. Indeed, the asset class could potentially offer double the earnings growth and triple the GDP growth, with only half the corporate debt and a quarter the sovereign debt. As such, we suggest clients consider a 50% overweight to the market capitalization level. Each individual's ideal recommendation will be different based on age, risk aversion and time horizon, and this decision should be made with the guidance of a financial professional who is familiar with each individual's unique needs and preferences.

How should an investor balance exposure to long-only or long/short approaches?

In a portfolio, an investor can have both approaches. It depends on what you're looking for. Long-only provides the opportunity to take advantage of broader market performance, while long/ short seeks to eliminate exposure to the broader market, and focuses solely on specific-stock returns.

We feel strongly that all investors should have exposure to emerging markets, given the long-term positive economic trends for the regions. But investors should consider the differences in risk of the strategy they decide to employ to gain that exposure as they. Investing in long/short strategies presents the opportunity for significant losses including in some cases, losses which exceed the principal amount invested. Ultimately investors should discuss allocations with their financial professional, taking into consideration their time horizon, risk appetite and portfolio composition.

Investment involves risks.Stock values fluctuate in price so the value of your investment can go down depending on market conditions.International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation andthe possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investmentsin emerging/developing markets or smaller capital markets. Long/short investing entails special risks. Short sales in securities thatincrease in value can cause a loss of principal. Any loss on short positions may or may not be offset by investing short sale proceeds inother investments. Investing in derivatives entails specific risks relating to liquidity, leverage and credit that may reduce returns and/orincrease volatility.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are those of the portfolio managers profiled as of September 12, 2012, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that may, in certain respects, not be consistent with the information contained in this report. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

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