(October 29, 2013) — Investors are taking on too much risk with their emerging market equity allocations by skewing them towards consumer-focused companies, according to Bank of America Merrill Lynch (BoAML).

The fund manager found that most investors were too heavily weighted in consumer sectors such as retail, internet, and telecoms, placing substantial risk on their overall portfolio.

These assets, typically described as “growth-orientated” assets, are also now worse value for money, according to Ajay Kapur, BoAML’s Asia Pacific and global emerging market strategist—a price/earnings valuation of 31 x PE, compared to 20 x PE for developed market growth assets.

Investors should be looking to the exceptionally underweight, unpopular state capitalist sector instead, Kapur argued in a BoAML global research report entitled “The Unbearable Heaviness of Investor Portfolio”.

And all of the things which have traditionally turned investors off that sector—higher financial vulnerability, worsening external/fiscal accounts, corruption perceptions and forthcoming elections and their impact—should be the reasons for investing in these assets.

Why? Because these countries have every incentive to change, taking their state-owned assets values up as they do so, Kapur argued.

“China, Malaysia, Indonesia, India, South Africa, Brazil, and Chile have had or will have elections/ political change in 2013/14. New leadership could start sweeping with a new broom,” he stressed.

The young demographic in these regions will drive their governments into a new direction, Kapur continued. These countries populations—mostly young and increasingly middle class—are concerned about perceived corruption and wealth inequality, and the state-owned assets are often at the heart of this frustration.

“The potent mix of a Chinese boom, QE, and strong economic fundamentals that allowed the State capitalism model to thrive is evaporating,” said Kapur. “Privatization, and/or significant reform is demanded by disgruntled populations, is made imperative by worsening fiscal (and current accounts), and is made possible by political change.”

Reforming these state-owned assets to raise their return on equity and ultimately privatizing them will bring in much needed revenues, lessening the burden to the government balance sheet.

There is a rising external constraint too: countries with the highest state-owned company concentration also have the most serious deterioration in their current account balances. “As quantitative easing wanes, potential withdrawal of foreign capital could be a potent threat for pre-emptive reform,” said Kapur.

There are of course risks associated with this new direction. The first big one is that momentum investing continues for longer than BoAML thinks it will, as successful emerging market growth investors raise more assets under management and then deploy it.

The second, Kapur said, was that consumer-friendly drivers like high property prices, nominal wage growth, low gas prices, and consumer lending growth stay strong. The third, that growth names deliver earnings per share surprises, and fourth, that Chinese nominal growth disappoints and so raises the premium for growth stocks.

Kapur’s pick of the crop were: Oriental Bank of Commerce, Petrobras, Huadian Power, SABESP, ONGC, Kunlun Energy, Sberbank, Bharat Electronics, Cia Energetica Minas, China Unicom, China Construction Bank, PetroChina, China Agri Inds, Rosneft, and Gazprom.

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