Archie Hart, portfolio manager at Investec Asset Management, addresses investor concerns about whether there is still relative value in emerging markets compared to developed markets by looking at emerging market valuations and what drives equity returns. He also considers whether the MSCI emerging markets benchmark accurately reflects the emerging markets universe and how this has had an impact on emerging markets returns.
Over the past decade, emerging markets (EM) equities have significantly outperformed global equities, and investors with long-term investment horizons have been handsomely rewarded for taking risk. Despite this, the MSCI Emerging Markets Index’s outperformance has faltered since 2011 weighed down by weak growth in the developed markets, fears of a ‘hard landing’ in China and the resultant emerging market earnings downgrades.
From a top-down view, many emerging markets are cheap relative to the US and Europe. We think that an active, bottom-up stock picking approach should deliver the best returns. We do not invest in China, Brazil or Turkey per se, but in Chinese, Brazilian and Turkish companies, as we believe it is not enough to get the trend or theme right; rather stock-picking is paramount in driving returns. The wrong stock picks in a bull market could sink an investor as surely as the right stock picks in a bear market.
Apart from a short period in 1999 and the onset of the financial crisis in 2007/08, emerging market equity investors have benefited from a wide differential between emerging market and developed market price-to-earnings ratios (PE). Since the financial crisis, PEs have converged but emerging market PEs are still lower than developed market PEs. The convergence in emerging and developed market PEs can in part be attributed to an increase in emerging market labour costs. However, emerging markets still benefit from cheaper labour relative to developed markets.*
Where are we now?
Consensus would broadly hold that economic prospects in the emerging world look brighter than those of the developed world in both the medium and longer term. We would not disagree. Indeed, emerging markets are now driving economic growth, with approximately 80% of global GDP growth coming from the emerging world. We would, however, caution that the correlation between growth and stock market performance in emerging markets is complex, as the composition of stock markets often bears only a very loose relationship with the economies they supposedly represent.
We believe emerging markets’ valuations are currently attractive compared to historical levels and do not show signs of being stretched. According to our study of Morgan Stanley MSCI data (to end 13 April 2012) we can see that investment at PE levels between 12x and 13x has provided the best return scenario for subsequent cumulative three year returns and current PE valuations are within this range.
Does the benchmark accurately reflect the emerging markets universe and how does this relate to EM returns?
From an asset allocation point of view, most emerging market allocations tend to go into global emerging market (“GEM”) type strategies, or even passive proxies such as the emerging market ETFs. With these approaches the seven largest markets, which we define as markets with greater than a 5% weight in the MSCI EM Index, dominate portfolio exposure because they account for nearly 80% of the MSCI EM Index. Therefore, we believe that the bulk of equity investment that goes into emerging markets as an asset class ends up going to these seven countries; the BRICs (Brazil, Russia, India and China), South Africa, South Korea and Taiwan. There are 21 countries in the MSCI EM Index, so beyond the seven largest there are 14 smaller emerging markets, such as Chile, Indonesia, Thailand and Turkey, that receive very little dedicated investment capital.
We attribute much of the MSCI EM Index’ underperformance over the last few months to the weakness of the BRIC markets, which has weighed on the benchmark. Both Brazil and Russia, whose economies are dependent on resources, have been impacted by weak commodities markets. Indian weakness earlier in the year, due to perceived government vacillation and currency weakness, was offset after the Indian National Congress party, against all expectations, announced a significant reform package.
Meanwhile China was hurt by fears of a ‘hard-landing’. Markets that have seen strong performance year-to-date, such as the ASEAN countries (Indonesia, Malaysia, Philippines and Thailand), Turkey and Egypt, have been unable to make an impact due to their smaller weighting in the benchmark. The clear divergence in the performance of individual emerging markets underlines the mixed nature of the asset group and the need to differentiate between countries on a macroeconomic level and individual stocks within those countries.
We believe that emerging market equities offer significant opportunities to generate outperformance for active managers who are benchmark cognisant rather than those who hug the benchmark.
In conclusion, we believe that emerging markets continue to provide opportunity and that there is still relative value in the asset class. Historically a key driver to the amount of money made from an investment is the price paid on entry – so with valuations at relatively low levels, we believe this creates an excellent entry point in to emerging market equities. However, it is necessary to have a strong bottom-up investment process to make the most of it. This needs to look through sometimes beguiling headline statistics and concentrate on seeking to buy good quality companies at attractive valuations.
Article by Investec Asset Management