By Archie Hart, portfolio manager, Investec Emerging Markets Equity Strategy
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, bottomup stock picking approach should deliver the best returns. 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-toearnings (PE) ratios. 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. 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. 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. 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 macro-economic 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. However, it is necessary to have a strong bottom-up investment process to make the most of it.
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