By Tapan Datta
Investment history is replete with examples of rotation between the ‘I love them’ and ‘how I despise them!’ investing bandwagons. One of the better recent examples of such mercurial sentiment is emerging markets, which have gone from hero to zero in just three years. A better case of the adage that ‘markets do nothing by halves’ is hard to find.
It is now hard to believe that emerging markets were more expensively valued than developed markets just three years ago. And let’s be honest, this was expensive and unjustifiable, though few said this at the time. The implicit view was that strong growth would continue and profits and shareholder returns would be delivered on a sustained long-term basis. How else could such valuations be warranted? Hope and hype conspired together.
Since then, we have turned full circle, and valuations are now closing in on where they were a decade ago. And revealingly, when it comes to the BRIC markets, which fed the great emerging markets boom of yester years, the circle has turned back in full. The disillusion with BRICs in many ways symbolises all that has gone wrong with emerging markets. I remember what 2003 was like – very dark days for emerging markets, coming after the repeated country crashes and defaults scattered across Asia, Europe and Latin America between 1997 and 2002. Country risk was a big factor in the then large valuation discounts given to emerging markets by investors. Since valuation discounts are now close to those levels, it is almost as though markets are saying that those risks are back, or that they never really went away.
Has nothing then really changed for the better in the past decade in the emerging markets world? I think this is harsh. Worries over China are commonly cited these days as a sign of resurgent country risk. It is clear that China is going through a period of deep structural change which implies potentially a prolonged period of weaker growth rates than we have become accustomed to. But this is some way removed from a prediction that this culminates in a crash that leads to the type of market dislocation that we used to see from emerging economy crises in days gone by.
Investors might now think that profits will be growing a lot more slowly than in developed economies. Maybe, but it is far from obvious. Returns on equity ratios in emerging market companies in aggregate continue to exceed those in developed markets. It is true that emerging economies have had a tough 2013. And though this may well mean some slowing in corporate profits (despite the link between economic growth and corporate profits being looser in emerging than developed economies), this does not mean that growth in profits will be lower than in developed markets on an on-going basis.
The more one thinks about it, the more it seems that emerging markets are once again the victim of an exaggerated cycle of sentiment swings. Just as they became unjustifiably expensive in the heyday of BRICs-related optimism, now they have become too cheap. It has become the asset class that virtually everybody loves to hate but this does not mean that they are ripe for turning just yet.
The negative newsflow out of emerging economies has been unrelenting and needs to ease off first. But that day is probably not too far away. For investors prepared to look a little beyond the current negative spin, the valuation argument is now looking increasingly compelling.
Tapan Datta is head of asset allocation at Aon Hewitt
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