Investors currently face two awkward issues that, for the most part, they have successfully managed to sidestep for the last five years – high equity valuations in developed world stock markets and whether to invest directly in emerging market (EM) assets.
Since 2012, UK forward earnings multiples and European price to book ratios have climbed, while in the US a surge in technology and social media stocks has lifted equity market multiples. Even the US consumer staples index trades at nearly 18 times next year’s profits. These pockets of overvaluation are most evident in social media stocks, IPOs, several recent internet-based acquisitions and certain parts of the low grade credit markets.
Secondly, for much of the last three years, global equity investors have been able to bypass local emerging market assets – instead, buying the profits of the new world through the equities of the old was simpler and more rewarding.
Since January 2011, emerging world assets have underperformed their developed world equivalents by almost 45%. While there were exceptions such as Indonesia and the Philippines, the factors behind this underperformance were similar across regions; among them, poorly judged macro-policy, rising labour costs, excessive credit growth and a heavy political calendar, compounded on occasion by opaque corporate governance and erratic dividend policies.
Those of us who were theme-based investors were among the first to become concerned about emerging market profitability. Our research showed deteriorating pricing power, over-reliance on Western innovation and brands, alongside reduced security of supply for many commodity producers at the time. In short, EMs had become a thematic wasteland, with superior economic growth but little to show by way of profits, or other investor returns.
However, value opportunities are now appearing. In key EM companies, there is a hunger for lower costs, better corporate governance and better capital discipline. It certainly looks as though both the Indian elections and the recent pronouncements of the new Chinese leadership (albeit in different ways) could produce substantial deregulation.
In India, it seems likely that Narendra Modi of the BJP will replace the Congress-led coalitions of the last decade. Modi’s overtly reformist, business-friendly agenda is supported by tighter policy from the Reserve Bank of India and by its highly credible, IMF-trained new governor Raghuram Rajan, who is already initiating a sweeping review of the monetary policy framework that will likely include formal inflation targeting.
So far, our analysis has led us to some interesting opportunities in the motor and insurance industries, where restructuring is most evident. Meanwhile, in our balanced accounts we have acquired our first direct EM debt by buying Indian rupee Eurobonds where payments are in dollars, giving us the security of a stable currency while retaining exposure to one that could materially benefit from the rising credibility of its central bank and the local elections.
In China, debt defaults are simply a widely publicised facet of a radical overhaul of the financial system that should improve efficiency and better price risks in the market. What’s more, the ongoing reform of State Owned Enterprises (SOE) should lift their efficiency, and could eventually lead to an increase in their dividend pay-out ratio.
However, as reform proceeds, growth will likely slow further to perhaps 5% (today’s 7.5% target is already the lowest annualised number since 1990). Ironically this may be good for Chinese equities. Slower growth means lower commodity demand and hence lower input prices, the high loan rates charged by banks will also fall, and more disciplined capital expenditure plans should feed through to shareholder returns. Fortunately, the government has ample room for manoeuvre as public debt remains manageable, and recent fresh initiatives on infrastructure spending and bank bailouts suggest the leadership has little appetite for a slowdown. Further, unlike most emerging economies, Chinese external debt is at extremely low levels, so there is little risk of a capital outflow driven crisis, as witnessed in Thailand in 1997.
Investors will not find it easy to embrace EM value stocks. We have all become too familiar with cash rich Western growth stocks protected by patents, brand and intellectual property. Arguably the price for such ‘sleep at night’ earnings is, in some instances, excessive.
Multi-year income growth is going to rely in part on EM cash flows tied to superior demographics, urbanisation and a rising middle class, with the prospect of a wider universe of thematic stocks capturing new EM franchises, government restructuring initiatives, innovations driven by internet and smartphone penetration alongside new consumer franchises. What’s more, these opportunities all come with valuations we remember fondly from Western markets several years ago.
Guy Monson is partner and chief investment officer at Sarasin & Partners
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