It is often said that history does not repeat, but it rhymes. And, while past performance cannot be considered a reliable indicator of future performance in terms of investment returns, we can, in our view, use metrics such as the price / earnings ratio (PER) and price-to-book valuations (PBV) to infer probabilities with regard to broad directionality. This can help us to address the dilemma of whether the glass is half full or half empty for EM investors; we will present scenarios for each case.
In terms of current valuations, we believe fundamental indicators are certainly not screaming ‘sell’ at this point. A PER of 11.6x appears undemanding, while a PBV of 1.5x and price / sales ratio of 1.2 also indicate that EM valuations are relatively attractive following the recent sell-off. Meanwhile, a return on equity (ROE) of 14%, dividend yields of 2.9% and free cash flow (FCF) yields of 8.5% on ‘clean’ (relative to EM history) balance sheets are also supportive. For context, in the 2011, 2014 and 2016 EM sell-offs, PERs dipped to around 10.5x and PBVs slipped to 1.3x. Conversely, 2009 provides us with a guide to normalised historic highs for these metrics – 22x PER and 2.2x PBV – and these collectively suggest that we could be nearer the bottom than the top of the current EM equity cycle, notwithstanding the exceptionally strong returns registered in 2017.
However, despite compelling valuations, should the following ‘glass-half-empty’ scenario manifest itself, EM equities will inevitably participate on the downside, but not, in our view, to any greater extent than their developed market counterparts. And, since EM valuations are much more attractive in relative terms, we believe there is a significantly greater prospect of EM equities demonstrating a positive asymmetric return profile from this point. Consequently, in the absence of the usual ‘half empty’ caveats, such as systemic contagion from EM credit and currency sell-offs, a Trump impeachment-driven / Fed tightening-induced slump in US equities or a ‘SARS 2’ type disease epidemic, we believe the value proposition of EM equities remains firmly intact.
EMs tend to be clustered together in one huge silo by investors and asset allocators, but the universe is incredibly heterogeneous. We deploy a regression process through which we seek to identify opportunities to buy higher-quality and liquid equity plays in higher quality credits at points of extremity. Many years of experience has confirmed that this approach typically yields sound results over time. In effect, this combination of top-down and bottom-up analysis reduces the ‘risk of being wrong’ by exploiting cheaper entry prices in a repetitive manner.
However, all cycles are different and it is not difficult to identify the abnormalities – the end of quantitative easing and the instigation of trade wars, to name but two – this time around. This means that our normal philosophy of buying high quality stocks at cheap entry points is being challenged in the short term. As such, we believe a constant qualitative overlay is key to avoiding the worst of these risks. But our view remains that you cannot keep a good stock down forever, especially if it is quoted in an investment grade country. Furthermore, our philosophy tends to orientate us towards the better credit profiles, with positive FCF or working capital, and such positions should be able to better weather any storms at the stock level.
Since we have already made reference to all cycles being different, it is worth exploring the question as to why EM equities have not suffered a much bigger fall against a backdrop of dollar strength, trade wars and pockets of extreme turbulence (Turkey and Venezuela). We believe the relatively modest sell-off (by EM standards – the universe dropped around 70% in US dollar terms during the Asian crisis of the late 90s) reflects our view that EM equities remain under-loved, under-owned and undervalued.
In addition, they are broadly appealing to investors in that they offer value, growth and yield (the main attributes that satisfy the three prominent investment styles). In addition, EMs are also viewed as ‘safer’ than before as 8 out of the 10 top EM markets are now investment grade, compared to just 4 a decade ago. Last but not least, it is important to remember that EMs experienced a 5-year bear market between 2011 and 2016. As such, EM equities are still trading below 2007 pre-financial crisis highs, unlike their EM credit and debt counterparts.
All of these reasons serve to reinforce our conviction in the positive asymmetric return profile, especially in the glass-half-full case presented below:
The Federal Reserve (Fed) is prepared to risk remaining slightly behind the curve for longer and moderates its hawkish stance. This would actually constitute a reversion to form as, until recently, the Fed pursued a policy of providing hawkish forward guidance, which it failed to follow up with monetary tightening. For example, four rate hikes were promised in 2016 and only one was delivered – in December of that year. Such a policy would also be consistent with Bernanke’s observation that ‘the coyote goes over the cliff in 2020’ (not 2019). At the same time, Japan elects to continue with easier monetary policy, while China slows its deleveraging process to reduce the risk of weakening its currency further.
While the preceding paragraph contains a potential scenario (or an EM equity investor’s wish list) the points that follow are based on facts:
Negative news flow from Turkey and Venezuela (as the former skirts with IMF / capital control risk and the latter hurtles towards failed-state status) are admittedly attracting headlines which could support the ‘glass-half-empty’ case. However, it is important to remember that both constitute a fractional weighting in the MSCI EM index and are effectively insignificant in the absence of contagion.
Similarly, 10 years ago, materials, energy and industrials collectively comprised around 50% of the MSCI EM index versus 12% today. Hence the EM equity universe is less sensitive to the direct ‘dollar up’ argument (although local currencies remain vulnerable to occurrences of further dollar strength).
Finally, as the driver of 50% of the world’s output and 80% of its incremental GDP gain year-on-year, it is crucial to understand that the risk / return is fundamentally skewed in favour of EM equities. The weighting of the universe in the MSCI AC World index is disproportionately small. As domestic pension support emerges (particularly in China and India) it should soak up a materially larger part of that listed equity. Hence, in our view, a PER re-rating is ultimately the most likely outcome as was the case in Chile in the late 80s / early 90s.
The days of EM equity being viewed as an optional extra, for a bit of additional beta kick, are well and truly behind us. We believe it can only be a matter of time before global investors begin allocating to the EM universe in the commensurate size to reflect this philosophical change. Secular and cyclical drivers (both relative and absolute) further enhance the case, especially as corporate governance becomes less of a drag on key EM markets. EM equities are therefore, in our view, cyclically cheap and set to benefit from strong underlying secular support.
As the last remaining ‘investment grade laggard’ we are seeking to build positions into weakness. Furthermore, we believe that EM equities offer broad investment appeal for value / growth ‘at a reasonable price’ or yield (FCF yield, positive carry trade yield, dividend yield or growth in dividend yield). Although we are wary of the risks, we wish to exploit the price distortions and run the volatility. As such we are holding our nerve and sticking to our philosophy (without succumbing to style drift) in the belief that it should yield positive results over time.