I will be writing an opinion piece about emerging markets later this month for one of the trade journals. Here are some preliminary thoughts.
"Companies with grand investment plans tended to be the ones that attracted greater foreign interest"
The big question with respect to emerging markets is when they’ll start performing. Since the second half of 2010, emerging markets have fallen by 45% in relation to developed markets. That by any standards is substantial and has prompted some to suggest that a change of fortunes is imminent. It is particularly interesting given that over the same period the MSCI AC World Growth index has outperformed its ‘Value’ counterpart by 15% (and by 29% since the end of 2006). If emerging markets embody anything it is ‘growth,’ surely!
The term ‘emerging markets’ was coined in the early 1980s by then World Bank economist Antoine van Agtmael. He was trying to launch a fund investing in the new asset class and was persuaded that ‘The Third World Fund’ wasn’t sexy enough. Ever since, emerging markets have been considered a great place to invest.
Goodness knows why!
Since the end of 1987, emerging markets have returned 7.4% annually in US dollars. This compares with returns from US equities of 7.7% annually. Given that emerging market equities have been far more volatile than US equities and that economic growth has been much higher, you’d have expected equity returns to be much higher.
Why haven’t they been?
It is hard to generalise about a region that constitutes 23 countries and well over 800 companies but a key problem is that high economic growth has not filtered down to minority shareholders. Nowhere is this truer than China. Since 1992, China’s nominal GDP has increased 2,217%. Its stock market however has only risen 17% including dividends, equivalent to 4.1% in US dollar terms. On an annualised basis, 4.1% equates to 0.2% per annum. Where did all that GDP go?!
Minority shareholders are just one of several stakeholders in any company. Others include employees, regional and central governments, and local suppliers. It seems that foreign investors who have poured money into emerging markets over the years have sorely underestimated the extent to which these other stakeholders would take their pound of flesh. In China’s case, raising wages has been a core tenet of government policy. This has been great for Chinese workers but will almost certainly have been at the expense of earnings per share.
Higher economic growth can be a double-edged sword. It has certainly been the main reason foreigners have poured money into emerging markets but arguably is also the main reason why investment returns have been poor. Investment opportunities appear plentiful in emerging markets, where incomes are generally low and the scope to increase productivity is high. Companies with grand investment plans tended to be the ones that attracted greater foreign interest and thus cheaper equity finance. Returns on that investment have often fallen far short of expectations, unless of course you were one of the other stakeholders.
This point is one that was well made in a paper written in 2012 by Yale professor Martijn Cremers titled “Emerging Market Outperformance: Public‐traded Affiliates of Multinational Corporations”. Cremers noted that the really strong performance in emerging markets has come not from the headline-grabbing, capital-absorbing local companies but from the listed affiliates of MNCs, which tend to have pretty dull businesses such as fast moving consumer goods. The combination of dull businesses and strong governance that permeated down from the parent made for a potent mix.
Cremers identified 92 such listed affiliates across emerging Asia, Eastern Europe, Africa and Latin America and found some startling results (see chart 1). Over the period under review, the 92 listed affiliates returned on average a total of 2,229% in US dollar terms. This compares with 1,157% for countries in which the affiliates were listed and 371% for emerging markets broadly (the affiliates tended to be listed in the better performing emerging markets).
The moral of the story is that one should be very selective in emerging markets. Companies with aggressive expansion plans have tended to disappoint while the dull and careful have delivered. In emerging markets, the tortoise wins the race.
Finally, a look at valuations. As can be seen in chart 2 below, there has been a stark divergence in price-to-book ratios of emerging and developed market companies. The gap may look appealing compared to where valuations were a few years ago but it has at times been much bigger. Back in the late 90s following the Asian financial crisis, the price-to-book ratio fell to 0.3 times at a time when the tech bubble was powering developed market companies to well over 3 times. While it is hard to imagine emerging markets getting that cheap again, it is worth remembering that if the return on capital is less than the cost of capital, as is often the case with emerging market companies, one should not pay more than 1 times book.
Published in Investment Letter, March 2016
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.