The Overlooked Value Anomaly Within Emerging Markets
When investors look at emerging markets, the gaze usually fixates on the developing world’s fast-growing growth stocks, such as Asian tech titans Tencent and Alibaba.
However, incessant investor demand for exposure to new economy sectors – such as tech – has driven valuations of many of the emerging world’s high growth companies to historical highs. Investors have ignored traditional value sectors – such as banks, insurance companies and industrials – with the divergence of valuations between new and old economy stocks now at the widest levels ever seen.
With many old economy stocks trading at depressed valuations, what can prompt a reversal of fortune? Value opportunities are highly-levered to domestic growth, so evidence of sustained improvements in the macro environment will be needed – something currently underway in many emerging markets.
MACRO MOMENTUM IS TURNING
In the developing world, macro momentum typically takes a long time to turn. Looking across the emerging world, economic activity has only recently reversed from a multi-year slump – as evidenced by the fact growth in the likes of Brazil and Russia have yet to return to long-term averages.
As for China, we are optimistic on the emerging powerhouse’s progress on supply-side structural reforms. While the world's second-largest economy faces a number of structural challenges, it is in a much better state now than at any time in the last five years. We believe in China's economic transformation story and hold positions in Chinese stocks sensitive to the domestic economy – such as banks ICBC and Agricultural Bank of China, as well as insurer PICC Property & Casualty. We are also optimistic on the building materials and industrials and business services sectors.
While concerns will linger over the threat posed by Fed monetary policy tightening, the overwhelming majority of emerging market countries are in better shape to negotiate higher US interest rates – with vastly improved current account positions and increased FX reserves.
CORPORATE BEHAVIOUR ON THE RISE
In conjunction with the encouraging economic signs, corporate behaviour has improved dramatically in recent years. Far too many companies went on spending sprees and ignored margin discipline during the boom years, enjoying the benefits of rising top-line revenues. Prior earnings growth was achieved by expanding sales in a time of strong economic growth.
The irrational spending led to supply gluts, excess inventory and overcapacity – finally resulting in falling prices and contracting margins. This behaviour became evident when economic growth began to slow from 2011.
Corporate management teams have now modified practices, adjusting to the new economic reality. This is particularly evident in the disciplined manner management teams are now allocating capital.
SOUTH AFRICA BOOSTED BY ZUMA EXIT
Even with the improving macro, investor expectations remain remarkably low. Valuations for many attractive old economy stocks are still pricing in revenue or profit growth in the low single digits, far below what we expect the emerging world to achieve in 2018 and beyond.
A good example of the valuation anomalies on offer can be seen in South Africa, a market we began to invest in during the early part of 2017. While South Africa was suffering a prolonged economic slowdown, our initial thesis pointed to a cyclical recovery into 2018 – supported by lower valuations of domestic companies.
The positive inflection point occurred in December last year – with the exit of President Jacob Zuma and the appointment Cyril Ramaphosa. With Ramaphosa – a former union leader and subsequently a very successful and now wealthy businessman – leading the country, we expect a strong anti-corruption drive and a commitment to fiscal consolidation.
INVESTORS WILL RETURN TO UNLOVED AREAS
The emerging world’s positive long-term growth, demographic and consumption trends remain intact and continue to be superior to developed economy peers. However, investors remain sceptical.
While investors have had little incentive to re-allocate from strongly-performing US stocks in recent years, it is hard to argue – from a valuation perspective – that US equities offer more compelling upside than emerging markets from here.
Where investors have emerging market allocations, it remains overly concentrated in high-growth areas – such as tech. However, with a record-wide valuation divergence between growth and value stocks in emerging markets, we believe it is only a matter of time before the region’s unloved and forgotten old economy opportunities return to investor favour.
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