Join our community of smart investors

Where to find value in emerging markets

Although emerging markets rose strongly last year, they still offer some value
March 8, 2018

Emerging markets have done well since late 2016, with MSCI Emerging Markets index returning 71 per cent in sterling terms and 55 per cent unhedged over the two years to 28 February 2018. However, after a market has had a good run a key question for investors is whether this can continue, and if it is still good value.

But before addressing if and where value remains in emerging markets, investors must remember that no two geographies or sectors are the same – especially in developing equity markets. For example, Latin American equities have risen 81 per cent over the two years to 28 February 2018, helped by greater political stability in Brazil, the largest regional economy, after a period of upheaval. Emerging Europe, by contrast, returned 67 per cent over the same period.

The difference between sectors and styles has been even more marked. Technology companies, particularly mega-cap stocks in China and South Korea, have carried markets with a return of 109 per cent over the two years to 28 February. This compares with only 32 per cent for consumer staples and 37 per cent for industrial companies. This has helped growth-style investing, picking stocks where the revenue and share price compound and grow, has outperformed more cyclical and value-driven strategies, which involve buying stocks that seem fundamentally undervalued.

These sector trends, which mirror those in developed equity markets over the same period, provide a foundation for judging where, when and if value remains in emerging markets.

 

Wider value

Many analysts and advisers believe investors should continue to have an allocation to emerging markets, and also that you could make good returns if you initiate an allocation to this area now. They argue that the drivers underpinning the recent rise in emerging markets will continue to have an effect.

Rory McPherson, head of investment strategy at Psigma Investment Management, says although emerging markets have returned 71 per cent over the two years to 28 February 2018 against 43 per cent for developed markets, over longer periods such as five years emerging markets lag developed markets, with a 39 per cent rise against 82 per cent.

"The economies are in good shape," adds Mr McPherson, who is tilting his clients' exposure to Asia as he believes the strongest emerging market returns will come from there.

"The key reasons for this are valuation and growth potential," he explains. "And emerging markets are under-owned by the broader investment community."

The metrics support this. MSCI Emerging Markets index is on an average price/equity ratio of 12.2 times, below its long-term average of 15 times and the 16.5 times for developed markets. This means emerging market share prices could increase further.

Asset manager Hermes has also found that profit margins across emerging markets reached 6.7 per cent in 2017, which is below the 20-year average of 7.7 per cent, suggesting some potential upside. Return on equity (ROE), which hit a low in 2015, should also rise as a result. Hermes says margins and ROE in emerging markets will be better than in developed markets in 2018, but on a price-to-book value basis emerging market shares remain substantially cheaper.

"Analysts are projecting earnings growth of nearly 14 per cent for this year, following the last bumper year which brought in earnings growth of over 22 per cent," says Mr McPherson.

Nathan Sweeney, senior investment manager at Architas, says the recent performance of emerging markets must be taken in context of the five years before that as the increase was from a very low base.

"We think it can continue," he says. "From a macro, valuation, earnings and technical perspective we are positive."

Mr Sweeney has slightly increased the allocation to emerging markets in Architas Multi-Asset Active Dynamic Fund (GB00B6ZRLF91) from 28 per cent to 30 per cent.

"Some of the growth sectors [such as technology] have performed well and you should see a continuation of that," he explains. "These companies are generating high earnings growth for a reason. You have had a pick-up in commodities as well. This was a headwind, so now other sectors are increasing their earnings and this provides a stronger backdrop than last year as it comes from a broader and diverse collection of sectors.

Darius McDermott, managing director at Chelsea Financial Services, adds: "Global growth is looking good and emerging markets tend to outperform when this is the case. Inflation is quite low, with only a handful of exceptions, and some countries' leaders are doing very pro-business things. Emerging markets are very diverse and include more than 20 countries, so there are plenty of opportunities."

 

Risks to consider

However, a report from economic consultancy Capital Economics suggests that emerging economies face a number of headwinds, and recent events could undermine investors' bullish view on this area. Capital Economics says the economic recovery "lost steam" towards the end of 2017, with economic growth of 4.4 per cent over the 12 months to the end of December 2017, down from 4.9 per cent over the 12 months to the end of September 2017. Emerging Asia and Europe were among the weaker areas, and production growth also fell.

"Events over the past month suggested that the emerging market recovery might not be as strong and stable as some seem to think," says Capital Economics.

Emerging markets are also volatile and higher risk. While the returns of share prices in these regions can be strong, and some fundamentals and economic metrics are currently positive, the corporate structures and governance can be weak. Investors are also less tolerant, and react quickly and negatively to macro changes leading to volatility.

Although MSCI Emerging Markets index has outperformed MSCI World index over the two years to the end of February its risk metrics are higher. Based on the worst-case scenario of when an investor entered and exited the market, the maximum loss you could have made in emerging markets during this period was 10 per cent, compared with 7 per cent for MSCI World. Volatility was also substantially higher during this period and is likely to remain so.

Ben Seager-Scott, chief investment strategist at wealth manager Tilney Group, is bullish on emerging markets, but his allocation to this area will remain limited because of the risks.

"Emerging market equities have high growth potential, however they are also high risk, so we think it is appropriate to set exposure accordingly," he explains. "It's an area we're relatively positive on. [But] there are still risks in China as it looks to manage a slowdown and there are also upcoming elections in Mexico, which may start to garner more attention in the next few months and provide a headwind."

So even though the outlook on emerging markets is positive, you should consider them as a diversifier and potential additional boost to other areas in your portfolio, rather than an asset class in which you should place substantial amounts. Tilney Group's aggressive portfolios have an allocation of 4.6 per cent to emerging markets and the same amount to Asia, while their defensive portfolios have 2 per cent allocated to emerging markets. 

You should not invest in emerging markets unless you have a high risk appetite and long-term investment horizon, and if you are looking to preserve capital they may not be appropriate in your portfolio.

 

Funds for emerging markets exposure

Emerging market returns are expected to come from a broader range of sectors and geographies than over the past 24 months, when technology and Latin America played a significant role. But exposure to emerging market technology companies is still relevant as this area could continue to do well.

For diversified exposure to emerging markets, options include RWC Global Emerging Markets Fund (LU1336213936), which is run by former hedge fund manager John Malloy. He selects shares according to their individual merits, but also invests according to themes, such as a commodities and industrials re-run. The fund only launched in January 2016 but over the two years to 28 February has returned 111 per cent against the Investment Association (IA) Global Emerging Markets sector average of 65 per cent.

Mr Malloy is willing to take positions in riskier, more esoteric sectors and geographies, but makes quick exits if necessary. The fund has a lower allocation to technology than some of its peers, making it a good diversifier if held alongside a more traditional emerging markets fund.

Hermes Global Emerging Markets (IE00B3DJ5K90), by contrast, has ridden the technology wave, though not only relied on this. Its manager, Gary Greenberg, selects shares according to their individual merits, a process that has led him to some of the most quality-driven emerging market growth stocks. The fund's 10 largest holdings include tech giants Samsung (SMSD), Tencent (700:HKG) and Alibaba (BABA:NYQ), but it also has exposure to financials and consumer cyclical companies giving it a quality-driven, diversified exposure.

Baillie Gifford Emerging Markets Leading Companies 
(GB00B06HZN29) invests in what its manager, Will Sutcliffe, deems to be the best 90-plus companies in these regions. Mr Sutcliffe currently favours technology, so the fund has a 47 per cent allocation to it, as well as financials and consumer stocks, and mainly invests in mega-cap shares.

This fund has outperformed MSCI Emerging Markets index over one, three and five years and has a reasonable ongoing charge of 0.79 per cent.

JPMorgan Emerging Markets Investment Trust (JMG) has been managed by Austin Forey for over 20 years, and he favours a high-quality growth strategy, focusing on financial and tech stocks. Tencent, Taiwan Semiconductor (2330:TAI) and Alibaba are among the trust's largest holdings. The trust has beaten MSCI Emerging Markets index over one, three and five years and has an ongoing charge of 1.07 per cent.

Although current metrics and sentiment do not suggest that quality/growth-style investing is going to go out of favour in the near future, buoyant global economic growth and rising bond yields should mean investors will become more willing to take on cyclical risk and so favour value-style investing.

M&G Global Emerging Markets (GB00B3FFXX47) has lagged its sector peers and MSCI Emerging Markets index in recent years due to its value tilt. But it is not a deep value fund, so also invests in companies such as Samsung, Taiwan Semiconductor and Baidu (BIDU:NSQ) – its three largest holdings. The fund holds 67 stocks so is diversified, but remains focused enough on value to benefit from any change in sentiment towards that area.

 

Performance of suggested emerging markets funds

Fund/benchmark1-year total return (%)3-year cumulative return (%)5-year cumulative return (%)Ongoing charge (%)*
Baillie Gifford Emerging Markets Leading Companies24.6959.5368.720.79
Hermes Global Emerging Markets23.9263.6883.231.13
JPMorgan Emerging Markets IT19.9548.1947.431.1
M&G Global Emerging Markets6.2538.7427.451.02
RWC Global Emerging Markets18.46--1.38
IA Global Emerging Markets sector average13.8239.9475.24-
MSCI Emerging Markets index15.143.0537.88-

Source: FE Analytics, *Morningstar as at 05.03.2018