By Andrew Miller, Chief Investment Officer – Emerging Markets Equity
When we started managing emerging market (EM) equities in 1996, consultants and clients questioned if value investing was appropriate in the asset class, some even laughed at the prospect. The argument being that emerging markets was a growth asset class and value investing wouldn’t work or be applicable to the plethora of high growth companies in high growth economies. Furthermore, people questioned Mondrian’s use of a dividend discount model to define value, arguing that these high growth companies were unlikely to pay dividends since they were growing so much. We always countered the argument reminding people of the high volatility in emerging markets due to the higher levels of risk prevalent across economies. The more volatile the asset class, the more important and relevant it is to have a defensive value approach that aims to minimize volatility. We always felt if we could be successful minimizing volatility and avoiding the greatest areas of risk in emerging markets, we would outperform and deliver very consistent performance characteristics. Over 20 years on, the long-term performance numbers and characteristics would suggest that this has largely been proven correct with the Mondrian Emerging Markets All Cap Composite up 8.4% against the benchmark of 6.4% (annualised 20 years to end September 2017, all returns USD). Additionally, since the inception of the MSCI EM Value index in January 2001 to end September 2017, Value is up 10.4% against Growth up 9.3%, demonstrating that value investing works over time in emerging markets.
The last five years however have proved altogether much harder for value managers, and once again, people are questioning its efficacy in EM. The MSCI EM Growth index is up 6.6% per annum in the 5 years to end September 2017, while value stocks are barely posting a positive return, up just 1.3%. Why is this so? We would argue three main features. Firstly, the emergence of big technology companies in China has changed the make-up of the broad EM index; secondly, this coincides with a period of unusually low volatility in global markets which has been helped by the third factor, quantitative easing and an unprecedented low interest rate environment. Let’s take each in turn and consider their sustainability.
Big Chinese tech companies were less than 2% of the MSCI EM index in June 2012, now they account for c.13% and include some of the biggest companies in the index such as Tencent, Alibaba and Baidu. This group of companies have grown profits considerably over this period and are undoubtedly successful, highly cash generative businesses, but as a result, trade on price earnings levels of approximating 50x. Their valuations reflect an ability to sustain a very high growth rate into the foreseeable future, while stock price rises, especially for Tencent and Alibaba have already been exceptional.
We question and doubt the likelihood that these already very large companies can continue to grow at the pace required to justify their prices, and hence see risk of underperformance in these names going forward. Most highly profitable businesses come under pressure at some point, be it from competition, regulation, or the sheer high base from which they need to keep growing from. Not owning these growth companies has cost us over the last five years, but we won’t change our disciplined, value style and have to believe that not owning them from here gives us an opportunity to add value as other, far cheaper companies outperform. Please see table below highlighting their impact on the MSCI EM index.
Secondly, volatility has been at extremely low levels over the last 5 years, as measured by the VIX index, but also when observing standard deviation for the MSCI EM index. In fact, the VIX currently trades at an all-time low level. Value investing typically struggles during periods of low volatility as it makes discerning stock picking harder. Our investment style has typically delivered value portfolios with low volatility – not only has value lagged, but one isn’t being paid for a low volatility approach either as the whole market is evidently so ambivalent about risk. If you see the chart below, you can see how our traditionally low volatility approach has performed much better during more elevated periods of volatility. It would be reasonable to expect volatility to increase over the next five years, which would create an environment more favourable to our investment style.
This in part is linked to the third and final point that hasn’t favoured value investing – the low interest rate backdrop. It is not surprising that the low interest rate and ultra-loose monetary policy environment post-crisis have led to many investors lowering their discount rates applied to anticipated future growth, and this has, in general, favoured growth stocks. Additionally this low cost of capital has encouraged investors to tolerate additional risk, such as that inherent in companies with poor governance or capital structures which mean that shareholders have very limited influence on the management of the company.
Extremely strong share price appreciation for high-profile tech companies like Alibaba, Baidu, Amazon, Facebook and Google, has given many investors confidence to ignore the lack of these important long-term controls. We expected value stocks to be more in favour this year as global growth improved translating to improved corporate profitability more broadly, hence helping value stocks such as financials and industrials. Yet, even with good performance from these names, it has been overshadowed by the sustained explosion of internet stock prices. Furthermore, the expectations of the US economy getting a boost from President Trump’s reflationary policies have recently been somewhat dampened, leading investors to once again doubt global growth prospects.
The gap today between value and growth in EM is at extreme levels. The discount on EM Value stocks, when measured on a trailing price-to-earnings ratio basis, has moved to its highest level in decades, see chart below.
We believe that as bond yields move higher in the US, which seems highly likely given the FEDs rhetoric, such a macro scenario would be more favourable for value stocks in EM over time.
Going forward, we continue to believe that value investing can and will outperform in emerging markets. The fundamental core principles at the heart of value investing are unchanged, and over the long-term, buying cheap has proven very successful. There have been various headwinds making relative performance challenging for us since 2013, but these cannot continue forever. Internet stocks have already outperformed almost all other stocks by a significant degree and this must abate at some point. Volatility is at all-time lows despite a host of geo-political risks such as North Korea and Brexit, plus the economic risks remain of high and unsustainable debt levels in many of the world’s major economies. At the core of value investing is often mean reversion, and we strongly believe, as history would suggest, that in investment nothing lasts forever. It is often most at the time when people start to question the validity of an investment style that it is close to coming into vogue again. Over the last 20 years investing in emerging markets we have used the same investment style to positive effect, albeit with some difficulty since 2013. There is no reason to believe the next 20 years will be any different, including tough periods as well as good ones. It remains our job to find undervalued companies that can deliver smooth returns over time. If we continue to do this thoughtfully, diligently and consistently, we are sure that our defensive, value portfolio will outperform once again.