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Today's wide valuation spreads and still solid fundamentals imply that investors should stay the course in emerging markets. A valuation-based, long-term approach has historically added value.


Stay the Course: Value Investing in Emerging Markets

Emerging markets (EM) have faced a challenging 2018. The dual-effect of a rising U.S. dollar and interest-rate hikes, and the risks these dynamics pose for capital account balances, have tested EM economies. The doubling of oil prices since early 2016 has helped the exporters but pressured the importers. Any potential recovery has been threatened by geopolitical tensions and the U.S.-initiated trade dispute aimed at China.

The confluence of these issues drove EM equities from near all-time highs in January to bear-market territory in the third quarter, significantly underperforming the developed markets (DM). Year to date, the MCSI Emerging Markets Index has fallen by 8.2%, trailing the 5.3% increase of the MSCI World index. On a price-to-earnings (P/E) basis, EM equities currently trade at 13.3x earnings, representing a 31% discount to DM's P/E of 19.4x.

Industry experts are divided on what will happen next: The bull case points to valuation discounts, better competitive positioning after sharp currency declines, and healthier balance sheets. The handful of isolated countries with high external debt are unlikely to spark contagion, as in the past, partly because they lack the regional linkages that precipitated the Asian Financial Crisis (AFC). Meanwhile, the bears consider increased debt levels and a slowdown in China, exacerbated by the trade war, as key threats. China's sizeable trade surplus with the U.S. provides it with few strategic alternatives to retaliate. A prolonged dispute could place an undue burden on an already levered China, destabilizing EM overall.

The uncertainty across EM has caused knee-jerk reactions to short-term news, creating valuation dispersions. As a result, today's value investors have an opportunity to increase exposure to select companies at even deeper discounts.

Uncertainty Has Led to Wider Valuations Spreads

When equity valuations diverge, the possibility of generating outperformance grows. Figure 1 shows a trend of widening valuation spreads1 over the last 15 years. Today's levels are on par with those of 2001 when markets were still recovering from the distortions of the AFC. What followed was a six-year bull run, with the MSCI's broad-based EM index posting average annualized returns of 32.1% through October of 2007. During that period, the MSCI Emerging Markets Value Index did even better, gaining 35.2% on an annualized basis. EM's next big value opportunity came when spreads topped out in February of 2016. Over the balance of the year, the broad index delivered an 18.4% return. Once again, the value index outperformed, posting a 22.1% gain through December 2016.

When seeing the extreme levels prior to 2001 in Figure 1, skeptics may wonder how wide spreads could go from here. The peaks reached in 1999 and 2000 represented consecutive Black Swan events — the AFC and the Y2k/internet stock market bubble. However, any attempt to compare today's emerging markets with the EM of the late 1990s would be to dismiss the widespread reforms made since then (e.g., the removal of the dollar peg, more prudent monetary and fiscal regimes and the development of local- currency financing). Corporate practices and governance have improved, as have global competitive positioning and leadership among some EM companies.

 

Figure 1: Valuation Spreadsi Approach Their Post-Crisis Levels Emerging Markets (1992-2018)
(Spreads between the least expensive and most expensive stocks)

graph

Data through September 30, 2018.
Spreads are based on price-to-book valuations (equally-weighted data).
Universe: ~1100 Largest stocks in EM by market capitalization.
Source: Sanford C. Bernstein & Co., Pzena analysis

 

Although these changes should have resulted in structurally lower spreads, today's levels are on par with those of the mid-1990s when EM was grappling with multiple cases of hyperinflation, the Mexican Peso Crisis, and other challenges. But today's cycle, fueled by a combination of quantitative easing and low interest rates, has aided the feeding frenzy in growth stocks and led to opportunities among overlooked value stocks. Current spread levels imply that it's feasible to generate incremental returns by focusing on the most undervalued stocks in the universe.


Good Businesses, Falling Valuations, and Rising Profitability

Long-term earnings power is a critical component of a franchise's worth. A price-to-normalized (P/N) earnings valuation approach, which considers a company's ability to generate earnings over an entire business cycle, may be more useful than a simple factor-based approach, such as the commonly used price-to-book (P/B) method. Based on our calculations, values in EM are widely dispersed today. The median P/N valuation of the so-called “cheapest stocks,” or “Q1,” is 7.7x, virtually half that of the broad EM universe's midpoint of 14.4x, based on our estimates.

Figure 2 illustrates the characteristics of businesses MSCI Emerging Markets Index Return on Equity Average ROE across the EM valuation spectrum, ranked by quintile (from the cheapest to the most expensive). A key reason to focus efforts on companies in Q1 is that they tend to offer similar long-term profitability growth but trade at significant discounts to their more expensive peers.

 

Figure 2: Companies in “Q1” are Just as Profitable but Sell at Deep Discounts

table

Valuation quintile buckets based on Pzena's P/N earnings estimates. P/E and P/S ratios are calculated using average sell-side consensus 1-year forward estimates.
Return on equity and revenue growth calculated over trailing 10-year period.
Universe is the ~1500 largest stocks in non-developed markets by market capitalization.
Data as of September 30, 2018.
Does not represent any specific Pzena product or service.
Source: FactSet, Reuters, Pzena analysis

 

This year's equity market correction has widened the gap between the most undervalued stocks and the broad EM universe. Based on Pzena's analysis, Q1's valuation midpoints have fallen by 20% (from 9.6x to 7.7x) since the end of the first quarter. These moves are indicative of the pain that's felt at the company level, but, on an aggregate basis, fundamentals appear on track. For example, EM's current return on equity (ROE) has moved back to just under its long- term average of 12.5% (Figure 3). This leaves today's value investors in a compelling position in EM — where profitability approaches long-term averages, equity markets have fallen, and Q1 stocks are trading at deep discounts.

 

Figure 3: ROE is close to its historical average, from depressed levels

graph

Source: Sanford C. Bernstein & Co., Pzena analysis


Patience is Critical

The real test of value investing — particularly among the most severely underpriced stocks — is time. By nature, underpriced stocks tend to exhibit greater price volatility over the short term. However, in our opinion, some stocks in Q1 have the potential to deliver noticeably outsized returns versus the broad universe over longer periods. The scatterplot in Figure 4 shows that over 5-year rolling periods, Q1 stocks outperformed the broad-based EM index the clear majority, or 85%, of the time. Furthermore, the outperformance was by a wide margin, an annualized 10% on average — a very compelling argument for maintaining a long-term, steady hand in EM.1

 

Figure 4: Q1 Stocks Have Historically Outperformed Over Time Annualized Returns

graph

Q1 of ~1100 largest company stocks in EM (equally-weighted data)
Data through September 30, 2018
Does not represent any specific Pzena product or service.
Past performance is not indicative of future returns.
Source: MSCI, Sanford C. Bernstein & Co., Pzena analysis

 

In addition, the belief that the most undervalued stocks drag down returns when markets are falling is a misperception.

Dating back to 1998, when the broad EM index posted negative returns over 5-year rolling periods, Q1 stocks outperformed 81% of the time. It's notable that in extreme periods, such as during and after the AFC (and the post-Y2k internet bubble period in the U.S.), when investors have been most concerned about underperformance, EM value stocks have historically outperformed the broader EM index when comparing relative MSCI indexes. During and after the AFC (between August of 1998 and May of 2003), while the MSCI Emerging Markets Index was posting declining 5-year rolling returns, the most undervalued (Q1) stocks outperformed by 19.8% on average. During the post-AFC era, EM has only endured a handful of 5-year periods that stocks were falling, and, in most of those cases, negative returns have been nominal. Even in these relatively muted downward markets, Q1 stocks still added to EM's incremental return, albeit by a more modest 1.1%.

Just as in DM, uncertainty and volatility can yield longer- term outperformance. However, rather than indiscriminately buying the most undervalued stocks, the goal should be to buy good businesses that are currently trading at deep discounts.

Selectivity: Buying Good Companies at Low Prices

For corporations facing near-term stress, the impact on valuations, earnings, and cash flow can be significant. In choosing from undervalued stocks, it is important to focus on companies with problems that can be deemed as temporary and that have viable plans to return to their long-term earnings potential. Well-capitalized balance sheets and durable business models can provide downside protection during periods of earnings normalization.

Today's environment of beaten-down valuations creates possibilities across a diverse opportunity set in EM. This diversity has allowed us to take on exposures, in some previously unexplored geographies (e.g., Romania). We have also increased weights in areas where valuations have fallen to irrational levels, in our view, like banks in India.

Conclusion:

There are plenty of issues in EM today. Beyond the trade-war concerns centered on China, fears persist over sovereign, currency, and interest rate risks. However, given stronger financial policies and improved corporate governance, today's emerging markets are structurally and fundamentally improved over previous eras.

Within the EM universe, there are plenty of healthy, globally competitive, and well-managed companies. Many of these businesses are proactively addressing trade-related supply chain and other strategic concerns in the current market environment.

While unexpected developments could lead to a range of outcomes, wide spreads imply that a lot of uncertainty has already been priced into EM. The amplified volatility, lower liquidity, and greater information asymmetry underscore why value investing makes so much sense in these markets. Regardless of which direction stocks move in the near term, diligent research and a disciplined investment process can enhance returns for long-term investors.


1 Does not represent performance of any account or strategy managed by Pzena. Returns do not reflect deduction of advisory fees, brokerage commissions, trading costs, or taxes. You cannot invest directly in an index.

i How company valuation spreads are often measured: It's common practice to segment a universe by quintiles to observe the level of divergence, or spread, between “Q1,” the least expensive stocks, and “Q5,” the most expensive. Frequently, spreads are measured based on price-to-book (P/B) data because it is widely available and uni- versally understood across markets and timeframes. However, this method is somewhat simplistic; at Pzena, we rank companies using long-term price-to-normalized earnings assessments.



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