- The investable emerging market (EM) equity universe has evolved from simple country selection on a tactical basis to the inclusion of sector allocations, and then to permanent allocations in individual stock-focused portfolios.
- There is a vast EM opportunity set in which to find latent value.
- The EM universe contains value-oriented opportunities distinct from those in the U.S. market.
What does value investing have in common with the emerging markets?
This is not a trick question. Rather, it is a statement of sympathy. Just as value investors are used to going down the road less travelled alone, so are emerging market investors. The rest of the investment community has written off both sets of investors as dinosaurs buried six feet under and forgotten about us. The MSCI USA Growth Gross Total Return Index has compounded at a 20.0% annual rate of return during the decade ending in 2021.1 On the other hand, the MSCI USA Value Gross Total Return Index has compounded at a 13.0% annual rate during the same period.1 While a 13.0% annual return over a decade is an attractive return, the per-year return declines and the differential with the growth index increases as the decade progresses. The final nail in the coffin was the period from 2018 to 2020 when the value index delivered an annualized return of 5.6%, whereas the growth index returned 24.4%, leading many to write-off the value discipline as at best “flawed” (thus the market talk of value having failed to capitalize technological innovation in book value), and at worst “dead.”1 With figures such as these backing one’s investment discipline, who needs enemies?
Emerging market investors carry the same cross as value investors with a 5.9% annualized return for the MSCI EM Total Return Index over the decade ending in 2021 competing against a 16.6% annualized return for the MSCI USA Gross Total Return Index over the same time period.1
The irony for value and emerging market investors alike is that we expect to outperform other investment styles / universes on an ex-ante basis. Indeed, many studies have confirmed the historical outperformance of value as an investment discipline over growth. The most comprehensive empirical study of the subject that I am aware of is a paper titled “What Has Worked in Investing” by Tweedy, Browne Company LLC.2 Emerging markets, for their part, offer the possibility of faster growth than developed economies owing to their higher rate of working population growth and greater room for productivity improvements – working population and productivity being the two determinants of a country’s long-term growth rate.
Proponents of a value discipline face the uphill battle of reminding the rest of the market that prices are not simply numbers but form an integral part of the investment return equation, and that cycles, including those that relate to investment styles, are the norm in markets. EM investors face a similar challenge when explaining the merits of the investment universe to U.S.-based savers as value investors face when advocating for their discipline to proponents of a growth-oriented approach. The added complication for those of us who focus on the emerging universe is that it has a more checkered history than value’s storied past in the U.S.
Emerging Markets Investing: A Brief History
The emerging market universe came into existence gradually as the Nixon administration engaged in rapprochement with China, and as the former Soviet satellite nations gained independence from the U.S.S.R. and abandoned the socialist ideology. As these countries began to integrate themselves in global cooperation structures (the International Monetary Fund (IMF), the World Trade Organization (WTO), among others) they literally transformed themselves into markets that were emerging. Given the basic nature of their economies that relied mostly on resource extraction and secondary industry (manufacturing), the early days of emerging market investing in the 1980s and 1990s tended to focus on country selection and then purchasing the largest publicly-listed bank and telecommunications company in the selected country.
With the U.S. dollar as the backbone of oil trading – and by extension of all other commodities – the stock prices of companies listed in the mostly-resource-dependent emerging markets were as volatile as the prices of the underlying commodity. In effect, commodity prices and emerging market stock prices became derivatives of U.S. monetary policy. Combined with the U.S. dollar interest rate and inflation volatility that followed Nixon’s abrogation of the Bretton Woods accord in 1971, significant price volatility plagued the early days of emerging market investing.
Thus, U.S.-dollar-based investors could only make tactical (not structural) allocations to the emerging markets, and the case for investing in the universe centered on the statistical diversification benefit to a portfolio more than on the pure investment merit of the emerging corporates per se.
China’s admission to the WTO in 2001, following the devaluation of the renminbi (RMB) in 1994 and the recapitalization of the Chinese banking system in 1998, provided the foundation for the exchange of Western technology for Chinese labor that would define the economic history of the following two decades. The credit expansion in developed economies that facilitated this exchange probably lasted longer than it would have otherwise due to the conspicuous absence of inflation in developed markets globally, itself probably a function of China’s deep pool of underemployment at the time combined with a closed capital account.
One cannot understate the importance of the latter point. China’s capital controls prevented the renminbi from appreciating despite massive trade and capital surpluses over the years. Combined with the Federal Reserve’s continuous lowering of interest rates for three decades, this symbiotic relationship between China’s foreign exchange policy and the U.S. interest rate policy culminated in China’s 4 trillion USD foreign exchange reserve peak in 2014. This trade distortion would have probably corrected itself before it reached such astronomical levels in freely operating economies with market-determined exchange rates and interest rates. The foregoing provides one explanation for why a recent U.S. administration sought to redress the issue with abrupt trade policy changes, given the original failure to allow the market to regulate the trade relationship between the U.S. and China.
Another consequence of this extreme trade relationship was the extraordinarily rapid economic development not just of China, but more importantly for our purposes, of the entire global emerging markets universe. What was remarkable about the first decade of the 21st century was not necessarily the creation of the infamous rising middle class in developing economies, but the speed with which the transformation took place. The supply-side reform in developing economies as global supply chains developed with the integration of emerging economies into global cooperation structures led to an enormous consumption boom in these countries. The result was that during the 2000s, emerging market investing evolved from simple country selection to include sector allocations based on the expanding list of industries with listed companies in the stock market as these economies developed beyond resource extraction, banking, and telecommunications.
The Global Financial Crisis of 2008 exposed the unnaturally high level of consumer debt in the U.S. and its corresponding capital account surplus in China. Emerging markets would spend the following decade diversifying away from their economies’ dependence on trade deficits in developed countries, as well as commodity prices. China itself emerged as an engine of growth for the global economy during this period with its self-started credit impulses (stimulus spending) alongside the Federal Reserve’s and European Central Bank’s own credit cycles.
The breadth and depth of capital markets in emerging economies continued to grow during the most recent decade, despite the double setback of restrained consumer debt growth in the U.S. and lower commodity prices following the Federal Reserve’s first attempt (of several) to normalize interest rates in 2013, as countries strived to promote gross domestic product (GDP) growth internally. Similarly, emerging market investing further evolved to focus more on individual stock selection, as opposed to old-school, top-down country / sector allocations. At present, capital markets have developed sufficiently to support permanent allocations from U.S.-based funds pursuing investments in individual companies over simply investing in these markets for tactical reasons primarily related to the statistical benefit of diversification for a portfolio.
This latest step in the evolution of emerging market investing is what motivated some of us to apply a value discipline to the emerging market equity universe.
- First, it stands to reason that an investment universe with a $27.8 trillion market capitalization as of year-end 2019 should accommodate more investment strategies than simply growth, which was perhaps more appropriate in the year 2000 when the market capitalization of the universe was $2.3 trillion and rife with price volatility.3
- Second, there are very few funds pursuing a value discipline in the universe, signaling the potential to reap unharvested, value-oriented investment returns.
- Third, emerging market corporate governance and capital discipline have improved tremendously over the past two decades, with dividends accruing to shareholders growing from a cumulative $0.8 trillion between 2000 to 2009 to $2.5 trillion in the 2010-2019 time period.4
- Fourth, the investable universe outside of the index is significantly larger than that which passive funds restrict themselves to. As of December 31, 2019, the MSCI Emerging Markets Index included 1,404 issuers with a free float-adjusted market capitalization of 6.2 trillion USD-equivalent. The universe overall contains 10,800 issuers with 27.8 trillion USD-equivalent of underlying capitalization. The 22 trillion USD-equivalent gap between MSCI’s float-adjusted capitalization and the total EM universe includes 10 trillion in excluded companies and 12 trillion in reduced weightings. This implies a capitalization coverage (defined as the ratio of index capitalization to total capitalization) of only 22%.3 Thus, there is a vast EM opportunity set, as yet only explored by growth-oriented active funds, in which to find latent value.
Not only is income generation, and not simply growth, now part of the emerging market total return equation, but I have been pleasantly surprised to find various forms of value that in my estimation are distinct to the universe. In my opinion, not only has the universe evolved to the point where individual stock selection by a value discipline can work, but it offers its own unique flavor of value.
Different Manifestations of Value
One way in which value manifests in the emerging markets that is different from the U.S. market relates to the traditional trade-off between growth and income. In the developed markets one usually has to invest in sunset industries, such as tobacco or printed media, to earn high dividend yields. The emerging markets, on the other hand, offer value opportunities such as Tabreed, a United Arab Emirates-based owner-operator of water-cooling facilities critical for the energy efficiency of air-cooling systems of buildings in many parts of the globe with hot climates. What was unique about this find is that the value on offer probably would not have persisted for so long in the U.S. In the emerging market context, Tabreed was considered a “boring” stock, growing about 5% annually, and generating dividend yields of about 5% in an uneventful industry located in one of the less-travelled regions of the investment world, the Middle East.
It took a long time for investors who saw Tabreed’s worth to reap the reward of purchasing this stock cheaply. The first sign that the public equity market was missing something was the 2017 purchase by a French utility company, Engie, of a 40% strategic stake in Tabreed at a 42% premium to the last traded price before the news. Subsequently, Tabreed engaged in mergers and acquisitions, and opened new avenues for growth outside of the Middle East. While the growth rate resulting from these initiatives will never compete against that of a South Korean or Chinese technology firm, it’s proven sufficient for the market to eventually realize that this boring stock engaged in 20-year contracts with customers, and yielding 5% was effectively a bond with moderate growth priced as equity. It took time, but the public equity market eventually recognized non-growth-oriented value in the emerging market context.
Another unique type of value on offer in the EM universe relates to the fact that the publicly-listed corporate sector has grown more rapidly than investor allocations to the universe or the diversity of strategies pursuing investment returns in these markets. This means that while most investors focus on the gorilla in the room – China – and other themes such as the growth of the middle class or technology stocks, there is a large and growing number of companies operating outside the purview of traditional, growth-focused investors, or mainstream EM indexes – the latter of which are mostly focused on issues of scale and replicability. Thus, one need not assume undue risk with a complicated, turnaround value stock idea to find an attractive valuation. A small, out-of-the-headlines country, such as the Czech Republic, offers attractively priced listed banks, such as Moneta Money Bank, that operate in a stable, profitable manner, and enjoy excess capital even after accounting for a prospective dividend yield exceeding 5%. Again, this kind of investment return is unlikely to exist for long in an efficient capital market with more sophisticated investors that don’t simply pursue growth in a single-minded manner.
A third type of value that is unique to the EM universe relates to companies undergoing a change of control or management. In the U.S., one has to search for failing companies as a precursor of probable management or ownership change. The difference in the emerging markets is that in addition to underperforming businesses, an investor can harvest the value addition of a new management team through the normal course of full or partial privatization of state-owned enterprises (SOEs). WH Group, a Chinese hog processor and owner of U.S.-based Smithfield Foods, represents a case in point. The company’s origins date back to 1958 as an SOE engaged in the cold storage business. After expanding into meat processing, the Luohe local government sold the company to a group of private investors, who, after developing the business further, listed the company’s shares in 2014 in Hong Kong to fund the acquisition of Smithfield Foods in the U.S. WH Group is now the largest hog processor in the world, delivering healthy financials.
There’s a plethora of SOEs in the emerging universe due to the history of centrally planned economies in these countries. While SOEs have a deserved reputation for lackluster financial results, active investors have the potential to identify those, such as WH Group, that successfully transition from serving state interests to serving consumers and shareholders. Indeed, WH Group has proven resilient to severe setbacks during the past few years: the U.S.-China trade war, which impacted its business with Smithfield Foods directly; the advent of African Swine Flu among hogs in China; and the onset of the Covid-19 pandemic. Throughout these difficult years, the company always earned a return on equity in the teens and the stock’s total return for shareholders compounded at a 12.2% annual rate of return during the five years ended December 31, 2020.1
Waiting for the Transition
Arguably, value investors are also waiting for a transition: a return to an investment environment where the fundamental laws of economics are allowed to work. Value is not “dead” because economic logic does not have an expiration date associated with it. I view value’s severe underperformance for more than a decade now as a sign of highly interventionist public policy that has constrained returns for value strategies. In my opinion, once the present, extreme monetary policy transitions from favoring borrowers at the expense of savers to serving the interests of all citizens impartially, the current market zeitgeist will also transition to more balanced outcomes.
While the track record of value as a discipline in the U.S. waits to return to its storied past, emerging market investors look forward to traveling back to the future. It is remarkable indeed, that through the last 40 years of supply-side reform in emerging countries – transitioning through political regimes, monetary policy regimes, economic recessions, and debt and currency crises – the investable equity universe has evolved from simple country selection on a tactical basis to the inclusion of sector allocations, and then to permanent allocations in individual stock-focused portfolios. The same way that the laws of finance are atemporal – thus, the idea that value is dead is nothing more than confused thinking – they are also universal. They apply equally to emerging markets as they do to developed economies. The issue is not whether a value discipline will work in the emerging markets, but rather who will self-select to go back to the future in their investment choices.Paul Espinosa
- The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
- Past performance does not guarantee future results.
- As of December 31, 2021, Tabreed (National Central Cooling Co. PJSC) comprised 1.7% of the Seafarer Overseas Growth and Income Fund, Moneta Money Bank AS comprised 1.8% of the Fund, and WH Group, Ltd. comprised 0.6% of the Fund. View the Seafarer Overseas Growth and Income Fund’s Top 10 Holdings. As of December 31, 2021, Tabreed (National Central Cooling Co. PJSC) comprised 4.7% of the Seafarer Overseas Value Fund, Moneta Money Bank AS comprised 4.7% of the Fund, and WH Group, Ltd. comprised 1.8% of the Fund. View the Seafarer Overseas Value Fund’s Top 10 Holdings. As of December 31, 2021, the Seafarer Funds did not own shares in the other securities referenced in this commentary. Holdings are subject to change.
- Source: Bloomberg.
- “What Has Worked In Investing: Studies of Investment Approaches and Characteristics Associated with Exceptional Returns,” Tweedy, Browne Company LLC, October 2014.
- Sources: Bloomberg, FactSet, Seafarer.
- Sources: Bloomberg, Seafarer.