For contrarian investors and for those who believe valuation multiples matter, these may seem like challenging times. But Raheel Altaf, manager of the Artemis Global Emerging Markets Fund, believes these could actually be vintage conditions for stockpickers…
For some time, ‘momentum’ has been king. Valuations aren’t reverting to the mean and undervalued stocks keep getting cheaper. Stockpickers are seeing company fundamentals playing second fiddle to ‘style’ - an example being that, for much of this year, stocks falling into the ‘quality’ style factor have been bought irrespective of their individual merits.
While valuation multiples and idiosyncratic stock risk don’t appear to matter today, history suggests that – at some point – they will.
Why the current environment is so ripe for stockpicking
Equity markets are currently exhibiting extreme levels of valuation dispersion. The chart below shows how the valuation premium (relative to the market average) of the most expensive quintile of stocks within emerging markets has varied over time.
The current valuation premium of the most expensive 20% of stocks in the market is unusually high compared to its historic average.
Source: Empirical Research Partners Analysis as at 31 October 2019
Today, the valuation gap in emerging markets between ‘expensive defensive’ stocks and cheap stocks is unusually wide, reflecting how elevated political and economic uncertainty has pushed risk aversion higher. This process is particularly pronounced in emerging markets because a handful of large companies attract most of the attention and there are a relatively limited number of perceived ‘safe havens’.
This process is particularly pronounced in emerging markets because a handful of large companies attract most of the attention and there are a relatively limited number of perceived ‘safe havens’.
At first glance, the macro case for buying safe havens seems entirely logical: global growth is slowing and central banks are easing monetary policy, so bond yields may remain low for the foreseeable future.
As bond yields fall, so does the discount rate applied to an asset’s future cashflows, mechanically boosting the value of those cashflows today. Put simply, if you expect global growth to remain sluggish for a very long time, any company expected to show reliable, ‘defensive’ growth in its earnings becomes more valuable than its low-growth (or no-growth) peers.
Conversely, at the cheap or ‘value’ end of the market, cyclical companies have been sold as investors fret about the short-term impact of the slowing global economy on their (less certain) future earnings.
Our belief is that this valuation gap won’t continue to widen indefinitely. As the chart shows, previous instances of extreme valuation dispersion over the past 22 years have been followed by rapid contractions.
Viewed in this way, current conditions actually represent an extremely good environment for active managers with longer-term investment horizons.
Our approach finds plenty of opportunities…
We follow a systematic approach that screens the emerging universe using both top-down and bottom-up inputs. Our objective is to find cheap, unloved companies that have good prospects for growth.
One of the inputs we screen the market for is investor positioning, which we regard as a contrarian indicator: we try to avoid the crowded trades and focus instead on the names that seem to be out of favour. Where do we find those cheap, unloved – but growing – stocks today?
…in telecoms
The telecommunications sector is currently out of favour because investors assume its growth will be slow and view the sector as being under threat from regulators.
Kenya’s Safaricom is a great example of a company bucking this trend. With relatively low penetration of branch-based bank accounts and a young, tech-savvy population, Kenya has fully embraced Safaricom’s mobile payment application, M-Pesa. This makes Kenya a world leader in cashless transactions and financial inclusion through technology. It also boosts Safaricom’s earnings growth.
…in utilities
Investors are worried about the capital expenditure needed to make the transition to renewable energy. As a result, utilities are a somewhat overlooked sector of emerging markets and offer some attractive opportunities.
Enel Chile, for instance, produces and distributes electricity. It has been managing the transition to renewables for years: more than 60% of its generation fleet is already based on sources of renewable energy. Its low sensitivity to the economic cycle should allow the company to pay a very healthy dividend even as it continues to transition its generation capacity towards renewables.
…in countries clouded by political risk
We find good opportunities in Turkey and Mexico, where the market-unfriendly reputations of their leaders have deterred investors.
Ulker Biskuvi is Turkey’s leading manufacturer of biscuits and chocolates. This is a stable market and demand for snacks is broadly immune to the economic cycle. With 40% of sales made outside Turkey, the company actually benefits from the weaker currency but its listing in Turkey means it is trading at a a forward p/e of just 9.4x.
Mexico’s election of a left-wing firebrand, Andrés Manuel López Obrador (‘Amlo’) as president in 2018 has also spooked investors. But it is unlikely his administration will suppress appetite for video and data consumption. Megacable is the second largest cable operator in the country. Its ‘triple play’ offering (fixed line, wireless and broadband) is leading to strong growth in subscribers.
...and among ‘state-owned’ enterprises
In a slightly different vein, we find many state-owned enterprises trading at valuation discounts. Investors regard them as instruments of local governments that pay too little regard to their minority shareholders.
But there are signs governments realise that improving corporate governance can unlock value in their assets. For example, earlier this year the Russian government pushed state-controlled Gazprom to raise its dividend pay-out.
The Chinese government is driving changes at the largest companies, pushing them to lead by example and to reform both their economic management and governance. We believe this could unlock value and, in time, start to reduce the valuation discount on which these companies typically trade.
Conclusion
The unusually large dispersion of valuations across emerging markets, is providing a window of opportunity for contrarian stockpickers.
Our contrarian, systematic approach allows us to identify attractive companies trading at low valuations despite their good growth prospects. While the timing is impossible to predict, we believe the current extreme valuation gap within emerging markets will contract. When it does, we believe our portfolio should prove well positioned to benefit from doubting the wisdom of crowds.
To find out more about the Artemis Global Emerging Markets Fund and its positioning visit the fund pages at www.artemisfunds.com.
THIS INFORMATION IS FOR INVESTMENT PROFESSIONALS ONLY. IT IS NOT FOR USE WITH OR BY PRIVATE INVESTORS.
The fund is a sub-fund of Artemis Investment Funds ICVC. For further information, visit www.artemisfunds.com/oeic.
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