18 Jul 2019
One of the biggest misconceptions about emerging market (EM) equities is that value opportunities are few and far between. This is not surprising, given EMs tend to be associated with high growth investing. Indeed, analysis of the EM equity investment universe (Figure 1) confirms this heavy bias, with 87% of all active money invested in either core or growth EM portfolios. Meanwhile, just 13% of all active money is invested in EM value strategies.
This wide disparity highlights the neglected nature of the EM value asset class. For active, fundamental investors, this provides a rich and opportunistic landscape to find good quality stocks that have been overlooked, forgotten or ignored. Given the under-owned and under-researched nature of EM value companies, the risk/reward opportunity is asymmetrical, with limited downside potential and the possibility of compounding on the upside.
EM equity universe AUM breakdown
As of March 31, 2019
Source: Morningstar Direct.Looking at the returns generated by the EM equity asset class over recent years, much of the performance has been driven by new economy* stocks, in areas like technology/software and consumer areas. In comparison, old economy** stocks have noticeably lagged the rally, despite rapidly improving free cash flow levels¹. As such, valuations of EM old economy companies currently appear cheap relative to history.
We believe that there is real opportunity to be found in looking more closely at some of these forgotten old economy stocks, many of which fall into the EM value space. However, simply being cheap is not reason enough for us to invest in a company, we also need to see clear potential for fundamental change. These can be external factors, such as a change in government, or a recovery in the economic cycle, or internal, such as cost-cutting, new management, or restructuring of the business. The point here is that value stocks do not necessarily need top-line growth to outperform.
More disciplined management is another factor supporting our positive outlook for EM equities generally. EM companies today are generating higher free cash flow levels and this is a direct result of management teams making better, more disciplined, capital allocation decisions. Profit margins have generally improved as a result, giving us confidence that EM companies are better positioned to deliver earnings growth and increased shareholder returns.
That said, capital spending as a percentage of sales among EM value companies has fallen to its lowest levels in more than a decade (Figure 2). After so many lean years, we believe that we could soon see a resumption of capital spending among EM value companies – as has been the case with EM growth companies since 2016 – and this could help to drive valuations higher for many of these companies.
Capital spending (Capex) to sales in EM
As of March 31, 2019
Source: Financial data and analytics provider FactSet. Copyright 2019 FactSet. All Rights Reserved.
South Africa is a good example of a country that had fallen off the radar with many investors. In recent years, political uncertainty and a slowing economy meant that the country has been largely overlooked or ignored. However, South Africa is home to many good quality companies, and the type of underappreciated opportunities we look for.
As early as 2017, for example, despite the weak domestic outlook, we started investing in certain South African banks. With strong balance sheets, limited bad debt, and paying healthy dividends, the low valuations did not reflect the underlying quality these companies, and the potentially significant upside as direct beneficiaries of a macro recovery cycle in South Africa. More recently, the more stable political environment has also proved supportive, following the May 2019 general election.
For active fundamental investors, EMs remain a fertile hunting ground for “forgotten” value opportunities. Given investors’ clear bias towards growth-oriented companies in EM, there are many good quality companies that are being overlooked or ignored. These are the forgotten companies that we look for, where the potential for fundamental change is under appreciated by most investors, thereby offering attractive upside potential.
Key Risks – The following risks are materially relevant to the strategy highlighted in this material:
Transactions in securities denominated in foreign currencies are subject to fluctuations in exchange rates which may affect the value of an investment. Returns can be more volatile than other, more developed, markets due to changes in market, political and economic conditions. The strategy has increased risk due to its ability to employ both growth and value approaches in pursuit of long-term capital appreciation.
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