Investors concerned about slowing economic growth and the prospect of muted equity returns in emerging markets should think twice before exiting the sector, global asset manager AllianceBernstein said today.
“There are still good returns to be made in emerging markets and the key to capturing them lies in a change of investment approach,” said Sammy Suzuki, Portfolio Manager—Emerging Markets Core Equities and Director of Research—Emerging Markets Value Equities.
“For most of the past decade, when emerging markets benefited from strong economic growth, investors did well by focusing on the ‘beta’ trade, or simply following emerging-market indices. For example, for the 10 years ended December 31, 2013, emerging-market equities and bonds delivered respective annual gains of 11.2% and 11.8%, far outperforming developed-market equity returns of 7.0%.[1]
“Those growth tailwinds are now diminishing as the credit, commodity and investment cycles have peaked and many developing-world countries feel the impact of China’s difficult economic transition.”
Emerging-market equity valuations have fallen and are now at deep discounts to their developed-market peers. While this might make emerging-stocks appear attractive from a pricing perspective, the return-on-equity advantage of emerging-market companies relative to the developed world has declined, as have earnings growth expectations for emerging-market companies.
“Despite this, we continue to believe that emerging-market equities belong in a well-balanced global portfolio. The difference now is that those exposures will need to be structured actively and focused on capturing ‘alpha’ or above-market returns,” said Suzuki.
This would include, for example, using bottom-up stock-picking rather than GDP growth expectations to determine a portfolio’s overall exposure to a particular emerging country. The GDP approach has proved to be an unreliable predictor of emerging-country returns in the past.
“An investor in the 1990s who believed that China was on the cusp of breakneck growth would have been correct, but would have been disappointed in the returns from investing on that view alone. Despite compound annual GDP growth of 15% since 1992, Chinese stocks fell by an annualised 2% through December 31, 2013.”
Mexico proved the same point in reverse: the country’s equity markets recorded 18% annualized growth over the same period, while GDP growth remained low-single-digit.
“Our research shows that a simple metric such as the average price/book value of the stocks within a developing-world market is much more predictive of that country’s future outperformance than knowing precisely what that country’s nominal or real GDP would be for the upcoming year,” said Suzuki.
Despite increased analyst coverage of emerging markets, they are still inefficient enough for active investors using a combination of deep fundamental and broad quantitative research together with a disciplined investment process to be able to identify opportunities to generate alpha.
Certain stock-picking tools—such as valuation, price momentum and balance-sheet quality—have proved to be far more reliable drivers of excess stock returns in emerging than in advanced markets, although others—such as net equity issuance—work less well.
“An active investment strategy is also important as a way of managing risk, as emerging markets are more volatile than developed markets, and this increases the risk of big losses,” said Suzuki. “But there are three steps investors can take to reduce these risks.”
They are:
• target reliable bottom-up sources of positive returns
• don’t be too quick to reload into losers or afraid to cut your losses (and, conversely, don’t exit winners too soon)
• invest in stable-growth, less volatile companies.
“In the coming decade, we expect investment success in emerging markets to hinge on the ability to identify the firms that can most deftly navigate the new environment,” said Suzuki.
“Finding tomorrow’s winners will take rigorous research entailing local knowledge, global industry insights and a discriminating eye.”
