Are Emerging Markets Stocks a Viable Asset Class?

It is a basic fact of investing that stock market returns are determined by earnings growth and the multiple that investors will pay for them. Over time corporate earnings generally grow in line with GDP growth, while the multiple put on earnings varies depending on how fearful or optimistic investors may be. Stock valuations may also be impacted by the cost of capital, so that investors will pay higher multiples on earnings when interest rates are low and vice versa. These relationships apply across all geographies, including emerging markets.

Valuations in emerging markets have persistently been lower than in the U.S. and other developed markets even though emerging market economies grow at nearly three times the rate. Relatively low valuations and high GDP growth are the perennial selling points for investing in EM stocks. However, at least for the past decade, returns in EM have lagged well behind those for U.S. stocks, and, understandably, this has raised concerns about the viability of the EM asset class.

However, there are good reasons to believe that the poor performance of EM stocks is temporary. Explanations for weak EM returns point to cyclical and circumstantial causes that should eventually revert.

First, the valuation gap between emerging markets and the U.S, market has widened considerably over the past ten years because of structural issues which are probably temporary. While EM stock markets continue to be dominated by low-growth capital intensive sectors (e.g. banking, manufacturing and natural resources), the U.S. stock market has been driven by “growthy” capital-light companies (e.g. Facebook, Apple, Netflix, Google). “Growth” stocks are long-duration assets (i.e., The concentration of cash flow and dividend payments are in the distant future) and therefore they benefit from the low discount rates implied by the current low inflation and  low interest rate environment. Concurrently, the combination of low-growth/low investment with historically low interest rates in the U.S. has resulted in unprecedented stock buy-back activity by U.S. corporations over the past seven years. This structural cause of EM underperformance is largely the same that has led to the poor relative returns of “value” vs. “growth” investing in the U.S. and global markets, since value stocks are also “short-duration” investments.

This importance of buy-backs is highlighted in a recent paper from analysts at ADIA, the Abu Dhabi Investment Authority (“Net Buy-Backs and the Seven Dwarfs”, Link). The ADIA researchers looked at the MSCI All Country World Index (ACWI) for the 1997-2017 period and determined that the primary determinant of country-specific returns was net buy-back activity (NBB), a measure of the net increase in issued stock in a market (e.g., IPOs, delistings, corporate buy-backs, mergers and acquisitions). Depending on the nature of the NBB, it may enhance or take away from shareholder returns. Markets where companies constantly issue stock –  either because they are in low-return capital-intensive businesses or because they lack capital discipline and shareholder alignment – do poorly. In this regard, the data shows evidence that poor corporate governance manifested by undisciplined capital management has suppressed returns in EM, with the result that earnings have grown at a rate well below GDP growth.

Over the period covered by the study this has especially been the case in China where huge and overpriced initial public offerings (IPOs) of state-owned companies (SOEs) have severely  hurt shareholder returns. The Philippines, Indonesia, Chile, Russia and Thailand have also suffered from negative effects of NBB. The data on NBBs for emerging markets from the ADIA study is shown in the chart below. NBBs had a an average negative 3.4% impact on annualized returns, with less than a third of EM countries showing positive NBBs. Given that stock buy-backs are rare in EM, those countries showing positive NBBs had this as a result of M&A activity and delistings (e.g., ABInbev’s takeover of Modelo in Mexico). The study’s total sample of 41 countries had a negative 2.2% impact on annual returns, slightly above the U.S. market’s negative 1.8%. Interestingly, NBBs for the U.S. market become hugely positive over the 2009-2019 decade and are a major reason for U.S. stocks outperformance over this period.

The second reason for the underperformance of EM stocks over the past decade is the mean-reversion of both valuations and the U.S. dollar.  The charts below show (left) the relative performance of the FTSE EM Index (VEIEX) and the S&P 500 (SPY) over the past twenty years and (right) the EM MSCI Currency Ratio which is the performance of the currencies in the EM stock index relative to the USD. The twenty-year period is neatly divided into the first 10 years of EM stock outperfomance and dollar weakness and the following ten years of EM stock weakness and USD strength.

The strength of the dollar has been a major headwind for EM stocks over the past ten years, reducing returns by 3% annually, as shown below.

Over this period, valuations in EM and the U.S. market follow highly divergent paths. The chart below shows the evolution of valuations for both markets using cyclically inflation-adjusted price-earnings ratios (CAPE), a measure that smoothes out earnings and provides a better basis for comparison. EM started with a very low CAPE ratio of 9.2x in 1999, which rose sharply to 19.6x in 2009 (after reaching a peak of 30x in 1997) and then falls back to 11.5x in 2019. S&P500 valuations start at a bubble -level ratio of 42x  in 1999, fall by half to 20.5x in 2009 and are currently at 29x today.

Conclusion

The outperformance of the U.S. market over the past ten years can be attributed to circumstances that are probably temporary. U.S. returns were boosted by the relatively low level of initial valuations 10 years ago, historically low interest rates over the period, buy-backs and a strong dollar. On the other hand, EM returns have been hurt by relatively high initial valuations, a strong dollar and negative net buy-backs. Predicting the next ten years is a fool’s errand, but low valuations, a weakening dollar and relatively high GDP growth may put the odds in favor of EM stock outperformance.

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