The Case for Value in Emerging Markets

 

Over the long term, stocks that trade at low multiples of earnings or net worth (book equity) have consistently outperformed the general market. This is known in investing as the “value premium,” and it is explained by the general public’s tendency to overvalue high profile, “growthy” stories. Simply put, investors prefer the glamorous stocks in the news, which gives an opportunity for contrarian investors to buy obscure and unpopular stocks at big discounts. However, now for over a decade value has performed poorly relative to the market, and this inevitably has raised the question of whether the value premium no longer exists.

The chart below, from Causeway Capital’s recent paper “The Compelling Case for Value” (Causeway) shows the long-term outperformance of value over growth stocks for the MSCI World Index. Similar results can be shown for the U.S. market and emerging markets.

However, over the past ten years the results have been very different, with growth more than doubling the returns of value across most markets.

MSCI, 10-year Annualized Return

There are two main arguments that are made to explain the recent underperformance of value.

  • The increasing prevalence of companies with little need for capital. If a company like Amazon can grow its business entirely with third-party capital (eg suppliers), then surely a price-to-book multiple becomes irrelevant. Warren Buffett, the most famous value investor of them all, recognized this at his shareholder assembly last year when he heaped praise on tech hegemons. Buffett said these companies were the “ideal business,” because they get very high returns for little capital. “I believe that probably the five largest American companies by market cap…if you take those five companies, essentially you could run them with no equity capital at all. None,”  said Buffett.  This is a remarkable statement from someone who, to this day, focuses much of his activity on capital-intensive businesses like railroads, utilities and manufacturers.
  • Low growth and low interest rates. Growth companies have benefited from  an unusually favorable environment. As the rate of GDP growth has fallen sharply over the past decade, it is plausible that those few companies able to achieve high growth could command higher premiums. This has happened at a time when interest rates have been at record lows, which means that this growth is discounted at record low rates.

Of course, we can’t know if these arguments will make sense in the future. Particularly in the case of low interests, it is likely that we will look back on recent years as exceptional, not a new normal.

Part of the issue with “value,” has to do with the definition of the term. Most value benchmarks rely exclusively on the price-to-book ratio. However, many successful  “value” investors have long migrated to different indicators. Buffett, for example, since the 1970s has focused on “relative value,” looking for  “wonderful companies at reasonable prices.”  Similalry, Joel Greenblatt’s “magic formula” picks quality companies (high returns on capital) at relatively low prices. Dimensional Fund Advisors (DFA), a prominent “quant”  value manager, introduces several indicators in its rules-based quant model to improve on the price-to-book metric. By doing this DFA has achieved much better performance in its “smart-beta” EM value fund (3.33% annualized for the past ten years vs -1.3% for the price-to-book based MSCI EM).

However, seeking explanations for value’s underperformance may be an exercise in futility. Paradoxically, it is exactly the long periods of anomalous underperformance that allows for any investment factor to perform over time. If any strategy was easy to pursue, it would quickly be arbitraged away. For example, Joel Greenblatt points to long periods of underperformance for his “magic formula” as the primary reason for why it continues to sustain results. Hugely successful value investors such as Seth Klarman of Baupost and Buffett himself,  have had long periods of underperformance, which might well have ended their careers at typical investment firms.

One of the most difficult challenges any investor faces during the allocation process is determining whether long-term parameters for valuations are still valid. The fear always lurks that the world has changed. The investor always struggles between accepting the usefulness of real historical data and being flexible enough to appreciate that valuation paradigms may evolve in compex adaptive systems like stock markers.

In the case of emerging markets today, I think it is reasonable to at least tilt portfolios towards value. I prefer relative value, but there is also a good case to be made for also owning low-price-to-book stocks. As the following chart from Pictet Asset Management shows, EM Value relative to EM Growth is approaching historical lows, and this at a time when GDP growth in emerging market economies is accelerating. This is not surprising, given that recent EM performance has been driven by Chinese tech stocks.

In a related topic, a recent paper by Michael Kepler and Peter Encinosa of Kepler Asset Management provides a detailed look at the “value” experience in emerging markets for the  MSCI Emerging Markets Index since 1988    (The Journal of Investing). To begin with, the authors note that the MSCI EM index has outperformed the MSCI World Index by more than 3% annually over the period (9.63% vs. 6.38%). However, this outperformance is achieved with much higher volatility (standard deviation of monthly returns of 6.71% for EM vs. 4.31% for the World). Volatility is a huge problem for most investors because it leads to emotionally adverse behavior, essentially panic selling at the bottom and buying at the top.

In their article, Kepler and Encinosa plot the relationship between price-to-book and future 4-year stock returns for both the MSCI World and MSCI EM. The plots shown below give a valuable perspective on the relative opportunities.

 

First for MSCI World, the regression analysis  using data between 1969-2016 shows an expected return of 8.5% annually for a price to book of 2.14, with a range of possible outcomes from -2.1% to +20.1%. At current valuations of 2.4 time book (February 2018), the expected return declines to below 7% annually, and possible downside of 8% and upside of 18%.

For MSCI EM, the regression analysis using more limited data  between 1988-2016 shows an expected return of 12% annually for the next four years for a price-to-book value of 1.56, with a range of possible outcomes of -8.8% annually to +36.9% annually. At current valuations of 1.81x book, expected returns are closer to 9% with a range of outcomes of -12% to +30%.

 

Fed Watch:

India Watch:

China Watch:

China Technology Watch:

  • Ten Chinese firms vying to beat Tesla (SCMP)
  • Shanghai give go-ahead for driverless car road tests (SCMP)
  • China on the leading edge of science (The Guardian)

EM Investor Watch:

  • No one is listening to Jeremy Grantham (Institutional Invstor)
  • The compelling case for value in global stocks (Causeway)
  • The fall of the Gupta’s in South Africa (FT)
  • Unlocking Indonesia’s digital opportunity (McKinsey)

 

Investor Watch:

  • Interview with Paul Tudor Jones (Zero Hedge)
  • A Criticism of CAPE ratios (FT)
  • Credit Suisse Global Investment Report (Credit Suiss)