No Lack Of Long-Term Value In Emerging Markets
The New Year hasn’t brought much relief for long-suffering emerging market investors. The MSCI Emerging Markets Index was down more than six per cent for the first month of 2016 and is now in negative territory over the past decade. However, we believe there are attractive opportunities to be found for investors who are able to look past the short-term macro noise. While we can’t predict when the performance of emerging market shares will improve, we do know that deeply out-of-favor markets often present attractive long-term investment opportunities.
Emerging markets are out-of-favour
As an approximate gauge of current investor sentiment, the Bank of America Merrill Lynch ‘Global Fund Manager Survey,’ which collects data on relative over- or underweight positions among global asset managers, shows that the preference for developed markets over emerging markets is the most pronounced it has been in the survey’s 15-year history. This sentiment is further supported by data from EPFR which shows that investors have taken more than $100 billion out of emerging markets in the last three years, while pouring over $500 billion into developed market equities over the same time.
Investors have flocked out of EMs and into DMs in recent years
Cumulative net flows to developed and emerging market equity funds, US$ billions, Dec 2010 through Dec 2015
While there are many ways to think about valuation, on a price-to-revenue basis the gap between developed and emerging market shares has widened significantly, and is presently the most extreme it has been in the past 15 years. Moreover, since 2000, there have been few occasions when emerging market shares have traded at valuation levels this low.
… and the valuation gap between EMs and DMs has widened
Price-to-revenue ratio of developed market stocks and emerging market stocks, Jan 2000 through Dec 2015
While emerging markets look relatively attractive on several broad measures, there is also a wide dispersion within emerging markets, which is why the real opportunity ultimately lies in bottom-up stockpicking as opposed to a bet on emerging markets as a whole.
Valuations between EMs differ substantially
Price-to-book-value and price-to-earnings ratios of MSCI emerging market country indices
Focus on identifying quality investment opportunities, one business at a time
Contrary to popular belief, investors don’t need to sacrifice quality when investing in emerging markets.
A good example is JD.com, China’s second largest eCommerce player and its largest retailer. Its operations are comparable to Amazon’s, with self-managed logistics, services, and infrastructure (e.g. warehouses) supporting the sale and delivery of goods directly to consumers. Thanks to JD’s scale and business model, whereby it sells and generates cash on products prior to paying related costs, its rapid expansion could be entirely self-funded, which is a very attractive characteristic. Moreover, as an eCommerce company, much of JD’s growth capital expenditure (capex) is effectively recorded as marketing expenses in its income statement, which, in our view, causes earnings to be understated. JD’s earnings are also affected by its decision to keep prices low in an effort to compete for market share. If the company continues to grab market share, it should be rewarded with rising profit margins as economies of scale lower procurement costs, while increasing the industry’s barriers to entry.
Since the earnings gestation period for internet businesses can be prolonged, we generally find that valuation multiples based on earnings are less useful. For eCommerce retailers, Gross Merchandise Value (GMV) ‒ the total value of goods sold through a site ‒ is a helpful measure in assessing long-term fundamental value. On an Enterprise Value (EV)-to-GMV basis, JD’s discount relative to its peers becomes most apparent. Its EV is less than 0.5 times trailing 2015 GMV, while Amazon trades at around one times EV/GMV. If JD can indeed deliver on our expectations of 40 per cent annual GMV growth through 2019 ‒ and better yet, cement a dominant position in Chinese retail ‒ it may become a significantly more valuable company than it is today.
In Korea, we have found compelling contrarian opportunities in the brokerage sector. These companies generally underperform in sluggish stock markets, as they mainly derive their income from investors’ trading activity. But we believe Korea’s weak stock market and its relatively low prevalence of financial products provide a meaningful margin of safety against downside risk as these factors tend to move cyclically.
As shown in the chart, Korea Investment Holdings trades at a discount to its global peers, despite having a higher return on those assets. While higher financial market activity and further deregulation should improve the overall brokerage sector’s fundamental performance, we prefer to invest selectively in companies that we believe possess meaningful competitive advantages, unique growth drivers and strong management teams.
Even though parts of the stock-market in India continue to command sky-high valuations (as illustrated in the valuation graphic above), there are also unpopular and overlooked parts of the market. Infrastructure-related companies, for example, have remained depressed amidst a weak investment cycle and financial shares face poor sentiment on account of muted loan growth and concerns about asset quality stress across the sector. IDFC, a leading Indian infrastructure-focused financial group that is in the process of transitioning into a full-fledged bank, has been doubly tarnished.
At its current share price, IDFC, the holding company, trades at a discount of around 50 per cent to the value of its stake in the underlying bank, which in itself, is valued more cheaply than its private banking peers in India. Amid a difficult operating environment, IDFC has created a large loan-provisioning buffer by effectively segmenting bad assets into a separate bad ‘mini-bank.’ We feel this approach, intended to keep the new bank on sure-footing, is prudent and can help fund future growth efforts as the bank strives to prove its capabilities in an improved environment.
Of course, even the most carefully selected shares are not immune to the gyrations of emerging stock markets. Indeed, JD.com has been punished in the short term along with pretty much everything else China-related, while Korea Investment Holdings and IDFC both remain deeply unpopular. But we think the key takeaway for investors is that there are investment opportunities worth considering on their individual merits in emerging markets thanks to the steady drumbeat of negative headlines and it would be a mistake to ignore these markets altogether, particularly when valuations in developed markets are looking increasingly stretched. All things considered, when it comes to generating good risk-adjusted returns over the long term, our experience suggests that geography is far less relevant than understanding the strength of each company’s business and comparing that to its share price.
Craig Bodenstab is with Orbis Investments. www.orbis.com