EM: History doesn’t necessarily repeat itself, but it can rhyme

T. Rowe Price makes the case for value investing in emerging markets.

Emerging economies have had a tough ride but, according to Ritu Vohora and Dan Hurley of T. Rowe Price, they are still attractive for investors. That was one of the key messages delivered at the Citywire Scotland Retreat.

‘82% of the world’s population is now living in emerging markets[1],’ explained Vohora, the firm’s capital markets investment specialist. ‘Importantly, they’re expected to be the world’s growth drivers, with two thirds of global GDP growth coming from emerging markets – and one third of that coming from China alone.’

Another significant trend she highlighted is the increase in the middle-class population. ‘As those individuals become more affluent, they’re consuming much more, whether it’s in goods or services,’ Vohora explained. Recent data from the IMF shows that the middle class grew by 635 million since 2005 in China alone, which will lead to ‘an incredibly powerful tailwind’.

Vohora acknowledged that while value has come back strongly in recent months, not least due to hopes of vaccine rollouts and economies reopening, markets over the last 10 years have been driven primarily by growth stocks. During the pandemic, we saw the widest divergence in 20 years, with value stocks underperforming growth stocks by around 20% in 2020. While we have seen some reversal, it begs the question: what’s next for value in emerging markets?

‘The environment we see today is very similar to the environment we saw 20 years ago when investors wrote off value investing completely,’ noted emerging markets portfolio specialist Hurley. ‘The headlines from last summer calling out Warren Buffett and Benjamin Graham’s style of investing as obsolete and redundant were exactly the same as 20 years ago, around the end of the tech bubble.’

It was also just before the start of China’s commodities super cycle that marked the beginning of a decade-long streak of outperformance among value stocks. ‘History doesn’t necessarily repeat itself in capital markets, but it certainly rhymes at points in time,’ he added.

Vohora highlighted two key areas of influence for a style rotation – the post-covid recovery and the world’s transition to a greener economy, fuelling a new investment cycle. For example, to reach its goal of becoming carbon neutral by 2060, it’s estimated that China alone will need to spend some US$16 trillion[2] – investing not just in renewable power and electric vehicles but also more traditional and old economy industries to enable that transition over the coming decades. ‘In our view, this should generate some very exciting multi-year opportunities in value’, she said.

Value is a neglected asset class

Emerging market investors, who tend to be heavily skewed towards growth parts of the market, have certainly felt the pain. According to Morningstar data as at 30 June 2021, 87% of the US$1 trillion + EM equity universe is invested in core or growth funds, with just 13% in value.

‘Of that 13%, we think that around half of it is in quant-style funds, which in our view is a very inefficient way of making the most of the opportunities in that part of the market,’ Hurley said. That inefficiency, however, is great news for active managers who are able to dig under the surface in EM and make investment decisions on a case-by-case basis.

Or as Hurley put it: ‘It’s about looking for attractively priced stocks within a very inefficient part of the market. Stocks that no one else is looking at or that have been forgotten.’

But that doesn’t mean he’s discounting tech stocks, which have sold off up to 30% recently. If the firm’s team of analysts identify fundamental improvements in cheap technology companies, Hurley doesn’t see any reason why they would not invest.

‘The businesses that our analysts seek to pitch to us will have some potential element of downside protection, the balance sheets are strong and there’s a catalyst or investment thesis that they believe demonstrates that the stocks are likely to rerate,’ he explained. ‘Those companies are compelling, they’re interesting. Why wouldn’t we take a closer look at them?’

‘Diversification in EM is key’, Hurley concluded. ‘We believe there’s a strong case for value in EM going forward, and an even stronger case for investors to diversify from having just growth exposure in their EM portfolios.

Emerging markets are less established than developed markets and therefore involve higher risks.

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[1] Source: IMF as of 30 June 2021.

[2] Source: Goldman Sachs Global Investment Research, December 2020.

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