Emerging Market Stocks: Getting Comfortable with the Uncomfortable

Executive Summary

Emerging market equity returns have been lackluster in recent years, leading many investors to write off the asset class. Value stocks within emerging markets are particularly cheap, trading at their largest discount since December 2001. While a number of narratives seem to be weighing on the asset class, we believe many of those concerns are overdone. Despite negative headlines and slowing economic growth, emerging market profitability is near its long-term average. While trade wars certainly represent a source of risk for equities across all regions, active management enables us to overweight countries and sectors further from the areas of stress. Today we believe long-horizon investors are being paid to bear the risks embedded in emerging equities, especially emerging value equities, and humbly suggest investors get more comfortable owning the uncomfortable.

Owning emerging market stocks has been a frustrating experience recently. Since the start of 2018, the MSCI Emerging Markets index has fallen 9.5% in USD terms (3.1% local)1 while other markets, the S&P 500 in particular, have rallied. Emerging’s disappointing returns represent the continuation of a long trend of underperformance leading many investors to write off the asset class. We believe that is the wrong move as emerging market stocks – value stocks in particular – represent the best investment opportunity in an otherwise muted landscape. We know from experience that holding an underperforming asset is uncomfortable. At times though, it is warranted. We believe today is one of those times.

What’s To Like About Emerging Market Equities?

While there is plenty to like about broad emerging market stocks, we believe the real opportunity lies within emerging value stocks. They are cheap, offer attractive yields, and are of growing importance due to their size and position among the “global leaders.” Importantly, emerging fundamentals (return on capital and profit metrics) are generally in line with historical levels and do not require overly optimistic assumptions to have a positive expectation of future returns. By using our in-house investment expertise to actively select which countries, sectors, and companies to overweight within the emerging markets, we construct equity portfolios with attractive characteristics. Specifically, the emerging equity portfolio within our flagship Benchmark-Free Allocation Strategy is cheaper and less levered than most equity markets, including the MSCI Emerging Markets Value index.

1. Emerging market value stocks are cheap.

Broad emerging stocks look reasonably priced and are attractive relative to other markets. From the end of 2009 through June 2019, the MSCI Emerging CAPE ratio declined from 20x to 15x as compared to U.S. price multiples, which rose from an 18x CAPE to a lofty 29x. When you look further within the emerging universe, as you can see in Exhibit 1, value stocks (in this case defined as the cheapest quintile based on Price/Earnings relative to MSCI Emerging) are particularly cheap, trading at their biggest discount since December 2001. Moreover, we are not expecting extraordinary fundamentals. Our emerging value forecasts assume modestly less than equilibrium levels of growth and income over the next seven years yet result in our highest forecasts due to multiple expansion.


As of 9/30/19 | Source: MSCI, S&P/IFCI, GMO