Polar Capital

Growth or value for an emerging market rally?

For years, emerging markets have been touted as a great growth opportunity for investors, their superior returns boosting portfolio returns while lowering the overall risk profile through diversification. The reality has been more complicated due to the various crises that have overwhelmed the asset class over the past 30 years, most of which have resulted in substantial losses largely due to currency depreciation. The current strength of the US dollar combined with President Trump’s protectionist narrative appears to be creating the basis for another currency rout in emerging markets with both Argentina and Turkey seeing their currencies fall by more than 40% in 2018. Spillover into South Africa, Russia, Brazil and India is giving the impression of an asset class either in crisis or approaching one. From its 2018 peak in late January the emerging market benchmark has fallen just shy of 20% (using the total return index), so technically not a bear market. Had it been then it would have ended the bull market that started in 2016 making it the shortest in measurable history.

The obvious point being that the best time to buy into emerging markets is at times of crisis and if President Trump continues with his aggressive rhetoric in the run-up to the US mid-term elections then it is quite possible that he will have created a tremendous buying opportunity. Valuations are already attractive at below 1.6x price to book (P/B), the same level as early 2017, and the P/B discount to developed markets at 35% is close to the lows seen in 2015, which in turn were the lowest since 2004. Furthermore, the Schiller P/E ratio for emerging markets is now less than one third that of the US market, an extraordinary and historically high differential.

The issue then is not whether emerging markets are a buy but whether to persist with the growth style that has rewarded investors since 2011 or rotate back to value which massively outperformed in the bull market of 2001-08. The latter was driven by commodity prices which soared on the back of surging Chinese demand. A repeat of that scenario is inconceivable given the state of China’s finances although there may be some shorter-term measures to counter any impact from US tariffs. Growth stocks are expected to thrive when earnings growth is diminishing but although recently there has been some deterioration in the earnings outlook for emerging markets, the state of global growth, the level of global PMIs and the strength of Asian exports all suggest that global GDP is in good health. Consequently, although there have been some recent downward revisions to earnings estimates in emerging markets, expectations for one-year forward earnings per share growth remain in double digits.

Growth stocks are now trading at a premium to value stocks in terms of a P/E of 86% compared with less than 40% back in 2011. In terms of P/B the premium is 168% compared with just over 80% in 2011. Put another way growth stocks, despite the recent correction, are still close to their post-financial crisis highs while value stocks trade at a P/B just 20% higher than the lows of the financial crisis. This is exemplified by certain parts of the growth universe that are now egregiously expensive. For example, Indian consumer staples’ companies now trade on a forward P/E of over 40x which compares with a pre-financial crisis high of 27x. The Indian growth story is a good one, but these are very rich valuations. Similarly, the Korean healthcare sector now trades on a forward multiple of over 60x.

It would be logical to conclude that investors have decided to pay up for earnings growth in this uncertain world, but the reality is that the earnings performance of growth and value has been remarkably similar since 2011, implying that all the outperformance is the result of multiple expansion. The danger here is that any disappointment on earnings can lead to these names being de-rated, as has been witnessed recently among some of the leading Chinese technology companies.
The variable that remains disappointing is return on equity which has improved from the lows in 2015 but where there is still no premium to developed markets in spite of the higher cost of equity.

One driver that can help improve returns for both growth and income stocks is dividends. Cash flow is recovering largely due to greater capital discipline which in turn is reducing over-capacity and helping to restore margins. Despite this the pay-out ratio in emerging markets has remained stuck in the 35-40% range for the past 20 years. The increased focus on dividend payments by investors and management, with the notable exception of the technology sector, is likely to see this ratio increase. The resultant increase in leverage will push returns up and that should lead to higher ratings.

William Calvert, Lead Manager
Polar Capital Emerging Markets Income Fund

September 2018

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