Active management in the 3rd evolutionary phase of emerging markets
Active management is still being touted as the best way for local investors to avail of market themes whether they want exposure to developed markets (DM), emerging markets (EM) or technology. The ‘active is best’ mantra was a feature of the 2024 Sanlam International Summit, held in Cape Town, Durban, George, Johannesburg and Pretoria recently … as was the promise that investors had not yet missed the return opportunities in the artificial intelligence (AI) trend.
A good time to consider EM opportunities
Robert Holmes, Portfolio Manager and Partner at Pacific Asset Management’s North of South Capital, was tasked with putting the case for EM . He introduced his fund as a dedicated investor in EM before discussing the relative valuation of EM versus DM. “The emerging world is looking good at the moment, and now is not a bad time to be looking at EM opportunities,” he said, illustrating the widening discount between the US S&P500 Index and the MSCI EM Index. PS, these indices remain popular measures of general value in their geographic regions.
At end-February 2024, the likes of Brazil, China and Korea contributed to EM forwards price-earnings (PE) ratios being significantly lower than those of Europe, the United States and the rest of the world, prompting Holmes to label the discount as “the widest it has been in living memory”. One of the main reasons for the discount is the apparent convergence of the cost of capital in DM and EM. The presenter commented that in 2000 there were no EM countries that had 10-year rates below the US Treasury rate; today the blended cost of capital across North of South Capital’s portfolios is broadly in line with that rate.
The portfolio manager offered a chart of EM vs S&P500 ‘equity risk premiums’ to illustrate a sizeable premium in the former over the latter. Are you being paid to take extra equity risk? “We are still getting quite a decent premium; so, it is all green flags for EM,” Holmes said, before commenting on the frequent complaint fielded by EM managers, namely that the sector had not been living up to its promise. Over the past decade, the annualised return from EM has hovered around 3% compared to a rather impressive 10%-or-higher from the S&P500.
Is this EM, or is it China?
The next section of the presentation showed why investors should not rely too heavily on index-related returns. It turns out that China, which remains a significant contributor to EM indices, has been a drag on such indices since 2014. China’s trailing 12-month earnings per share (EPS) grew by 16.3% per annum over the period 2003 to 2014 compared to a 2.5% per annum decline in the following 10-years. “We encourage you not to look at index returns because market capitalisation-based indices can give some quite significant biases when they have significant individual country weightings; they can really hide what is going on below the surface,” Holmes explained.
Reported differently, EM index performances have been knocked down by China while the likes of Brazil (+1% per annum over the last 10-years); Korea (+1.3%); Mexico (+1.6%); India (+2.3%); and Taiwan (+2.3%) have done remarkably well on a 12-month trailing EPS measure, from 2014-2024. For comparison, the US achieved around 2.2% per annum over the same period. These statistics, said Holmes, explained why investors “should always go active [rather than] passive within the emerging world”. He supported this call by observing that “the price discovery process in the emerging world was inefficient” compared to DM.
The ‘active over passive’ call was supported by an interesting comparison of ‘dispersion of returns’ in the two regions spanning two decades beginning 2001. “Active managers have much greater scope to outperform in EM than they do in DM, primarily because the dispersion of returns is much greater,” Holmes said. In addition, EM offers greater diversification and, somewhat counterintuitively, lower volatility. Over 10-years the ‘volatility on average returns’ in these regions has levelled out at 15.6% against 15.3%. These comparisons set the scene; but fund manager’s mandates or style remains the key decider when choosing shares with EM exposure.
The rise and fall of Alibaba
Pacific North of South are value investors seeking out opportunity in EM, which are traditionally understood as growth markets. Holmes used the rollercoaster performance of China’s ecommerce ‘darling’ Alibaba to show how fund managers could be right about growth but miss the mark on value. This firm has achieved a 10-fold increase in revenue between 2014 and 2024 but seen its enterprise value plummet from around USD200 billion in 2014 to just over USD5 billion presently. Today, you can pick up the counter at a 40% discount to its IPO.
Going forward, EM-focused investors will have to consider the impact of emerging trends, including the geopolitics-related ‘gem’ called nearshoring. “Nearshoring [is part of] the third evolutionary stage in the emerging markets story, which I am generically calling rebalancing,” Holmes said. He added that the emerging stage was when the EM stopped being a trading investment and was viewed as more of a trading destination; the second stage or converging period was led by the significant broadening of the EM middle classes; and the third was a rebalancing forced by heightened geopolitical risks and supply chain realignments.
As the presentation continued it became clearer than ever that China’s outsized influence over EM was a thing of the past. “China has become a victim of its own success” screamed slide-13 which highlighted the tailing-off of China’s GDP per Capita and its falling share of US imports. “You now have a dynamic where a Mexican worker is cheaper than a Chinese worker,” Holmes said. He noted that China had fallen into a so-called “middle income trap” which is incredibly difficult to emerge from.
On AI, governance and nearshoring
The nearshoring trend will have positive spin-offs for many countries in the emerging world, but there are other themes that are creating opportunities. These include AI and the “entire ecosystem surrounding technology supply chains”; the ongoing turnaround in governance and capital allocation across the region; and opportunities in the Middle East as countries seek to diversify away from hydrocarbons. Companies that got special mention during the presentation include Alibaba (China); Emaar Development and Emaar Properties (Dubai); and Petrobras (Brazil).
The final slide showed that the MSCI EM offered investors a 12.7 times current PE and a 2.9% dividend yield compared to the MSCI World on 18.8 times and just 1.9%. “You should think of the emerging world as an active allocation in inefficient markets [as opposed to] a passive allocation in efficient markets,” Holmes concluded. He said the EM asset class was “transitioning from a homogenous asset allocation to a much more heterogeneous allocation [in recognition of] different investment themes playing out worldwide”. Overall, investors will benefit from the new dynamic of actually getting paid to hold EM equities, by way of dividends.
Writer’s thoughts:
EM has been a tough sell over the last 10-years, dragged down by China; but the US FAANGs and Magnificent Seven have carried DM ever higher. Do you still consider EM when advising your clients on their offshore exposures or are you ‘all in’ DM? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts [email protected].
