The “Value” Opportunity in Emerging Markets

Investors categorize themselves as either in the “value” or “growth” camps. The “value” followers focus on stocks that are overlooked by investors and judged to be temporarily mispriced: this is akin to finding $100 bills on the sidewalk or, as value guru Ben Graham described it, picking up  “cigar butts” with one puff left in them. The “growth” proponents, on the other hand, look for companies with bright long-term prospects and the potential for compounding cash flow streams.  While value investors find the future to be opaque, growth investors visualize huge bonanzas on the horizon. Because growth investors see the future as much better than the present, they are happy to pay higher multiples on current earnings and owner’s equity (book value). Because of this, the investment industry has generally categorized “growth” stocks as those with high valuation multiples (price-to-earnings and price-to-book) relative to the market.

Looking at the historical record, “value” stocks have provided better returns than “growth” stocks. This is known in academia as the “value premium” and is attributed to value stocks being underpriced because they are riskier and unpopular while “growth” stocks are overpriced because of their notoriety and bright prospects. Glamorous growth stocks are sometimes compared to “lottery tickets” as they can generate the excitement of a potential huge pay-off in the future. One of the main features of “growth” stocks is that they benefit from low interest rate environments, such as the one we are currently experiencing; this is because the huge future pay-offs investors are counting on can be discounted at lower rates and are therefore worth much more.

Though the value premium is well-documented by academics and is persistent over time and geographies, it will not prevail at all times.  In fact, any “factor premium,” or for that matter any investment strategy,  will go through valuation cycles, from cheap to expensive and back again. Over the past decade, value has been in a severe declining cycle, becoming gradually cheaper relative to the market, setting itself up for another opportunity for investors to harvest premia.  The cyclical evolution of value over the past forty years is well depicted in the chart below from the asset-manager GMO, which shows that currently in both developed and emerging markets “value” is priced at a deep discounts to the market.

Value stocks in the U.S. have underperformed 9 of the past twelve years for an average of 2% annually, one of the longest losing streaks ever recorded. Over the past ten years, in non-U.S. developed markets and in emerging markets annualized value returns have lagged the market by 1.6% and 1.1%, respectively.

Predictably,  as “value”  has become cheaper it has also become less popular with investors. Over this period, assets in value funds have declined sharply relative to the market. In emerging markets, the decline of value has been particularly severe.

Historically, value investors have had a big role in emerging markets. Particularly in the 1990s, stocks in emerging markets were very inexpensive and in a process of re-rating in response to market reforms, privatizations and capital inflows. However, since the 2008 financial crisis, low GDP growth, reform-fatigue and the rise of the tech sector in Asia has changed the dynamics in favor of growth, both in developed and emerging markets. This has resulted in a sharp decline in “value” funds, with many losing assets and shutting down. Interestingly, in the ETF space, which is where almost all marginal flows have gone to over this period, there is not one traditional value fund offered.  Instead, the vast majority of assets are flowing into capitalization-weighted indices (MSCI EM, FTSE). Taking the place of “value,” the industry has promoted RAFI and multi-factor “smart-beta” ETFs.  RAFI, which stands for Research Affiliates Fundamental Index, is a partial “value” substitute to the extent that position sizes are determined by fundamental factors (sales, cash flow, book value and dividends) in contrast to the capitalization-weighted method most commonly used.  Multi-factor “smart-beta” funds, on the other hand, use a mix of “factors” such as price-momentum, sales growth, “quality” and low-volatility in addition to traditional value measures.

Assuming that markets and valuations will continue their historical patterns of mean-reversion, the current opportunity for outsized returns in emerging markets “value” stocks is substantial. Emerging Markets by themselves are already very cheap relative to developed markets, so the deep discount of the value segment provides a significant opportunity for extraordinary returns. Those few remaining funds that still specialize in buying discounted “value” stocks are likely to enjoy a very good run as other investors and ETFs start chasing the return of the “value” premium.

However, a word of caution is warranted. Value stocks are usually cheap for a reason and this is tied to the more problematic and stressed nature of the companies (e.g., more debt, cyclical margins, vulnerability to economic downturns). Given the current global slow-down and the rising risk of U.S. recession, “value” may still have another leg of underperformance. The currently undergoing and expressive decline of global interest rates also continues to favor long-duration “growth” stocks. In short, value may have to wait a while longer, but this will only make the upcoming opportunity even greater.

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