February 1, 2018
Frustrated investors in emerging market value stocks may be clinging to hopes that a solid pick-up in the developing world’s economic growth rate will herald a long-awaited change of fortunes.
Value stocks, typically defined as those with a low price-to-book or price-to-earnings multiple, have underperformed more expensive growth stocks for the past six years.
As a result, the valuation gap between emerging market growth and value stocks blew out to its widest level on record in December, whether measured in terms of the gulf in price/book or, as the first chart shows, forward price/earning ratios.
According to data produced by Geneva-based Pictet Asset Management, much of the underperformance endured by value stocks in recent years was understandable: between 2012 and 2016, the differential between economic growth rates in the emerging and developing worlds narrowed, a trend that has historically undermined value stocks.
However, the relationship completely broke down in 2017 — value stocks spectacularly undershot their growth peers, rising by 23.3 per cent while growth stocks surged by 42.1 per cent, according to MSCI’s style indices, even though the economic growth gap started to widen, as the second chart shows.
This breakdown could, in theory, herald a new paradigm, with the historical relationship between the two measures consigned to the dustbin of history.
But, with the IMF forecasting that the EM/DM growth differential will now progressively widen year on year all the way up to 2022, those who do not buy into the new paradigm theory may be increasingly expectant of a change in market leadership.
“We believe that if the acceleration of global growth, and of EM growth versus DM growth, continues then it’s a matter of time before value starts to outperform,” says Klaus Bockstaller, co-head of global emerging market equities at Pictet AM.
The logic for the historic relationship is that value stocks typically include many cyclical companies, particularly in the materials and energy sectors. These stocks tend to do well when global economic growth is accelerating.
“That [acceleration] usually coincides with a widening of the EM/DM gap. To a certain extent, emerging markets are a leveraged play on developed markets,” says Mr Bockstaller.
Previous research has shown that EM value stocks also tend to outperform when the dollar is weakening, as this usually pushes up commodity prices in dollar terms, aiding energy and resources companies — another relationship that has broken down.
The two crucial questions for investors are why these historical relationships have gone Awol, and whether or not they will reassert themselves at some point.
Mr Bockstaller admits he is unsure why the widening EM/DM growth gap is not aiding EM value stocks, but suggests investors may be somewhat sceptical about the forecasts for emerging market growth, which the IMF predicts will hit 4.9 per cent this year and 5 per cent in 2019, even as developed market growth slows to 1.8 per cent next year.
Alternatively, the underperformance of value stocks could result from structural changes in the global economy.
Mr Bockstaller believes that “value” manufacturing stocks, which traditionally perform well in a cyclical upswing, are being held back by overcapacity in many sectors.
This, he argues, has been exacerbated by a capital expenditure recovery that started in the US in 2016 being led by the oil and gas sector, followed by metals and mining.
Traditionally a cyclical recovery in US capex would be good for cyclical emerging market stocks, Mr Bockstaller says, but this has not been the case this time around because the investment in oil and gas has been concentrated in shale developments, rather than offshore fields, “and you don’t have many [EM] companies that are servicing or delivering equipment for shale. There are shipbuilders building floating platforms in South Korea, but that’s not what the US is buying”.
Likewise, the capex investment in metals and mining is primarily benefiting developed market capital goods companies such as Caterpillar and Hitachi, so emerging market stocks are not getting the benefit.
More universal factors are also likely to be at work, given that value stocks have also had a bad run in developed markets.
Seattle-based Smead Capital Management said this week that large-cap US value stocks had now underperformed their growth peers for 126 months, the longest slump in history, outstripping the slides witnessed during the Great Depression and the 1990s technology bubble.
The similarities with those previous periods are striking. The 1930s depression was a time of falling inflation, as the recent period has been, while the ongoing stratospheric rise in the share prices of technology stocks witnessed in the 1990s has also been repeated.
One difference is that, this time around, the IT surge has also spread to emerging markets because of the meteoric rise of companies such as Chinese internet powerhouses Alibaba and Tencent.
Indeed, the data suggest the tech stock rally has been even more pronounced in the EM world than in developed markets.
This structural reshaping of the global economy has clearly been a major factor behind the outperformance of growth stocks and poor showing, in relative terms at least, of value plays.
Some observers believe this pattern will finally break down in 2018, however, allowing traditional norms to reassert themselves.
Mr Bockstaller says that if the capex cycle in developed markets “goes more in the direction of infrastructure, and there are hints that it is, then maybe it might be much better for EMs”. Copper miners, steel producers and South Korean engineering companies are among those that would benefit from higher investment in infrastructure or construction, he says.
JP Smith, a partner at Ecstrat, an investment consultancy, believes value is now “very cheap” but that much depends on one’s view of China.
“If you believe the Chinese growth is sustainable at 6.5 per cent then there is a strong case for going into value because the rally in commodities is sustainable,” he says.
Mr Smith also notes that, alongside materials and energy stocks, the EM value bucket now contains financials, utilities and telecoms companies, which are often under state control.
As such, he argues they could prove attractive if investors believe there is fundamental reform of state-backed enterprises taking place, as arguably there is in Brazil with scandal-ridden oil company Petrobras; India, with its recapitalisation of state-run banks; and possibly even China, which has forced the likes of coal miners and steel companies to cut output, helping tackle overcapacity and raise prices.
Geoff Dennis, head of global emerging markets equity strategy at UBS, believes there are tentative signs that the worm is starting to turn amid a gathering view that “growth has become very expensive”.
So far this year, emerging market energy stocks have risen 12.4 per cent and financials 11.3 per cent, bettering the 7.6 per cent return of technology stocks and the 7.7 per cent of the broader MSCI index.
This led to a narrowing of the gulf in price/earnings ratios, as seen by January’s upward tick in the top chart above, although it is far too soon to suggest it is a decisive move, given that it has occurred in previous Januarys as well.
Nevertheless, Mr Dennis says “we are starting to see a little bit of a hint of a reversal, we are beginning to see people rotating from tech in China to financials.
“Financials, in our opinion, are the classic value sector now in EM. It’s early days to know how far this is going to go but it’s interesting to see. It could be the beginnings of normal service being resumed, but it’s way too soon to say that is actually happening.”
Mr Dennis adds: “Every metric broke down last year and we think they will re-engage this year.”
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