The three misconceptions of EM equity investing

Ridhima Sharma
clock • 4 min read

For some investors, emerging markets (EM) will always be regarded as a purely short‑term tactical play - offering potentially high returns, but also the prospect of heightened risk and volatility.

However, this traditional view no longer accurately describes today's emerging markets. Below are three of the common investor misconceptions surrounding EM equity investing:
 
Myth 1: it is best to avoid EM in times of volatility
One of the biggest investor misconceptions is that EM is all about dynamic, high‑growth companies - with attractive EM value opportunities few and far between. This view seems to be confirmed by various surveys showing the bulk of active money flows into the EM equity universe is allocated toward core and growth portfolios, with just a fraction value‑focused. Given this large bias, there are many areas that are being overlooked or forgotten, which is a particularly rich environment for value‑oriented EM investors.

For example, in the quest for growth, many of the old economy companies have been forgotten, offering attractive upside from depressed valuations. Of course, simply being cheap is not reason enough for us to invest. We look for out‑of‑favour companies we believe are strong candidates for a positive rerating, based on our expectations of fundamental change. This might include a change in management, improving economy, or any business‑specific event able to drive the stock price back to fair value.
 
Myth 2: there is a high risk of corporate error in EM
Evidence of stronger management discipline and better decision‑making is one of the factors underpinning our positive longer‑term outlook for EM equities. As a result, companies have generated more free cash flow compared with previous years, as management teams pay more attention to spending and other capital allocation decisions. Profit margins have improved, giving us confidence EM companies are positioned to start delivering improved earnings growth and shareholder returns.

Given this more disciplined approach, capital spending as a percentage of sales for EM companies has fallen to the lowest levels in more than a decade. However, after many lean years, a resumption of capital spending could have a significant impact, in terms of spurring job creation, loan growth, and wage increases.

Given this expectation of increased corporate spending, one area we like currently is financials. Banks, for example, stand to benefit considerably from an expected upturn in borrowing/loan growth. Meanwhile, having been out of favour with investors for some time, financial sector valuations remain well below long‑term averages. We like certain forgotten South African financials, for example.

Balance sheets are sound, there has been good progress on cleaning up bad debts and we see are attractive dividends. The companies are also leveraged to the economic recovery cycle in South Africa, as well as having prominent exposure within continental Africa.
 
Myth 3: EM cannot outperform in today's uncertainty
The recovery in the EM cycle is less advanced than in developed world, so it has further to run. Capital spending discipline should lead the next leg of EM growth, as we expect companies to continue to focus on better capital allocation and cash flow generation.

Meanwhile, in China, despite trade‑related concerns and worries about a slowdown, we do not expect a hard landing. This backdrop is conducive to finding good opportunities overlooked by other investors. For example, many of the state‑owned enterprises (SOEs) in EM countries offer good potential, in our view. Global investors generally have a negative view of these businesses. However, the sector has been tainted by a small group of very bad, highly publicised companies.

SOEs exist in all EM countries, therefore it is possible to uncover good‑quality, but unloved, SOEs trading at low valuations. Sberbank, for example, is owned by the Russian central bank and is widely regarded as one of the highest‑quality, most progressive banks in the EM universe. Elsewhere, Chinese SOEs are also undergoing major change. Not only has Beijing cut excess industrial output - thereby boosting the profits of many SOEs - significant efforts are also being made to become more shareholder‑friendly, with some large SOEs even paying out special dividends. This was rarely seen in the past. Many Chinese SOEs are also reintroducing stock option incentive programs for management - which is a positive step moving forward.

Ernest Yeung, portfolio manager of the T. Rowe Price Emerging Markets Value Equity Fund