Following macro-economic factors such as slowing growth in China and the tightening of US monetary policy, emerging market equities have considerably underperformed against the likes of the FTSE All Share and S&P 500 over recent years, leading many investors to view them as undervalued. However Smith, who is a global strategist at the group, warns that investors who view those falls as a buying opportunity are making a huge mistake.
“The bottom line is, don’t be blinded by last year’s marked underperformance, the emerging market stocks you actually want to own are not that cheap,” Smith said.
“Valuations were boosted by the portfolio effects of quantitative easing, but earnings growth has done well and the outlook from here remains weak relative to developed markets.”
According to FE Analytics, the FTSE All World Emerging index has lost 19 per cent over three years while the FTSE All World Developed index has returned 19 per cent.
However, that divergence in performance was magnified last year when emerging market equities lost 6 per cent while developed market equities delivered a return in excess of 20 per cent.
Performance of indices in 2013
Source: FE Analytics
While experts generally agree that there are still a number of headwinds facing the developing world, a number of them, such as Unicorn’s Peter Walls, have been adding to their exposure on valuation grounds.
Old Mutual’s John Ventre has also been topping up his exposure to China because the region is hated by the market.
However, Smith urges investors to think carefully before they buy an emerging market fund again as they shouldn’t confuse underperformance with bargain basement prices.
“It’s not unsurprising that people have been asking whether or not now is a good time to go back into emerging markets,” Smith explained.
“Some of those markets lost 20 per cent last year while developed markets performed well, which was compounded by currency weakness.”
“However, just because an areas of the market has performed badly, that doesn’t mean it’s automatically cheap.”
“If you were to look at the whole index’s P/E ratio, then yes they do look slightly cheaper than their historical average. However, a much more successful way to gauge valuation, and what future returns could be, is the trimmed mean P/E.”
The trimmed mean ratio disregards the three most expensive and cheapest sectors from the index.
According to Smith, one of the cheapest sectors are banks, which he says are going through huge structural and regulatory change and are seeing a lot less demand for loans as previous credit booms across the emerging markets are unwinding.
The other two areas are oil producers, which are facing mounting costs, and utilities which are largely state-owned and not run in the interest of minority share-holders.
Smith says that the regular P/E ratio on the Thomson Reuters Datastream Emerging Market index is 12.5, but according to the trimmed mean ratio the figure currently stands at 17.8.
“Once you have taken those out of the equation, you realise that the cheapest sectors were having a huge impact on that valuation,” Smith said.
“If you discount banks, oil companies and utilities using the trimmed mean ratio, emerging markets are actually rather expensive. Despite some massive falls, they don’t look cheap whatsoever.”
Smith warns that earnings growth in emerging markets is also coming down and current expectations could well prove to be too high.
James De Bunsen, who runs the Henderson Multi Manager range with FE Alpha Manager Bill McQuaker, is underweight emerging market funds across his portfolios.
He agrees with Smith that the headline valuation on emerging market equities is misleading as he says the cheapest parts of the market, which dominate the index, are large state-run business that are managed for the population and not investors.
Performance of fund vs sector over 5yrs
Source: FE Analytics
De Bunsen, whose five crown-rated Henderson Multi Manager Diversified fund has been the best performing IMA Mixed Investment 0%-35% sector, also says that emerging markets will have to fall a lot further before he will look to add to his exposure.
“The valuation isn’t attractive enough for us to get over our macro concerns,” de Bunsen said.
“If the valuations were lower it gives you more of a built in safety, but we are not there yet. I’m sure there are some opportunities out there, but on a relative basis developed markets are still a lot more attractive. We still expect emerging market data to disappoint from here.”
De Bunsen is bearish on emerging markets as he expects further currency weakness and further interest rate rises across many of those economies as the authorities will have to deal with current account deficits and mini credit booms. He is also concerned about China.
“Clearly, China is the major swing factor and the bellwether for emerging markets. I don’t think anyone really has a handle on whether there will be huge credit crises there which will engulf the global economy, but what we are confident of is that growth will continue to slow,” he said.
The other issue for De Bunsen is that though there might be pockets of value in emerging markets, for investors who want to access that exposure via funds, there aren’t many options available.
“Obviously, there are some decent funds out there. However, some are basically core holdings, like M&G Global Emerging Markets, where the manager is never going to take big off-benchmark positions but will generate alpha over time.”
“But, a lot of funds are just copying the Aberdeen and First State strategy, of investing in quality, which has worked so well in the past.”
“As a fund selector, it is a challenge. The majority of funds in the sector tend to either have a lot of small-caps –which we don’t think is a good place to be right now –hug the benchmark, or follow the Aberdeen and First State mould.”
