When investors think of emerging markets, what usually springs to mind are fast-growing growth stocks – the likes of Asian tech titans Tencent and Alibaba. 
Indeed, investor demand for many of the emerging world’s high growth companies has driven valuations of many ‘new economy’ sectors – such as technology – to historical highs. The divergence of valuations between new economy stocks and traditional ‘value’ sectors – such as banks, insurance companies and industrials – have been stretched to the widest levels ever seen.
What can prompt a reversal of fortune for ‘old economy’ stocks, many of which are trading at depressed valuations? As these value opportunities are highly-levered to domestic growth, investors will need evidence of sustained improvements in the macroeconomic environment – something currently underway in many emerging markets.
Macro backdrop finally improving
Macro momentum typically takes a long time to turn, particularly in emerging markets. Looking across the developing world, economic activity has only recently reversed from a multi-year slump – as evidenced by the fact growth in the likes of Brazil and Russia have yet to return to long-term averages.
Brazil’s economy is finally recovering and emerging well from its worst-ever recession – which brought high unemployment, lower wages and significant deflation. The country has weathered the slowdown and prices and wages have adjusted downward, setting the stage for the current recovery.
In Russia, while the political situation remains challenging, inflation is under control and the domestic economy is showing signs of recovery. In addition, Russia’s cash returns to minority shareholders, in form of dividends, has improved dramatically over the past five years – with Russian equities now offering the highest dividend yields ever.
As for the emerging powerhouse China, we are optimistic on the country’s progress on supply-side structural reforms. The credibility of policy actions from Chinese authorities has also improved dramatically over the past five years.
As for the danger posed by ongoing Fed tightening, most emerging market countries are in better shape to weather the impact of higher US interest rates – with improved current account positions and increased foreign exchange reserves.
Corporates adjusting to new reality
Not only are emerging market economic prospects on the rise, corporate behaviour has also improved dramatically in recent years. During the boom years, far too many companies went on spending sprees and ignored margins discipline, enjoying the benefits of rising top-line revenues. Much of the earnings growth in the past was achieved by expanding sales in an environment of robust economic growth.
The result of this irrational spending was supply gluts, excess inventory, overcapacity, and, ultimately, falling prices and contracting margins. It was not until economic growth began to slow from 2011 that the results of this behaviour began to show.
Today, companies have adjusted to the new economic reality, with management teams modifying practices. This has been particularly evident is in the way company management teams have allocated capital.
South Africa buoyant on Zuma exit
While the macro picture across emerging markets is clearly improving, investor expectations remain incredibly low. Valuations for many attractive value opportunities are still pricing in revenue or profit growth in the low single digits, far below what we expect the emerging world to achieve in 2018 and beyond.
A good example of the attractive opportunities on offer can be seen in South Africa, a market we began to invest in during the early part of 2017. While South Africa was suffering a prolonged economic slowdown, our initial thesis pointed to a cyclical recovery into 2018 – supported by cheap valuations of domestic companies.
The political inflection in point in December – the exit of President Jacob Zuma and the appointment Cyril Ramaphosa – surprised us positively and boosts the prospects for South Africa. With Ramaphosa – a former union leader and subsequently a very successful and now wealthy businessman – leading the country, we expect a strong anti-corruption drive and a commitment to fiscal consolidation.
Banking on a reversal of fortunes
We also continue to see widespread mispriced value opportunities elsewhere in the emerging world – particularly in China. While the world's second-largest economy faces a number of structural challenges, it is in a much better state now than at any time in the last five years.
We believe in China's economic transformation story and hold positions in Chinese stocks sensitive to the domestic economy – such as banks ICBC and Agricultural Bank of China, as well as insurer PICC Property & Casualty. We are also optimistic on the building materials and industrials and business services sectors.
While the positive long-term growth, demographic and consumption trends are intact for emerging markets – and remain far superior to developed world peers – investors remain sceptical. Where investors do have allocations to emerging markets, it remains overly concentrated in high-growth areas – such as technology companies. We believe investors can take advantage of many valuation anomalies in emerging markets – with numerous examples of neglected and mispriced ‘old economy’ stocks.
Ernest Yeung is portfolio manager of the T. Rowe Price Emerging Markets Value Equity fund. All views are his own and should not be taken as investment advice.