There are both structural and cyclical reasons as to why emerging market equities look as though they are at a “massive, unbelievable, multi-decade anomaly”, according to GAM Investment Management’s Tim Love.
The manager of the $927m GAM Multistock Emerging Markets Equity fund said there are both short-term timing factors as well as long-term structural reasons to back the region.
While the secular argument is “long in the tooth”, it remains an important one for investors, he said.
Currently the region makes up more than 50 per cent of global GDP, more than 80 per cent of the overall output but yet its index composition in the MSCI AC World index is a mere 11 per cent.
Source: MSCI
“Why on earth have they been given such a ridiculously punitive level in terms of equity index? That is a massive, unbelievable, multi-decade anomaly,” Love said.
The arguments range across the board including the region being on a huge discount for environmental, social & governance (ESG) factors.
The theory is that, as they are poor on corporate governance, they should not have the same element of free-float adjustment in a major index, the manager added.
But this is improving in the region and he noted: “If you asked me 20 years from now what weighting they will be it will be much more aligned to 50 per cent.
“By definition just on the secular argument there will be closing of that weighting gap and it will because of the less negative ESG in particular China and India.”
Therefore, he noted that investors with a 15-year time horizon will do pretty well just on the secular argument, which as a starting point is a “massive distortion”.
However, there are a whole host of cyclical factors that mean that the asset class is appealing to investors right now, as well as to those with a long-term outlook.
Love said that the current cycle since the financial crisis, which has been one of the longest in history, has been extended and driven quantitative easing (QE).
This has boosted the developed markets and has left the emerging markets lagging behind somewhat as they took longer to recover.
At the bottom of the previous cycle in 2008 emerging market equities struggled as investors were “absolutely terrified of their existence,” Love said.
“People didn’t know if the doors would be opening the next day so why on earth would you want to open yourself up to emerging market, high volatility equity?”
As such, the credit market, which historically has half the volatility of equities and allows investors to clip a reliable coupon became more popular.
“As a result of that when you are out of the other side of this huge pumped up QE bubble, emerging market credit is up and the very volatile emerging market equity was down,” he said.
However, like the secular reasoning above, this is another anomaly, an “extraordinary occurrence” compared to the 20 years before.
As well as emerging market credit, high-risk cousins such as the Nasdaq and small-cap US companies have been more popular than the emerging markets.
“Normally we lead in terms of Sharpe and absolute return at the top of the cycle,” Love noted, but currently, while the aforementioned sectors have already reached or surpassed their previous highs on a valuation basis, emerging markets have not.
Therefore, the asset class is trading at a discount relative to other high-risk equities, as well as emerging market credit.
“Emerging Market equity isn’t even off its backside,” Love said. Indeed, since the start of 2010, the MSCI World developed market index has returned 74.31 per cent while the MSCI Emerging Markets index is up just 73 basis points in US dollar terms.
Performance of indices since January 2010
Source: FE Analytics
“You are appealing to everybody in the church: we appeal to value, growth and yield [investors] – it is rare we appeal to all three,” Love said.
The market has struggled this year as idiosyncratic markets such as Turkey and Argentina have impacted sentiment but Love also sees this as a positive development.
While the MSCI Emerging Markets index has fallen 13.96 per cent in dollar terms, the manager said its underperformance for the last decade has actually helped in 2018.
“The reality is: why the hell is it not down 80 per cent? When you have [quantitative tightening] at the same time as a normal FOMC [Federal Open Market Committee] hiking cycle you would normally be down 80 [per cent],” he said.
The reason is that from a value standpoint, after years of improving earnings but sideways movement from the stock market, the asset class is undervalued, meaning it has had less far too fall.
“We are on 10.5-11x price-to-earnings ratio, a price to book of 1.1x, return on equity of 14 per cent, dividend yields of 3 per cent, free cash flow yields of 9 per cent – growth on dividend yield of 15 per cent,” he said.
Growth is up next and as previously mentioned, high-growth alternatives in the US and elsewhere in the developed markets have done well in this cycle and are therefore much more expensive compared to the emerging markets.
“If I am right that the S&P or Nasdaq or Russell are at their peaks, if their earnings continue to be good for another year or two because of the ‘one foot on the gas’ policies from Donald Trump plus fiscal spending offsetting the FOMC foot on the brake then by definition they are likely to go sideways, the GAM Multistock Emerging Markets Equity fund manager said.
“It means the gap is most likely to be closed by us rallying than the S&P cracking,” he said.
However, he noted that there is a risk that excess volatility could lead to market sentiment changing and these asset classes falling down to the levels of the emerging markets rather than them rallying.
Finally, it is appealing for those looking for yield – something that has been bid up over the last decade in the era of ultra-low interest rates.
“Crossover guys come in from currency where the positive carry is 3-5 per cent,” Love said. “When they come in and coupon clip the dividend yield, I don’t care what stock you are in if you are an exchange-traded fund, big-cap, liquid name you are going up.”
Similarly, when these investors get nervous, as they did in 2008/09 these assets will fall. There is a 98 per cent correlation, Love noted.
“It is totally and utterly ridiculous to look at factor analysis in my asset class if you don’t understand cross-asset class flows. But if the yield is unbelievably attractive you are in ‘rocket fuel land’,” he said.
However, it is important for investors to have a top down overlay as well as a bottom-up approach, as country-specific factors can be important.
“The currencies go up and down 65 per cent minimum in every cycle so portfolio construction is critical,” he said.
“If you take a bit bet against a country – like China last year – you can blow not just one year’s performance figures but five courtesy of portfolio construction.”
Performance of fund vs sector and benchmark since inception
Source: FE Analytics
Since its launch in 2015, the GAM Multistock Emerging Markets Equity has returned 41.76 per cent in sterling terms, beating both the IA Global Emerging Markets sector and index.
It has a clean ongoing charges figure (OCF) of 1.09 per cent.