To state the obvious: The headlines are discouraging.
Geopolitics is the word of the day as everyone wonders what Russian President Vladimir Putin will do in Ukraine and what will happen in Israel and the Gaza Strip. I won't venture guesses about the future, but I do know that geopolitical issues come and go. In retrospect, for example, it would have been smart to invest immediately after 9/11 or when the buzzword was "Grexit"- shorthand for the possible exit of Greece from the eurozone in late 2011. Or take your pick from a number of other instances.
Open eyes: Gauging risk and reward
To be clear: Although we've seen geopolitical risks come and go over the years, we're not complacent about them - nothing could be further from the truth. We are, after all, in the business of risk. Our goal is not to avoid risk at all costs, but rather to make sure that we assume risks with open eyes and, most importantly, that the potential reward warrants incurring those risks. In my view, investors are currently "paid" to carry those headline-grabbing risks in emerging markets.
EQV: Guarding against risk
So how do we guard against risks, whether geopolitical or otherwise?
As always, we remain focused on our bottom-up investment approach of identifying attractive companies that fit our EQV - earnings, quality and valuation - investment process. We look for high-quality growth that exhibits stronger organic revenue growth, high returns on capital, pricing power, strong balance sheets, cash generation and reasonable valuation. In addition, we continue to favor companies that are able to consistently generate that cash during weak economic environments.
Here's a snapshot of emerging markets viewed through our EQV lens.
- Gross domestic product (GDP) growth is a little slower than it used to be, but importantly still materially faster than in advanced economies.
- Earnings estimates continue to be cut, although at a much slower rate. Consensus now seems to expect 8.2% growth in earnings per share for the year,1 neither great nor terrible. Post a lengthy period of cuts, current estimates are more conservatively struck and far more realistic. Remember that markets are forward looking and generally turn well before the turn in earnings estimates.
- Returns on equity (ROE) continue to trend down, although emerging market ROEs are still higher than those in advanced economies.
- Flows have been negative for the past two years, or in aggregate, since 2010. We've seen small improvements since the March lows. However, flow data conceal important differences between retail and institutional investors: While cumulative flows for retail investors into emerging markets are negative over the past decade, institutional investors have continued to pour more money in as emerging markets have gotten cheaper (and therefore more attractive to long term investors). Retail flows, unfortunately, have historically been poorly timed.
- Emerging markets' price-to-book ratio, the metric least susceptible to optimistic estimates, is currently at a 30% discount to that of world markets - the highest since 2004 - as measured by the MSCI Emerging Market Index relative to the MSCI World Index. Relatively speaking, when compared with other asset classes such as bonds or domestic equities, emerging market equities are now very cheap. While they're not screaming-from-the rooftops cheap on an absolute basis, I believe they're at attractive levels for long-term investors.
- A further point on the relative attraction of emerging market stocks: If emerging economies falter from here, it's highly unlikely our domestic economy will do particularly well given how important emerging markets are today - roughly a third to a half of global GDP. Decoupling could have happened 10 years ago, and it certainly happened in the '90s when emerging markets were a blip on the screen of the world economy. But of this I'm certain: Decoupling will not happen today.
Here's a timely postscript on both the improbability of decoupling and the temporary nature of geopolitical fallout. I recently received an email with this headline: "Greece-Focused Hedge Funds Soar 160%." Apparently, it's taken only three years for Greece to transform from despicable beast to beauty queen.
1 Source: Morgan Stanley Research, July 30, 2014
Price-to-book ratio compares a stock's market value to its book value.
Return on equity (ROE) is net income divided by net worth.
The MSCI Emerging Market Index is an unmanaged index considered representative of stocks of developing countries. An investment cannot be made in an index.
The MSCI World Index is an unmanaged index considered representative of stocks of developed countries.
Decoupling is the occurrence of returns on asset classes diverging from their expected or normal pattern of correlation. Decoupling takes place when two different asset classes that typically rise and fall together move in opposing directions, such as one increasing and the other decreasing.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
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