By Jeremy Schwartz, CFA, Director Of Research & Tripp Zimmerman, CFA, Research Analyst
When investors allocate to emerging markets, they typically do so through broad-based market cap-weighted exposure. More recently, investors have shown interest in specific cuts or subsets of the broader emerging markets, such as country rotation, high- dividend-yield strategies, small caps, low volatility and other investment strategies.
We've seen growing interest in the degree of exposure to state-owned enterprises (SOE) in various investment strategies. State-owned enterprises are typically defined as companies that are either wholly or partially owned or operated by a government. Some investors believe that government ownership can negatively impact the operational aspects of a company because government-owned companies might be influenced by a broader set of interests, beyond generating profits for shareholders.
In the figures below, we will take a detailed look at the state-owned enterprises in the emerging markets from both the composition and valuation perspectives. Also, we will introduce a new Index, the WisdomTree Emerging Markets Ex State Owned Enterprises (EMXSOE), designed to measure the performance of broad-based emerging market stocks that exclude state-owned companies.
Characteristics Of State-Owned Enterprises
State ownership levels can vary significantly among sectors and countries, depending both on a sector's significance for providing public goods or fostering economic growth and on the governmental structure. WisdomTree identified 424 companies out of an initial 3,000 companies as state-owned enterprises (SOE), with government owning more than 20% of shares. The SOEs had market cap of over $1.31 trillion, about 26% of the original universe's market cap of approximately $5.07 trillion. Figures 1 and 2 illustrate the market cap profiles of the SOE universe by sectors and countries.
Ownership Concentrated among Public Good Sectors: Given that the Financials, Energy, Telecom and Utilities sectors are among the most systemically important sectors to economic development, we are not surprised that governments tend to play a more active role in these sectors.
Less Ownership among Private Good Sectors: Currently, governments are less involved in the Consumer Discretionary and Consumer Staples, Information Technology and Health Care sectors. Companies in many consumer-focused sectors tend to be less vital to the strategic economic development and welfare of emerging market governments. These sectors also are often the focus for growth investors who see a burgeoning opportunity as emerging market consumers develop and increase their income and standard of living.
China Displayed the Largest Government Involvement: Given China's communist background, it is not surprising that almost half of the SOE market cap companies are Chinese companies. A large percentage of the Chinese government's market cap ownership comes from the stakes it holds in the country's large financial institutions. These large state-owned banks are among the lowest-priced areas of the entire emerging markets, with average dividend yields over 6% and price-to- earnings (P/E) ratios below 5x.
Russia Also Displayed Significant Government Involvement: Russia's socialist and communist history has led to noteworthy government ownership in the Energy and Financials sectors. Although the recent Ukrainian conflicts have further depressed valuations, the Russian Energy sector had already displayed depressed valuations compared to the broader emerging markets before the crisis. For example, Gazprom (OTCQX:GZPFY) and Rosneft (OTC:RNFTF), two of the largest state-owned energy companies, have dividend yields north of 5% and P/E ratios under 5x.
Looking At The Companies
Continuing our analysis, we will turn our focus toward companies in each classification. We will look at a few of the largest companies in each classification and then expand the analysis to a broader subset of emerging market equities.
Sector and Country Composition: Six out of the ten largest SOEs by market cap are Chinese companies, and eight out of the ten are from the Energy and Financials sectors. The top four non-SOE companies are from the Information Technology sector, and the country list displays more diversification.
Valuation Comparison Favors SOEs: Looking at the simple average of the top 10 companies in each classification reveals a significant yield advantage for SOEs of around 3.3% and a P/E discount of close to 50%.
A Further Valuation Comparison
Expanding our current analysis beyond some of the largest companies, we will look at median dividend yield and median P/E ratios for a broader set of emerging market equities. We will compare the median dividend yield and P/E ratios over time and try to determine if any historical relationship exists.
SOEs Displayed Higher Dividend Yields: The current yield advantage is over 30 basis points (bps). It is important to note that the median dividend yields began to separate at the end of 2011; before that, they tracked pretty closely. Some analysts have argued that the divergence comes from governments that had strongly encouraged companies they own to increase their dividend payouts to help provide revenue during periods of sluggish economic growth. One example would be the Russian government, which has mandated state-owned companies to pay out 25% of their profits as dividends.
SOEs Displayed Lower Valuations: The current P/E ratio is selling at a 20% discount. The P/E ratio, similar to dividend yields, began to separate in 2011 and has remained disconnected. While many factors may contribute to the discount, such as country of domicile or sector, most market participants may still require a lower valuation, due to the government's involvement and the belief that governments may not always be the best stewards of capital.
Performance Tells Another Story
Over the past five years, broad emerging market returns have lagged the U.S. markets cumulatively by over 80%. One of the major reasons for this underperformance has been the lackluster performance of the state-owned enterprises, which have dragged down broad index returns.
State-Owned Enterprises Lagged: On a cumulative basis, over the most recent five years, SOEs lagged by over 27.5%. Also, on a three-year basis, SOEs lagged by a cumulative 9.7%, but over the last seven years, the returns differential decreases to around 6%. Obviously, past performance can't dictate future results, and, at times, state-owned enterprises performed better and were in favor.
Reform Agenda Catalysts: A political reform agenda in state-dominated companies can often be a focal point for the relative performance of state-run companies. Brazil comes to mind here. On October 26, 2014, Brazil had an election in which Dilma Rousseff, who previously ran Petrobras (NYSE:PZE), the largest company in Brazil, won a narrow victory over a candidate who was viewed as more market-reform oriented. Petrobras slumped 11% on the day after the election on the disappointment for a lack of reform with Rousseff staying in power (while the broader Bovespa Index was down 2.8%). Certainly there are other factors moving the markets here, but any signs of reform in Brazil certainly have affected the performance of Petrobras and other state-dominated companies, compared with the rest of Brazil's companies.
WisdomTree Emerging Markets Ex State Owned Enterprises Index
WisdomTree created a broad-based Index to emerging market stocks that are not state-owned enterprises. To WisdomTree, state- owned enterprises are defined as those having government ownership of more than 20% of outstanding shares.
The Index employs a modified float-adjusted market capitalization weighting process to target the weights of countries in the universe prior to the removal of state-owned enterprises while also limiting sector deviations to 3% of the starting universe float- adjusted market. The application of this rule was intended to provide a type of beta exposure that targets the initial universe from a country perspective, once the state-owned companies have been removed.
Eligible Universes: Must be incorporated or domiciled and have their shares listed on exchanges in one of the following countries: Brazil, Chile, China, Czech Republic, Hungary, India, Indonesia, Malaysia, Mexico, Peru, Philippines, Poland, Russia, South Africa, South Korea, Taiwan, Thailand or Turkey.
- State-Owned Enterprises: Companies with more than 20% ownership by government body removed.
- Minimum Market Capitalization: $1.0 billion.
- Weighting: Modified float-adjusted market capitalization.
- Holding Caps and Weight Adjustments: Country Weights target weight equal to float-adjust market caps of universe prior to removal of SOEs; Sector Weights constrain differentials to 3% differentials from starting universe, after country adjustment.
Information Technology Rises to the Top: Given emerging market governments' low involvement in the Information Technology sector, we are not surprised that the weights of some of the largest companies increase after the state-owned enterprises have been removed. Although the sector is well represented among the top five holdings, the Index caps sector differentials to 3%, compared to the starting universe, at each annual rebalance, in an effort to remain diversified and not take large sector risks.
Positioning Compared To Other Emerging Markets Indexes
Comparing the WisdomTree Emerging Markets Ex State Owned Enterprises Index to market cap emerging market exposure you will notice similar sector and country exposure, which is by design. Even with similar sector and country exposure, there are still differences in composition, valuations and other characteristics. In Figure 8, we show the similarities and differences against broad emerging market indexes and different emerging market subsets.
Ex State Owned Enterprises Slightly More Expensive: Comparing the dividend yield and P/E ratios with the MSCI Emerging Markets (MSCI EM) Index shows Ex State Owned Enterprises to be slightly more expensive. Given the 30% greater exposure to state-owned enterprises in MSCI EM and that these companies were selling at more attractive valuations on a median basis, it is understandable that the Index valuations are more attractive. On the other hand, the Ex State Owned Enterprises Index displayed some of the highest growth expectations of the Indexes shown above. Firms that have exhibited higher growth typically trade at premium earnings multiples and they also have lower dividend yields because they reinvest the majority of their earnings.
Dividend Weighting Increases State-Owned Enterprise Exposure Beyond Market Cap Weighting: The WisdomTree Emerging Markets Dividend Index (WTEMI) is a broad-based emerging market index that annually screens and weights companies by their cash dividends paid. As of the most recent annual rebalance, this process has increased exposure to state- owned enterprises, which makes sense to us, since these companies tend to be very large, and many have been increasing their dividend payouts over the past few years. Screening securities by dividend yield further increases an index's exposure to state-owned enterprises, as displayed by the WisdomTree Emerging Markets Equity Income Index's (WTEMHY) 50% weight. WTEMHY annually screens the top 30% of emerging market dividend payers and then weights them by their cash dividends paid. Compared with market cap weighting, this had led to an over-weight of Chinese state-owned financial firms and Russian state-owned energy firms, with both groups yielding over 5%.
Consumer Growth-Focused and Small Cap Indexes Offer Lower SOE Exposure Than the MSCI EM Index: The WisdomTree Emerging Markets Consumer Growth Index seeks to measure the performance of companies with the ability to capitalize on emerging markets' consumer growth trends, while at the same time maintaining sensitivity to valuation. The Index over-weights the Consumer Discretionary and Consumer Staples sectors, which typically have low government participation, compared to the MSCI EM Index. Also, the Index excludes the Energy sector and large banks, so it is able to steer around the large state- owned energy and bank enterprises. The WisdomTree Emerging Markets Small Cap Dividend Index is another way to lower exposure to state-owned enterprises because the Index focuses on small capitalization dividend-paying equities, allowing it to avoid the largest state-owned companies.
As emerging market countries continue to grow and transform, investors will demand more ways to gain access to this unique asset class. Recently, some investors have expressed concern over state-owned enterprises and they have sought tools to limit their exposure, even after understanding the valuation differences. These investors are interested in concentrating their exposure on the private sector and accessing the higher growth potential. Although it is impossible to know which area will be more beneficial to focus on going forward, we think it is important to have different tools available, and the case for either exposure could be made, depending on an investor's goals and objectives.
Unless otherwise stated, data source is WisdomTree.
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WisdomTree Emerging Markets Ex State Owned Enterprises Index: Measures the performance of emerging market stocks that are not state-owned enterprises. State-owned enterprises are defined as government ownership of more than 20% of outstanding shares of companies. The Index employs a modified float-adjusted market capitalization-weighting process to target the weights of countries in the universe prior to the removal of state owned enterprises while also limiting sector deviations to 3% of the starting universe. WisdomTree Emerging Markets Consumer Growth Index: A fundamentally weighted index designed to measure the performance of emerging market equities that have a potential heightened sensitivity to increased emerging market consumption. Weighting is by earnings. WisdomTree Emerging Markets Dividend Growth Index: A fundamentally weighted index designed to track the performance of dividend-paying emerging market companies that WisdomTree believes have the potential to increase their dividends due to certain factors, which include estimated earnings growth, return on equity and return on assets. Weighting is by trailing 12-month cash dividends. WisdomTree Emerging Markets Dividend Index: A cash dividend-weighted index measuring the performance of dividend-paying equities incorporated in emerging markets. WisdomTree Emerging Markets Equity Income Index: A subset of the WisdomTree Emerging Markets Dividend Index measuring the performance of the higher-yielding stocks as measured by trailing 12-month dividend yields, weighted by cash dividends. WisdomTree Emerging Markets SmallCap Dividend Index: A subset of the WisdomTree Emerging Markets Dividend Index measuring the performance of the smallest firms by market capitalization weighted by cash dividends. MSCI Emerging Markets Index: A broad market cap-weighted index showing performance of equities across 23 emerging market countries defined as "emerging markets" by MSCI. S&P 500 Index: Market capitalization-weighted benchmark of 500 stocks selected by the Standard and Poor's Index Committee, designed to represent the performance of the leading industries in the United States economy.
WisdomTree Funds are distributed by ALPS Distributors, Inc.
Jeremy Schwartz and Tripp Zimmerman are registered representatives of ALPS Distributors, Inc.
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Jeremy Schwartz, Director of Research
As WisdomTree's Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel's head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper "What Happened to the Original Stocks in the S&P 500?" and the Wall Street Journal article "The Great American Bond Bubble."
Tripp Zimmerman, Research Analyst
Tripp Zimmerman began at WisdomTree as a Research Analyst in February 2013. He is involved in creating and communicating WisdomTree's thoughts on the markets, as well as analyzing existing strategies and developing new approaches. Prior to joining WisdomTree, Tripp worked for TD Ameritrade as a fixed income specialist. Tripp also worked for Wells Fargo Advisors, TIAA-CREF and Evergreen Investments in various investment related roles. Tripp graduated from The University of North Carolina at Chapel Hill with a dual degree in Economics and Philosophy. Tripp is a holder of the Chartered Financial Analyst designation.