Earnings Matter In Emerging Markets

Mar. 15, 2021 3:15 PM ETEEM, VWO, IEMG, SCHE, EDC, EDZ, XSOE, SPEM, EMF, ADRE, ESGE, EUM, EEV, MSF, EET, FRDM, AVEM, FEM, LDEM, DBEM, HEEM, MFEM, EEMX, DIEM, RFEM, ROAM, ISAPF, ISEM, EJUL, DMRE1 Comment

Summary

  • It's been more than a year since the initial outbreak of COVID-19, but the global pandemic continues to challenge economies and their health care systems.
  • Ongoing technological transformation and innovation in emerging markets, which accelerated as a result of COVID-19, have translated into higher free cash flow generation, relative to developed markets.
  • A combination of domestic consumption, innovation and technology have created a dynamic emerging market landscape, one that really puts the notion to bed that emerging market assets are only cyclical commodity plays.

By Andrew Ness, ASIP, Portfolio Manager, Franklin Templeton Emerging Markets Equity

The resilience of emerging markets in the wake of COVID-19 shouldn't come as a surprise, according to Franklin Templeton Emerging Markets Equity's Andrew Ness. He says fundamentals still look attractive in select markets and reminds investors of what really matters - earnings.

It's been more than a year since the initial outbreak of COVID-19, but the global pandemic continues to challenge economies and their health care systems. While new variants of the virus have spread just as countries start to rollout vaccines, we think emerging markets will likely show continued resilience in the face of new challenges. Prior to the pandemic, emerging market fundamentals appeared generally attractive, and we still believe that to be the case.

While recovery in economic growth could remain muted this year in many markets, we expect more normalization in 2022. Stress in emerging market banking systems has been manageable, despite the loan moratoriums and government support policies for borrowers in many emerging market countries.

Consumerism among the emerging market population is also a well-told story, but it remains a multi-year growth opportunity. We think there could be new opportunities across a wide range of goods and services in the wake of the pandemic and still see a continued trend of premiumization, where consumers with higher disposable incomes desire higher-quality goods.

The Emerging Market Earnings Story

Ongoing technological transformation and innovation in emerging markets, which accelerated as a result of COVID-19, have translated into higher free cash flow generation, relative to developed markets. This cash flow has helped deleverage balance sheets, but also found its way back to investors through dividends and share buybacks, and encouraged companies to adopt improved governance standards and better capital discipline. In our view, this all adds up to a higher quality earnings story.

According to our analysis, emerging market earnings have been the top driver of total returns in the MSCI Emerging Markets (EM) Index over a five-year period (see chart below).

In addition, annualized total returns have been greater in the MSCI EM Index (7.6%) than in the UK FTSE 100 (4%), S&P 500 (7%) and TOPIX (3%) indexes over a 20-year period.1 Earnings really matter when it comes to emerging market investing.

With US earnings multiples at a two-decade high, emerging market equities appear undervalued; the emerging market price-to-earnings discount to the United States stands at a near two-decade low at -36%.2 We think valuations are not reflecting the real narrative and see an earnings rebound in 2021 from a low base in 2020. A combination of better cash flows, stronger balance sheets, improved capital efficiency and less cyclicality wasn't being fully reflected in valuations, in our view.

Many Businesses Entered the Crisis in Good Shape

In our view, the aftermath of the global pandemic will not likely change the positive fundamentals that have been driving emerging market economies. A combination of domestic consumption, innovation and technology have created a dynamic emerging market landscape, one that really puts the notion to bed that emerging market assets are only cyclical commodity plays. Many emerging market countries also remain less leveraged in general than developed economies at the sovereign, corporate or even at household level.

Many of the themes we've been investing in for some time will likely remain relevant in a post-COVID-19 world, and some will even accelerate as a result of the pandemic. Many businesses entered the crisis with stronger balance sheets compared to those in developed countries. Those with net cash levels that were once considered inefficient have ultimately proven to be somewhat prudent. Those countries benefitting from institutional reforms in recent years entered the crisis in better shape, too. With stronger foundations and greater fiscal flexibility relative to both history and developed-market peers, we think emerging markets should generally be on a smooth recovery path out of the global pandemic.

Emerging Market Transformation Continues

We've been talking about the emerging markets transformation story for quite some time. The nature of emerging market economies has fundamentally changed over the last decade, with institutional resilience borne from years of fiscal policy improvements. Domestic consumption and technological advancements drive many emerging market economies today - countries like China are no longer fully beholden to recovery in Western economies for growth.

Many emerging markets have leapfrogged the developed world in many areas, including social media, messaging platforms and e-payment systems, and more recently with the global pandemic, online education and health care. Most notably, e-commerce businesses in China, South Korea, Russia and Brazil have adapted to increased demand and upped logistics operations. Meanwhile, online technology platforms are rapidly expanding and opening up research and development technology centers in places like India, to support increased levels of adoption for video conferencing solutions globally.

We think the longer-term story within emerging markets is positive, and look forward to uncovering investment opportunities in the years to come.

What Are the Risks?

All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets' smaller size and lesser liquidity. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments. China may be subject to considerable degrees of economic, political and social instability. Investments in securities of Chinese issuers involve risks that are specific to China, including certain legal, regulatory, political and economic risks.

1. Source: Bloomberg, February 2021. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.

2. Sources: MSCI and Bloomberg, as of 30 September 2020. © 2020 Morningstar, Inc. All Rights Reserved. Important data provider notices and terms available at www.franklintempletondatasources.com.

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

This article was written by

Franklin Resources, Inc. (NYSE: BEN) is a global investment management organization operating as Franklin Templeton Investments. Franklin Templeton Investments provides global and domestic investment management solutions managed by its Franklin, Templeton, Mutual Series, Bissett, Fiduciary Trust, Darby, Balanced Equity Management and K2 investment teams. The San Mateo, CA-based company has more than 65 years of investment experience and over $908 billion in assets under management as of May 31, 2014. For more information, please call 1-800/DIAL BEN® or visit franklinresources.com.

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