With historic perceptions of emerging markets and equities no longer matching reality, institutional investors have the opportunity to scoop up good companies at low valuations, said Kamil Dimmich, portfolio manager for the emerging markets equity strategy at Pacific North of South Capital, during the Canadian Investment Review’s 2023 Defined Benefit Investment Forum in December.
While he acknowledged that emerging market equities have underperformed the S&P 500 over the past decade, their reputation as an asset class where investors “don’t get paid for risk” is unfair. “If you look at the previous decade, from the end of the 1990s to 2010, it was quite the reverse picture. . . . In fact, probably the best time to be looking at them is after a long period of underperformance.”
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Historically, fiscal and monetary policy choices in many emerging markets resulted in a high cost of capital and significant risk premiums for bonds, as well as lower equity valuations in response. But many emerging markets have emerged from the coronavirus pandemic in better shape than developed countries, with lower inflation, lower budget deficits and lower debt to gross domestic product ratios. They’re also borrowing at reasonable rates in domestic currencies, rather than in U.S. dollars.
“If I’m looking at investing in equities in some of these markets, the argument that we previously required a discount because there was a very high cost of capital isn’t really there anymore,” he said, noting the emerging market equity discount is “still very much present,” providing investors plenty of opportunity to find good businesses that are undervalued.
Emerging market equities offer diversification benefits, with different underlying drivers from those of developed markets, including a significantly younger demographic profile. The countries in the emerging markets basket are themselves quite varied, with some markets even negatively correlated with each other.
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Given their inefficiency relative to developed markets, emerging markets provide much more opportunity for active managers to outperform. But while most emerging market and growth managers aim to capture demographic and wealth growth, Dimmich said that can result in chasing and overpaying for the same growth stories and ultimately underperforming the market, adding that a value investing approach is preferable.
Chinese e-commerce and retail giant Alibaba Group Holding Ltd. is a good example of this approach, The company, which listed in 2014, was seen as a growth play, with access to China’s huge growth market, a growing middle class and a dominant position in the market that gave it room to grow its revenue further. Today, revenues are close to 20 times what they were when the company went public.
But in that same time frame, investors went from overpaying for growth to refusing to pay for growth. Alibaba’s enterprise value has dropped by 40 per cent in the past nine years, which Dimmich attributed to investors’ fears that China is becoming uninvestable and the potential of regulatory crackdown. That has made it a “fantastic” value stock for investors who understand the investing landscape in the country.
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He also pointed to Dubai’s Emaar Properties, which is trading at an inexpensive valuation but benefitting from the government’s immigration changes that have spurred an influx of residents and a structural shift in the housing market, away from speculation and towards owner-occupied. While investors tend to buy Indian companies to get exposure to the growing middle class, he said a company like Emaar provides the same exposure without paying the high multiples common among Indian equities.
Institutional investors looking to evaluate their managers’ emerging market strategies can assess the consistency of investment style and whether they’ve outperformed the market in the past and for a framework that can handle such different markets.
Read more coverage of the 2023 Defined Benefit Investment Forum.