Value in emerging markets is eroding fast
Emerging markets have been through the mill: a sharp sell-off in January that prompted emergency rate rises, followed by a bounce, and now, a renewed bout of geopolitical tension centred on Crimea.
Such confusion creates opportunities, but few seem to have taken them. The rules for extracting outperformance in the developed markets are now well-known and well tested. But while the same rules apply in emerging markets, they do so far more weakly.
That at least seems to be the main lesson from a huge historical study produced last month by Elroy Dimson, Paul Marsh and Mike Staunton, three London Business School academics, for their annual exhaustive research exercise, the Credit Suisse Global Investment Returns Yearbook .
They, like other academics, have identified three repetitive effects in developed markets that lead to outperformance in the long term. These are the value effect (cheaper stocks outperform); the size effect (smaller stocks outperform); and the momentum effect (winners tend to keep beating losers). There is controversy over whether these effects are driven by human behavioural anomalies, or are a rational response to risk, but there is no doubt they exist.
In emerging markets, the value effect is even stronger than in the developed world. The Dimson/Marsh/Staunton research, going back to 2000, finds that companies that are cheap judging by their dividend yield outperformed by 4.3 percentage points per year, compared to 3.1 percentage points for developed markets.
But the size effect is very much weaker, with larger companies outperforming in six emerging markets over this period. Overall the “size” premium has only been 1.9 percentage points in emerging markets, compared to 6.6 percentage points in the developed world.
As for the momentum effect, a policy of buying the previous six months’ “winners” while shorting the “losers” led to an outperformance of 0.78 per cent per month in the developed world, but only 0.24 per cent in emerging markets. Seven emerging markets had negative momentum returns.
Russia should be a buy
So the same basic effects are at work in emerging markets, but their strength is very different. Buying cheaply will eventually work out. Relying on momentum, given the choppiness of sentiment in these markets and their proneness to sudden reversals, is more awkward. Similarly, buying smaller companies in markets that are often oligopolistic and dominated by a few big players can be a problem – or alternatively, the big emerging market players that have turned themselves into globalised conglomerates in recent years have proved prohibitively difficult to bear.
Amplifying the problem, emerging markets traders complain that over the past four years, neither value nor momentum has worked. Cheap stocks and countries have stayed cheap, while the markets have traded in a large range with no clear direction (although there has been a steady underperformance of the developed world).
The imbroglio over Russia is a perfect example. Russia has been a screaming “buy” on value screens for a while. As of Friday night, before the military escalation in Crimea, it was the cheapest of all emerging markets, according to MSCI, when measured by either earnings or book multiples (a few countries had higher dividend yields). Russian shares were available for less than 70 per cent of their book value. This did not avert Monday’s sell-off, which brought the Russian stock market to barely half its post-crisis peak.
This seems like clear downward momentum. But momentum strategies would also have been foiled by the rapid switchbacks in prices over the past few days. Russia’s RTS index dropped 14 per cent at one point on Monday, and then gained 9.5 per cent from there over the following 24 hours.
Crises prompt higher rates
The momentum problem is not limited to Russia. Civil unrest has provoked crises of varying severity in three different countries within the last six months: Thailand, Turkey and Russia. In all cases, higher rates from central banks have been part of the response.
And the emerging market political timetable for the rest of the year offers little respite. Important elections are scheduled in Colombia, Turkey, Hungary, India, South Africa, Indonesia and Brazil. Expect populist rhetoric and perhaps fiscal pump-priming to increase in these countries. There will also be what promises to be a very interesting election in Ukraine. Such political crises, and the market discontinuities they provoke, make momentum investing impossible to play.
The problem is ably put by John-Paul Smith, global emerging market equity strategist at Deutsche Bank, who contends that “governance is the corollary of value in emerging markets”. Companies may well trade at a discount to their replacement cost, or their intrinsic value. But if their managers are not working for minority shareholders, or are instead working for the government, he complains, shareholders cannot expect to see that value.
Governance has generally been worsening post-crisis. The stocks most obviously cheap on value screens tend to include formerly nationalised energy groups, or Chinese banks, where the issue of governance is particularly acute.
Added to all of this, the macroeconomic backdrop for emerging markets is ugly. They face rising rates as the Federal Reserve slowly exits from quantitative easing, but also a slowdown in demand for their goods from China.
This makes emerging markets investing even harder than usual. Do enough homework on the intrinsic value of a company and you will ultimately be rewarded. Value works, if given long enough. But value investors in emerging markets also have to do extensive homework on governance issues.
Anyone patient enough to do this work will find some bargains. But none of them will be in Russia.
Copyright the Financial Times 2013.