The valuation divergence between value and growth stocks in the Emerging Markets (EM) has reached an extreme, surpassing previous peaks seen during the technology bubble and the GFC. We believe that today’s record valuation dispersion highlights the significant opportunities available to investors, as well as the risk to existing growth-biased EM portfolios.
Much has been written about the unprecedented impact of the coronavirus pandemic — the depth of the economic contraction, the swiftness of the market correction as well as the unparalleled monetary and fiscal response of the policymakers. However, the extraordinariness of the situation does not stop there. Investor fears arising from the pandemic have exacerbated the divide between growth and value stocks within the emerging markets, creating an exceptional valuation gap. The valuation difference between growth and value stocks, on P/E terms, now far surpasses previous peaks seen during the technology bubble and GFC. (See Fig 1)
In fact, the most expensive 20% of the stocks within the MSCI Emerging Markets Index is now three times pricier than the cheapest 20% of the stocks within the index — a valuation dispersion not seen in the last 20 years. (See Fig 2).
Any discussion on the valuation dispersion between growth and value stocks invariably leads to criticism that certain valuation metrics such as P/E are now obsolete as the intellectual property, brand, and marketing positioning of dominant technology companies do not exist on balance sheets, unlike hard, tangible assets. We agree. That is why we do not rely on a single valuation method. We consider signals, both absolute and relative from a range of valuation measures including P/E, P/B and dividend yield.
Paying the price
We are not suggesting that many of the growth companies that have outperformed are not good businesses. Many of the sectors or sub-sectors that have led growth stocks’ ascent are likely to benefit in the new normal post-Covid — e-commerce, cloud, streaming to name a few. We believe that there are key technological trends that will reshape the global landscape as consumer behaviour changes for good.
What we question is the premium which investors are willing to pay for such stocks. And whether the premium is based on extrapolating a continuation of these companies’ outsized profits, market share and monopolistic influence into the distant future.
We are also not suggesting that every stock within the cheapest quintile of the index will eventually shine. There are companies that are cheap for a reason. Through fundamental analysis, we filter out poorly-run companies, broken business models as well as value traps and seek to identify good companies that are trading below their fair valuations.
Ultimately, we invest in companies where we are highly confident that their discounted valuations are a result of temporary near-term headwinds and that these companies would deliver sustainable earnings over the long term. At the point of writing, we have found attractive opportunities in South Africa and Mexico where investors may tend to overlook given the unfavourable news headlines.
We also have broad exposure across China, just not in the overpriced sectors. Our investment philosophy takes advantage of investors’ behavioural bias — the tendency for investors to overreact to both good and bad news, causing them to overpay in the former and underpay in the latter. The pandemic has compounded these tendencies.
We believe that buying value stocks at this point in the cycle at such extreme valuation dispersion, increases the probability of us adding significant value (excuse the pun) to our portfolios over the medium and long term.
Why value now?
Value has underperformed growth in the last 10 years, testing the resolve of even the most committed value investor. So why look at value now? For one, we believe that today’s record valuation dispersion highlights the significant opportunities available as well as the risk to existing growth-biased emerging market exposures.
At the same time, value’s decade-long underperformance has taken place against a backdrop of eroding inflation expectations and falling interest rates. Low discount rates have in turn justified the lofty valuations of many growth stocks.
Today, the unprecedented fiscal and monetary stimuli aimed at offsetting the impact of Covid-19 has caused money supply to spike. Fig 3 shows that M2, a measure of money supply which includes cash in circulation as well as in savings deposits, has hit a record high as a percentage of nominal GDP.
In more normal times, such high levels of excess cash would fund the purchases of financial assets (which we have seen) as well as goods and services. In the months ahead, optimism over a successful vaccine or treatment can cause a rise in inflationary expectations. Less uncertainty over the macro outlook and higher discount rates can compel investors to seek out the bargains found in value stocks.
Time to diversify
Our research tells us that most asset owners are likely to have a growth bias in their existing emerging market exposures since value managers currently account for only about 10% of the Global Emerging Market universe. This implies value managers are likely to offer substantial diversification benefits for long term investors with existing emerging market exposures.
Even for investors without existing growth-biased emerging market exposures, it is reasonable to assume that the extreme valuation divergence is throwing up attractive opportunities. Ironically the extended period in which value investing has not worked, which sets the stage for value investing to return. History tells us that the rotation to value tends to be hard and fast. Investors may want to get prepared.
