How to Value Invest in Emerging Markets
Value Investing Is Making a Come-back in Emerging Markets
Emerging markets have historically been a prime market for growth-oriented investors. After all, these economies are known for their rapid gross domestic product (“GDP”) growth compared to developed countries in Europe or the United States. These growth rates have slowed down since the Great Recession in 2008. However, it has also created a potential opportunity for value investors to get involved.
Let's take a look at why value investors may want to look at emerging markets and some strategies for getting involved.
Why Value Investing?
Value investing has become increasingly popular in both developed and emerging markets. A large and growing body of evidence suggests that investing in stocks with below-average price-earnings or price-book ratios or above-average dividend yields providers superior returns over the long run. Successful investors like Warren Buffett have capitalized on these tendencies and generated exceptional above-market returns over time.
A paper published in Emerging Markets Review in 2002 showed that these tendencies carry over into emerging markets, with ‘value’ stocks generating higher returns than non-value stocks. A subsequent Credit Suisse report found that value stocks outperformed in all but three of 21 emerging markets between 2000 and 2013, with the average ‘value premium’ being 4.3 percent per year compared to just 3.1 percent in developed countries.
The risk profile of value stocks may also be attractive to many investors, including those interested in emerging markets. By purchasing equities at a discount, there is presumably less potential downside than a high-flying stock with few assets or earnings. There is also evidence that value stocks are no more volatile than ‘high growth’ stocks, which means that investors aren’t necessarily assuming a lot more risk in terms of beta.
Value Investing in Emerging Markets
Emerging markets have experienced a significant downturn during the Great Recession in 2008, which worsened when the U.S. Federal Reserve announced that it would scale back its quantitative easing (“QE”) program and raise interest rates. Many emerging market currencies witnessed a significant decline in value and $2 trillion in dollar-denominated debt – used by many emerging market governments and companies to borrow – became costlier to repay.
The dramatic decline in crude oil prices exacerbated these problems, since many emerging markets lack the diversification of developed economies. In fact, developing economies are, on average, concentrated in 50 percent fewer product categories than the developed world. Crude oil accounts for a significant portion of economic output for countries like Russia and Venezuela, as well as most of the countries located in the Middle East.
These dynamics have led to significant capital outflows from emerging markets, which has depressed their valuations relative to developed markets. For example, the U.S. S&P 500 trades at a 25.37x earnings multiple, as of January 19, 2017, whereas the MSCI Emerging Markets index trades with a price-earnings ratio of just 12.06x. Value investors may, therefore, find emerging markets have more opportunities than developed markets.
ETFs, Mutual Funds and Stocks
International ETFs represent the easiest and most cost-effective way to build exposure given that they provide an entire portfolio in a single security with lower expenses than most comparable mutual funds. While there are many different emerging market ETFs to choose from, only a handful of them are focused on value investing opportunities. Most of these are so-called smart beta funds using alternative indexing strategies.
The most popular emerging market value ETFs include:
- FlexShares Morningstar Emerging Markets Factor Tilt (TLTE)
- iShares MSCI Emerging Markets Minimum Volatility (EEMV)
- SPDR S&P Emerging Markets Dividend (EDIV)
- WisdomTree Emerging Markets High Dividend (DEM)
There are arguably more mutual funds to choose from that are focused on emerging market equities, but most of these are actively managed rather than passive (albeit smart beta) funds. Their expense ratios may also be significantly more expensive than ETFs, which means that it’s important for investors to consider the manager’s track record and other factors.
Some popular emerging market value mutual funds include:
- T. Rowe Price Emerging Markets Value Stock Fund (PRIJX)
- American Century Emerging Markets Value Fund (AEVVX)
- Brandes Emerging Markets Value Fund (BEMIX)
Finally, investors can purchase individuals stocks as either American Depositary Receipts (“ADRs”) trading on U.S. exchanges or foreign stocks. Often times, the easiest way to find these opportunities is to use stock screeners and look for foreign stocks trading at discounted multiples or high dividend yields using tools like FinViz (www.finviz.com). The downside is that it may be more expensive to build a portfolio and many of these stocks are less liquid.
The Bottom Line
Emerging markets have historically been growth investor targets, but their recent downturn has created opportunities for value investors. When looking at opportunities, investors may want to consider value-orientated funds or screening for individual opportunities, while keeping mind the impact of higher expenses, liquidity, and other risk factors.