Authored by: Bart A. Grenier
Emerging markets (EM) posted its best U.S. dollar-based return since 2012, ending a five-year run of being out of favor. 2016 also marked the first time value stocks outperformed the market since early 2010. Beginning last spring, we felt the EM asset class was poised for prolonged recovery—one led by a rotation into lower-valued, out-of-favor countries, sectors, industries and companies. The last twelve months featured many such stories with notable recoveries in Brazil and Russia as well as rebounds in EM Energy and Materials. However, we believe the building blocks for a more durable move toward value and rotation back to emerging markets remain firmly in place and should gain momentum in 2017.
Performance Reversal for Emerging Markets Value
Valuation dispersions in the EM asset class are notable. As shown below, the spread between the average price-to-book valuation of the least expensive one-third of the MSCI EM Index to most expensive one-third hit record levels in late 2015 into early 2016, only recently rolling over slightly. Our white paper from June of last year explained some of the elements driving this divergence with investors preferring defensive stocks over cyclicals. In the context of strengthening global growth led by the U.S. and ongoing improvements in EM profitability and earnings power, we are likely at the leading edge of the rotation.
MSCI EM Index: Price-to-Book Value Dispersion
When you broaden the lens to assess relative return potential across the global equity space, there's a strong argument for a greater allocation to EM in order to capitalize on burgeoning earnings and margin improvement – both of which could also drive multiple expansion. For example, the EM asset class looks cheap relative to the U.S. on a price-to-earnings basis when adjusted for normalized earnings (Shiller's price-to-earnings ratio), as shown below. We believe the potential for spread narrowing is meaningful. Incorporating a mixture of structural improvements and company-specific restructuring also helps underpin the ongoing opportunity in the asset class.
Emerging Markets Valuation Opportunity: Cheap on Normalized P/E vs U.S.
We think distinct improvements in export competitiveness, capital expenditure discipline, mergers and acquisitions and political reform will ultimately unlock this historic opportunity in emerging market value investing.