Emerging market equities: a brighter decade ahead?

#1 Undemanding valuations for a diverse range of opportunities

On pretty much any metric we look at, EM equities are cheap in relative terms compared to global and US equities. Investors often focus on China as the dominant emerging market, but we believe there are also many interesting opportunities elsewhere that are arguably being overlooked by investors nervous about the situation in China. It is important to remember that EM equities are not a homogeneous asset class – they comprise many distinctive economies, with different drivers and features. 

In Asia, markets like South Korea and Taiwan have some correlation with global economic growth and the technology cycle. As a result, they are fairly volatile at the moment. The ASEAN region has different characteristics and looks interesting to us now – markets like Vietnam and Malaysia are benefiting from companies moving their supply chains away from China, while Indonesia is a large commodity-producing nation, with favourable demographics that could boost economic growth. 

Mexico is also benefiting from ‘nearshoring’ (companies moving operations to a neighbouring country), given its proximity to the US – demand for commercial real estate in the north of the country is very strong. Elsewhere in Latin America, we see value in Brazil, another commodity-heavy economy, which we consider has some of the best run companies in the world, with very high standards of corporate governance.

#2 Change in corporate behaviour

In the past, EM companies, particularly in China, were arguably too focused on growth. Many overinvested in the expectation that the growth would remain high, destroying capital on unprofitable ventures. We are now observing a change in behaviour, by state-owned companies, conglomerates and private firms. Companies are showing much greater capital discipline when committing to new projects. They are also increasingly focused on delivering returns to shareholders in the form of dividends and share buy backs. We are encouraged by this improvement in capital allocation and balance sheet behaviour and remain optimistic that it can help EM equities close the gap with developed market stocks.

#3 Improving fundamentals

In addition to a relatively favourable macroeconomic environment for EM compared to developed markets, we are observing encouraging trends at the micro, or company level, which could benefit emerging market equities. Profitability trends at EM companies have improved recently and we believe this is driven partly by a change in corporate culture. 

Emerging market firms have realised the days of easy growth are over and, in our opinion, are, by and large, becoming more professional and starting to understand the importance of using capital efficiently. We think capital discipline has improved: companies are investing more sensibly to generate returns on capital. They are also becoming more shareholder friendly: firms are distributing more capital to shareholders. For example, over the past couple of years, we have seen a sharp inflection in the dividend payout ratio in China. 

M&G’s investment edge in EM

As we look ahead to 2024, the prospect of interest rate cuts by central banks, notably the Federal Reserve, and falling inflation globally represents a potentially supportive backdrop for emerging market equities. Ongoing geopolitical tensions between the US and China, the crisis in the Middle East and the significant number of elections around the globe this year, could create some volatility in the asset class. However, as established EM investors, we recognise that unpredictability and pronounced swings in sentiment are often associated with EM equities.  

Investing in emerging markets involves a greater risk of loss due to greater political, tax, economic, foreign exchange, liquidity and regulatory risks, among other factors. There may be difficulties in buying, selling, safekeeping or valuing investments in such countries.

A disciplined, bottom-up approach

We have a long-term investment horizon and believe that volatility can often create opportunities for discerning investors. We have been investing in EM with the same philosophy and approach for nearly 15 years. Using a bottom-up, value-orientated approach that focuses on returns on invested capital, we have remained disciplined during volatile episodes and have waited patiently for the right opportunities. 

When investing in EM, we believe it is essential to look beyond the market ‘noise’. As bottom-up investors, our focus is on the long-term outlook of individual companies: we want to build conviction in the level of return on capital they might be able to generate in 3-5 years’ time. To do this, we concentrate on the fundamentals of the company and the industry they operate in. We seek to avoid the distraction of market narratives, short-term drivers and momentum – staying disciplined enables us to exploit valuation dislocations as the market swings between excessive greed and fear in reaction to short-term events.

There are three core tenets to our investment approach: return on capital, valuations and shareholder alignment.

Return on capital

The starting point for a stockpicking approach is the belief that fundamentals, specifically a company’s return on capital, provide evidence of a company’s success in creating value for shareholders. Understanding what drives a company’s return on capital is therefore at the heart of the strategy. We analyse company business models, assets and management strategies to determine what level of returns a firm might achieve in future. 

Valuations 

The second and arguably most important element of the process is valuations. We look for companies where we think the market is underappreciating their future returns. We do not invest in companies without material valuation upside; therefore, we always build a margin of safety in the investment case, and we do not let other factors overrule the valuation tenet. 

Shareholder alignment

The final factor we consider is shareholder alignment. A company may look undervalued, but we want to establish that the company is run for the benefit for all, not just minority, shareholders. We carefully assess each company’s governance structure, incentive alignment and pay particular attention to management’s capital allocation track-record to avoid investing in companies that might destroy shareholder value. 

Bright prospects for EM

With a large and diverse investment universe of improving companies, as well as some of the most advanced, cutting-edge businesses globally, we believe that the outlook for emerging market equities is extremely bright. 

Short-term sentiment driven volatility is an unavoidable feature of the asset class, but we genuinely believe that the combination of a disciplined, long-term approach and an experienced, well-resourced team of investors gives us the potential to identify attractive opportunities efficiently and repeatedly. 

After a sustained period of underperformance, we are optimistic that EM equities can emerge from the shadows in the coming years and can play a valuable long-term role in investors’ portfolios.