Latest Emerging Market Viewpoints
From Matt Linsey and the North of South Capital team
Investors we meet are often preoccupied with their exposure to style factors. The largest dichotomy seems to exist between the growth and value investment style. We at North of South Capital subscribe to the view that value investing works over time and allows an active manager to outperform the market. Our investment process is built around this premise.
There is a general consensus that in recent years value investing has not worked, with growth stocks significantly outperforming. The MSCI Emerging Markets Value index has underperformed its Growth counterpart by over 16% during the past ten years. In the US, the divergence has been even wider. At the same time the North of South Emerging Markets fund has outperformed the MSCI Emerging Markets Index by 35% and the Growth version by 24%. This despite not running a 100% market exposure. How can this be possible? The crux of the matter lies in two very different definitions of value – only one of which is easily automated and converted into an index.
Value indices, smart beta funds and quant value strategies tend to go for a statistical definition of value that was popularized by Fama and French. This is an easy calculation as it relies on current or historic numbers such as book value, reported earnings or dividends. Stocks can easily be ranked and qualified as “cheap” or “expensive” based on the ratio of their market capitalization to earnings or book value. Investing in the value factor simply means buying all the stocks that look cheap relative to a current snapshot of their P&L or balance sheet. Underlying this, is an assumption that over time all companies tend to revert to the same level of profitability and returns on equity – therefore no business should trade on a premium or discount to another.
Value investing as described by Ben Graham and others on the other hand, requires an understanding of the underlying business and its future potential. When we buy a stock, it is its future cashflows, not historic ones that we are purchasing. These will be determined by the returns on capital that this business can sustain over the medium to long term. We look for stocks whose price does not reflect the value of expected cashflows. This is very different from blindly investing in stocks on low multiples – it also requires far more work and judgement. Such an approach also brings into play the cost of capital since an appropriate discount rate needs to be applied to these future cashflows.
In our Emerging Markets universe, buying stocks on low multiples alone would have led to significant underperformance over the past years. This is because markets were reasonably efficient at putting low valuations on shares in companies that were likely to destroy value over time. The culprits have tended to be state owned enterprises or other companies with poor corporate governance. They have also included businesses that were capital intensive with low and declining returns due to lack of barriers to entry – whether in the commodity or manufacturing sectors. At the same time we have seen active value strategies such as ours deliver considerable outperformance.
The flipside of the underperformance of statistical value during the past decade has been an outperformance of the statistical growth style. Growth stocks by definition are long duration assets, with the majority of their value out in the future when the business is expected to be significantly larger than today. Thanks to low interest rates, the discount rate applied to that future growth has been reduced and investors have been happy to pay increasingly high valuations. This mechanism is now at risk from rising interest rates which make cashflows today increasingly more valuable relative to cashflows in the future. The other issue is that many growth companies have now become so large that it becomes increasingly challenging to extrapolate similar continued growth rates too far into the future.
Being a value investor does not mean being anti-growth. However it requires a significant degree of scepticism as to the ability to forecast very far into the future. This is why in our models we tend to fade the growth of stocks beyond a period of reasonable visibility - if we are able to buy stocks that look inexpensive even with modest assumptions, we are building in an extra margin of safety and upside. We will however miss out on stocks that are priced for near perfection and actually deliver it. While we believe that real value investing never went out of style, the market's focus on growth and quality alone has certainly been something of a headwind for disciplined investors. Inexpensive stocks have often remained inexpensive, while growth stocks have seen their market value increasing even faster than their earnings.
For example, Tencent currently trades at significantly higher multiples than it did five years ago. We do believe that this will eventually turn, providing value investors with a friendlier market environment that allows for a re-rating of underappreciated stocks relative to growth superstars. We will of course continue doing what we have always done – focus on acquiring undervalued cashflows discounted at the appropriate rate.
IMPORTANT INFORMATION | Issued and approved by Pacific Capital Partners Limited, a limited company registered in England and Wales, authorised and regulated by the Financial Conduct Authority. The information contained herein is not approved for use by the public and is only intended for recipients who would be generally classified as investment professionals. Information or opinions contained in this article do not constitute an offer to sell or a solicitation, or offer to buy, any securities or financial instruments or investment advice or any advice or recommendation in respect of such securities or other financial instruments. Where past performance is shown it refers to the past and should not be seen as an indication of future performance.