Latest Emerging Market Viewpoints
From the North of South Capital team
There has recently been much excitement about market rotation and a reversal of momentum. Since the end of August the S&P value index has indeed sharply outperformed the growth equivalent without much of a move in the broader market. This is a relatively rare occurrence in recent years and has led to some soul searching by strategists.
UBS’s quantitative research team point out that the valuation premium of growth companies versus value in the S&P is at the widest since 2001. We see a similar discrepancy in the MSCI Emerging Markets growth and value indices although in our case we already surpassed the 2001 differential some years ago. UBS also point out that in the market sell-off of 2001 as well as in Q4 2018 valuations were highly relevant. Expensive stocks underperformed less expensive ones. They suggest this may be because valuations and positioning have become extreme and any redeeming characteristics of growth stocks over value stocks are more than priced in.
At North of South we tend to be sceptical of simplistic indices and strategies such as “smart-beta” that fail to take account of an appropriate cost of capital and the real world business and political environment. The MSCI EM value index consistently outperformed its growth equivalent between 2000 and 2011. Ever since then it has broadly been the other way round. If you had put money in both indices at the end of 2003 you would today have had exactly the same returns, albeit with a different path. On a global scale based on Fama/French studies of equities, value factors had been outperforming since at least the 1970s. This run similarly ended around the financial crisis and its aftermath.
And yet, we remain value investors. Our approach to value consistently produces a portfolio that combines a lower average cost of capital with lower valuation multiples than the index. At the end of August, our long book had prospective dividend yield at 3.9% compared to 3.3% for the MSCI Emerging Markets index. It was on an estimated forward P/E of 8.9x against 11.9x for the same index.
We believe that cheapness does not necessarily equate with value but we refuse to pay for blue sky future growth that remains highly uncertain. At the same time we have an eye on potential disruption to business models and the competitive landscape – in some cases this justifies low valuations.
Searching out inexpensive stocks will inevitably lead us to own many that would score poorly on “momentum” or “growth” style analysis. We half-jokingly say to investors that we are in the business of picking up “fallen knives”. However, if we are successful in our stock picking, the portfolio will also contain stocks that are seeing positive fundamental and price momentum as they narrow the valuation gap identified by our approach.
One of the stocks we have talked about the most in recent years and which remains our largest long position, illustrates this in practice. We have owned China Meidong, a Chinese car dealership, in the fund since its IPO in 2013. At the time we felt this was an exceptionally well managed business in a growing but unsophisticated market. When the stock initially dropped from the IPO price, we added to the position and again in 2017 at lower levels. Despite growing by 30% annually over the previous four years, the stock was still trading on 6x earnings by the end of 2018. Our models continued to show very significant upside even assuming a slowdown in this pace.
Finally, the stock seems to have caught investors’ attention and has rerated this year to 11x expected twelve month earnings. However at the same time the business has opened new avenues for growth with higher margin brands, which makes it less dependent on growth in the overall market. Even after a 140% rally year to date we continue to see around 50% upside to fair value if we assume a sharp slowdown in growth rates.
In the longer term of course, the valuation differential between “growth” and “value” stocks remains the big historic anomaly. Given the value characteristics of our portfolio, we would expect the unwinding of this to be highly beneficial. Meanwhile though, we are glad to be fishing in a deep pond of value stocks.
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