For most of the past decade, growth stocks have benefited from a low-growth, low-interest-rate environment. This has been true across both developed and emerging markets, and many growth-oriented stocks have benefited further in the wake of the pandemic. However, the global growth/value cycle may have turned in late 2020, leading to significant outperformance of value stocks since. We think this style reversion may have some legs, particularly among emerging market equities. This article explains why now may be an opportune time to favor a value orientation in emerging markets.
A look at emerging markets performance
Figure 1 shows rolling three-year returns of the MSCI Emerging Markets Value Index (MSCI EM Value) and the MSCI Emerging Markets Growth Index (MSCI EM Growth) and the three-year rolling excess returns of the MSCI EM Value over the MSCI EM Growth since August 2009. The gray line highlights the significant underperformance of value stocks for most of this period—until recently. Indeed, since October 2020, the MSCI EM Value has returned 31.9% compared with 11.1% for the MSCI EM Growth through August 31, 2021, and much of the growth underperformance can be attributed to regulatory events unfolding in China. For example, many high-growth Chinese equities have suffered under the Chinese Communist Party clampdown on the education and internet sectors, and increased regulation appears to be on the horizon. A fresh round of proposals were introduced recently, including actions aimed at bolstering the rights of delivery drivers working for online companies as well as increases in oversight of the live-streaming industry. The president of Tencent, an internet and technology company headquartered in Shenzhen, China, publicly commented that he expects additional regulations in the near future.
More broadly, lower vaccine deployment and recurring waves of COVID-19 variants have had a greater impact on emerging markets as a whole than they have on developed markets, delaying reopening and potentially giving a longer runway to value stocks. While emerging market equities are underperforming developed markets year to date—giving some investors impetus for trimming their overall allocation—it is important to note that emerging market value stocks are up 7.68% year to date. Much of the selling has been concentrated in growth stocks.
The rebound in value stock performance has not dented their attractive relative valuations
Growth stocks are naturally priced at a premium to value stocks due to the nature of their higher expected growth trajectories. However, the valuation premium placed on growth is still far beyond long-run historical levels, even after the recent outperformance of value stocks. Figure 2 shows the price-to-book values of the MSCI EM Growth and the MSCI EM Value indexes from August 2011 through August 2021. It is noteworthy how growth valuations have nearly doubled over this period while value stock valuations have remained near their historical norms.
As we mentioned at the outset, growth historically tended to outperform when rates were low, yet it is difficult to see how policy rates can go much lower in developed markets, and we have seen rates pick up in many emerging market countries, including South Korea, Brazil, Russia, Mexico, and others. While higher rates may benefit value-oriented financials, they can erode the discounted value of the more distant earnings projections in high growth sectors. The inflation outlook also plays into brighter prospects for certain cyclical sectors, particularly if inflation is not as transitory as is believed by consensus—industrials, materials, and energy sector names may have a stronger footing if longer-term inflation expectations take root. Growth sectors, on the other hand, may be subject to earnings downgrade from both cost inflation and regulatory constraints.
True emerging market value equity managers are scarce
Emerging market equity tends to be known as a “growth” asset class due to emerging markets’ higher structural growth expectations over developed markets. It should be no surprise then that much of the manager universe caters to a growth orientation. A review of the manager universe of eVestment Alliance shows the most recent distribution of active and diversified emerging market strategies across the style spectrum. In Figure 3, we can see that only 10% of assets managed in the broader emerging market equity all-cap and large-cap universes are managed within value-oriented strategies.
Ostensibly, the broad emerging market universe tilts toward growth strategies, in both the number offered and in assets under management. However, some consultants have found that many strategies categorized as core emerging market strategies appear to have higher growth orientations, making the broad universe even more growth oriented than it first appears. The portfolio composition of many of these strategies has been deleterious to performance in the past several months, particularly following the recent pullback in several prominent American depositary receipts (ADRs). Specifically, the top 10 Chinese ADRs, which include household names such as Alibaba, Jd.com, Pinduoduo, Nio, Baidu, Netease, New Oriental Education, Tal Education, Yum China, and Trip.Com, accounted for fully 10.65% of the broad MSCI Emerging Markets Index at the end of 2020. These names now comprise only 7.51% of the index—nevertheless, these names are still widely held and are, arguably, over-owned by both institutional and retail investors globally. The growth orientation of stocks held as ADRs and their increased domestic scrutiny within China, not to mention the increased scrutiny of foreign regulators, suggest that value stocks may be spared some of these headwinds going forward.
Ten years of data indicate that emerging market value stocks retain an edge over their growth counterparts in relative valuations, even after their recent outperformance. As a specialist in value-oriented names, we pride ourselves in our ability to identify value in this space as the world continues to adjust and reorder itself in the wake of the pandemic. There are relatively few managers that specialize in this space. But, by and large, the long-term outlook of the asset class as a whole remains positive due to many structural factors that favor emerging markets, and we believe the most likely beneficiaries will be those investors who have patiently held assets with strong fundamentals and attractive valuations that operate within these regions.
Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.
Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.
Mutual fund investing involves risks, including the possible loss of principal, and may not be appropriate for all investors. Stock values fluctuate in response to the activities of individual companies and general market and economic conditions. Bond values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. Changes in market conditions and government policies may lead to periods of heightened volatility in the bond market and reduced liquidity for certain bonds held by the fund. In general, when interest rates rise, bond values fall and investors may lose principal value. Interest rate changes and their impact on the fund and its share price can be sudden and unpredictable. Funds that concentrate their investments in a single industry may face increased risk of price fluctuation over more diversified funds due to adverse developments within that industry. Foreign investments are especially volatile and can rise or fall dramatically due to differences in the political and economic conditions of the host country. These risks are generally intensified in emerging markets. Smaller- and mid-cap stocks tend to be more volatile and less liquid than those of larger companies. High-yield securities have a greater risk of default and tend to be more volatile than higher-rated debt securities. Consult a fund’s prospectus for additional information on these and other risks.