Claims that emerging market investors herded into quality companies in the first half of 2014 raise concerns about troubled times ahead. But as Lynn Strongin Dodds finds, some of that trade has already unwound – and there is a strong counter-argument that investors were, in fact, looking for growth rather than safety
During tumultuous times, investors tend to take cover under the defensive tarpaulin and this summer was no exception in the emerging markets.
Research from Eastspring Investments earlier this year showed that the Ukraine crisis coupled with tension in the Middle East and a spluttering economy in China led to a significant amount of crowding in these markets. The valuation spread between popular and out-of-favour stocks pushed the popular picks into bubble territory, it claimed.
Eastspring’s premise, according to fund manager Andrew Cormie, is that during periods of uncertainty, in developed or emerging markets, investors’ time horizons shorten dramatically as they become more risk averse and less concerned about capital appreciation.
“This was the case with Asian equities where investors did not want to hold companies sensitive to a slowdown in growth,” he says. “They were more interested in quality companies which were being rewarded by the market and pushed to a new valuation premium against cheap stocks.”
The last periods when such a wide price-to-book spread appeared between the most and least expensive quintiles of the market occurred during the tech boom of 2000 and the commodity bull cycle seven years later. Eastspring’s research showed that this time around, the ‘quality bubble’ in emerging markets favoured three sectors – IT, consumer staples and consumer discretionary. Companies being shunned belonged to financials, energy, and materials whose prices were beaten down by interest rate sensitivity and cyclical growth rates.
Since the research was done, Cormie believes that investment horizons are now beginning to lengthen and value is slowly creeping back onto the fund manager agenda.
“I would not want to make any promises and call this a turning point but the bubble has been pricked,” he says. “I think, though, that we have a long way to go and quality stocks will continue to underperform until the bond markets normalise.”
Not everyone agrees with the Eastspring view.
“Eastspring uses the price-to-book ratio of the most expensive and cheapest quintile of the largest stocks to illustrate its point but I think this measure can be misleading because of the accounting treatment of the different sectors,” argues Kunal Ghosh, portfolio manager at Allianz Global Investors. “For example, service economies such as IT, heathcare and consumer staples do not have high capital expenditure and have intangible assets. They typically trade on higher multiples compared to sectors such as industrials which has heavy capital spending and are not rewarded.”
Ghosh prefers to look at emerging markets through the lenses of earnings and the certainty of growth.
“This would still include consumer staples such as food but the reasons would be tied to their strong bottom-line figures,” he explains. “We also like financial companies, such as the Bank of China because of its consistent earnings growth and 6.6% dividend yield. The stock will perform better than others in times in of market stress.”
Gustavo Galindo, emerging markets portfolio manager at Russell Investments, adds that, while political uncertainties pushed investors into quality names, he would hesitate to qualify this as a bubble.
“We did see some concentration, particularly in the consumer sector over the summer, and my suspicion is that events in Russia and Ukraine as well as concerns over China’s economy spooked investors,” he says. “However, there is no evidence of a long-term trend. Also, some of the technology stocks that did well were in the semiconductor industry, which was benefitting from the growth of smartphones in Asia. There was also a rally driven by large-caps in India on the back of [the election prospects of Bharatiya Janata party leader] Narendra Modi.”
Jan Dehn, head of research at Ashmore Group, also would not classify recent market movements as a quality bubble but a reflection of sustained growth rates due to strong domestic demand.
“This is not being driven by short-term stimulus or quantitative easing but deep structural fundamental changes in many emerging market countries,” he adds. “There have been and will continue to be massive migration from rural communities to urban centres and this will help strengthen the consumer sector. It will also help offset any weakness exporters may feel due to currency volatility surrounding the normalisation of monetary policies in developed economies.”
Similarly, Claire Peck, client portfolio manager, emerging markets equities at JP Morgan Asset Management, sees the divide more as one between growth and value than between ‘quality’ and the rest. She points to the decoupling between emerging and developed markets as the primary culprit behind the multi-year slowdown in emerging-market profits, the decline in relative market performance and, within emerging market equities, the outperformance of growth stocks over value.
“In this environment of weak economic growth, investors have crowded into growth stocks and avoided value names, which has created a sharp divergence in the performance of growth and value stocks,” she argues. “China provides a good illustration of this trend, where the relative absence of macro growth stories has led investors to look for micro-growth opportunities wherever they can find them – most notably among the Chinese internet stocks – growth names, rather than banks, which are value names.”
Peck’s colleague Emily Whiting, client portfolio manager, emerging market equities, adds: “In times of uncertainty people will pay more for a clear earnings stream but, as we saw with the recent IPO (initial public offering) of Chinese internet company Alibaba, people can be drawn in by an exciting growth story.”
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