Emerging markets should always be a dedicated part of an investor’s equity exposure. Although the asset class is having an excellent 2017, it still lags behind developed counterparts over the past few years and is under-owned by many global managers.
Recent data from EPFR Global suggests that the average global equity manager has an allocation of 8 per cent towards developing world stocks versus an all-country benchmark weighting of roughly 12 per cent. This reflects poor relative performance over the three-year period to the beginning of 2017, and the fact that as a region the stocks have been out of favour.
Global managers’ weighting to emerging markets will vary, and they have been overweight historically – such as in 2012 – but they’re unlikely to ever be specialists. Our preference at Psigma is for global stockpickers to run money versus developed market benchmarks that exclude emerging markets, and to have a specialist and targeted exposure to the asset class. Add in the sector and stock concentration of the underlying indices, and we also lean towards being active with a particular focus on Asian economies.
Emerging market stocks are currently attractive, not least because of their valuations. At a forward price-to-earnings multiple of around 12.6 times, they are trading at a marked discount to their developed market counterparts, which trade on a full 16 times multiple of next years’ earnings.
In addition, emerging market corporates are enjoying extremely strong earnings growth – expected to run at 20 per cent this year – combined with the virtuous kicker of rising profit margins. This earnings growth is especially pronounced within Asia.
As an index, the space has changed dramatically over the past three years and this is perhaps underappreciated by some investors. It’s no longer fair to say that an exposure to emerging markets is laden with manufacturing sectors such as energy and materials, as the current preference is for IT and banks. IT as a sector constitutes roughly 27 per cent of the index, with energy and materials having a combined weight of just 14 per cent.
Asia is where the highest rates of growth can be seen, and thus the region constitutes roughly 70 per cent of the benchmark. In addition, policy is being eased and inflation rates are generally falling. The region’s emerging nations are also net commodity importers, and hence can benefit from the bottoming that is seemingly evident in commodity prices.
Perhaps counter-intuitively for an index with almost 850 stocks, MSCI Emerging Markets is fairly narrowly concentrated. The top-five stocks make up nearly 20 per cent of the benchmark, and the top-five technology stocks account for almost 16 per cent.
By owning emerging markets passively, investors are taking a fairly concentrated position and buying into the more expensive end of the index.
Owning these stocks has clearly been the way forward this year, with the IT sector up almost 50 per cent in dollar terms and the big five tech names up 60 per cent on average. But this comes with risks that need to be appreciated. Thus our preference is not to invest passively as this is skewed towards IT stocks and state-owned banks: both at opposite ends of the valuation spectrum and both with risk.