February 15, 2019 | Institutional Perspectives | 6 min read

The Case for Emerging Markets

As stock pickers in the developed world, we find unicorns high-quality businesses with sustainable growth opportunities and deeply discounted prices to be rare. Identifying one requires not only the skill and resources to break through the noise obscuring that value, but also sufficient noise to fool the rest of the market in the first place. These types of opportunities are ultimately born of market inefficiency – so the less efficient markets (with fewer analysts covering them, financial disclosures that are less regulated and less easily analyzed from afar, less liquidity) naturally make for better unicorn breeding grounds. For bottom-up stock pickers like our partners at Barrow Hanley (and us), it is in the muck of market inefficiency that we like to spend the bulk of our time.

Emerging Markets (EM) equities can be as good as the best ideas we can find across our developed market portfolios. Consider the following stories:

• A Chinese jewelry company commanding the country’s largest retail network, that brings scale and brand advantage over its competitors but trades at only 13 times forward earnings and carries a dividend yield greater than 8%;
• A food company in Brazil, which is the largest chicken exporter in the world to regions with growing meat consumption like the Middle East and Asia, with, we believe, a 50% upside to the current valuation; and
• A South African fashion brand with over 720 stores across their domestic market, capitalizing on a fast-growing consumer base and trading at an attractive valuation of 11 times earnings.

You may not have heard of Chow Tai Fook, BRF, or Truworths, but they all appear in our Emerging Markets Fund, where they provide exposure to these compelling opportunities from all corners of the globe. And there are others waiting to be found.

Why add emerging markets to your equity portfolio?

There are several good reasons why adding emerging markets (EM) to your portfolio may make sense, and why we are seeing more interest in the asset class from some of our larger institutional clients. Emerging markets are a growing and significant part of global markets. They now represent more than 10% of global equity indices, a weight that has doubled in the last 15 years yet still under-represents the region’s share of global economic activity. A growing share of the world’s population lives in these countries, with China and India alone making up more than a third. EM countries also have a younger workforce with a growing middle class and a consumer base that is getting wealthier.

Well-managed companies in these areas can take advantage of these trends, providing our portfolios with opportunities for diverse earnings streams.

It’s no secret that emerging markets have been more volatile historically than their developed counterparts. The argument for investing there must therefore be supported by the requirement for higher expected returns or diversification benefits from lower return correlations, or both.

We undertook a 20-year study of emerging and developed markets indices, and found the data supports both of these requirements. Table 1 shows our findings. While EM markets experienced higher risk (volatility), they also outperformed developed markets by a significant margin, more than compensating for the higher risk levels. The resulting EM Sharpe ratios, which measure the “efficiency” of returns by comparing them to the risk taken (higher is better), were commensurately attractive.

We found that if EM can outperform other equity markets in the future by 1% or more per year, an allocation to EM of more than 10% of an equity portfolio would be warranted, even if the higher risk repeats. The diversification benefits are powerful enough.

As an added bonus, since EM markets outperformed at different times versus developed markets, being up when they were down and vice versa, this provided diversification benefits to portfolios the only free lunch in investing.

Finally, we calculated what return premium was required from EM to justify its higher risk. We found that if EM can outperform other equity markets in the future by 1% or more per year, an allocation to EM of more than 10% of an equity portfolio would be warranted, even if the higher risk repeats. The diversification benefits are powerful enough.

Figure 1: Historical risk and return metrics for Emerging, Canadian, and Global Developed Markets (ex-Canada)

Will EM outperform other markets by 1% or more per year?

Of course, we can’t predict future returns with certainty, but there are a few reasons we feel that now may represent an opportunistic time to invest in emerging markets. For one, recent concerns about trade wars have applied downward price pressure on EM stocks, widening the already significant valuation discounts compared to other equity markets. As can be seen in Figure 2, the price-earnings multiples are attractive when compared to other points in the last decade.

Our EM portfolio is trading at a significant forward P/E discount to developed markets, which could provide an attractive tailwind should that normalize over time.

From a longer-term perspective, the significant size of the populations, higher levels of population growth, and growing and more affluent middle classes in emerging markets provide fundamental support for well-run companies operating there. China alone is a fascinating study. The pace of their growth is staggering, placing them second largest among the world’s economies. Our EM portfolio has a 20% weight in Chinese companies (largely listed in Hong Kong). This exposure is only available to our clients through our dedicated EM strategy.

Will EM outperform other markets by 1% or more per year?

Figure 2: Forward Price-Earnings Ratio Discount for Emerging Markets Relative to Developed Markets Over Time

Isn’t investing in EM risky? And how do you manage these risks?

It can be, and the higher risks are managed in three ways.

First and foremost, as stock pickers we do our own research on the businesses we buy. We interview management, analyze the financials, and enter only when we’re satisfied the price is attractive. We believe the value-based approach we use is even more advantageous in emerging markets, as price movements are wider, and so provide us with more compelling entry points.

Second, our research also prioritizes businesses that generate free cash flow and pay dividends. This discipline helps us to avoid problem businesses or more opaque financial statements. By keeping an eye on the cash till of the companies we own, we expect far fewer surprises.

And third, we manage total risk for our clients in a portfolio context by sizing allocations to each of the asset classes. By understanding each client’s unique risk tolerance, we can size an appropriate EM position to provide diversification benefits with the expectation of improved returns to the total portfolio.

Over a year ago, we started the Leith Wheeler Emerging Markets Equity Fund (series A, B, F), sub-advised by Barrow, Hanley, Mewhinney & Strauss (BH). BH manages our large cap US equities strategies and the team there has also been investing in emerging markets for more than a decade.

IMPORTANT NOTE: This article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided is compiled from our own research that we believe to be reasonable and accurate at the time of writing, but is subject to change without notice. Forward looking statements are based on our assumptions, results could differ materially.

Reg. T.M., M.K. Leith Wheeler Investment Counsel Ltd.
M.D., M.K. Leith Wheeler Investment Counsel Ltd.
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