Emerging-markets equities: A promise half-fulfilled
Their economies have astonished; their stock gains, not so much.
Hop into a time machine, journey to 1999. Much seems familiar. Technology companies are booming, discount brokers attract millions of new customers, and children teach their grandparents about the Internet. Perhaps, some speculate, the Dow Jones Industrial Average will reach 36,000. One thing, however, is quite different: investors are intrigued by emerging-markets stocks.
The reason for it is their economic prospects. The Asian Tigers of Hong Kong, Singapore, South Korea, and Taiwan have enjoyed remarkable development, to the point where many no longer consider those nations to be emerging. Attention has now turned to their successors: Brazil, Russia, India, China, and South Africa, later to be nicknamed “the BRICS.” Those countries are expected to grow rapidly.
That they very much did. In 1999, per the World Bank, the BRICS accounted for 11.5 per cent of global gross domestic product. By 2009, their share was 17.2 per cent. In another 10 years, they had reached 22.5 per cent. Their economic explosion - which, admittedly, owed primarily to China, secondarily to India, and little to the remaining three countries - was unprecedented.
One would expect those who bought emerging-markets stocks in 1999 to have benefited from their decision. After all, many emerging markets had recently been rocked by the 1997 Asian financial crisis. Then Russia defaulted on its debt. Although the consensus was that the emerging countries would eventually overcome their problems, the streets nevertheless contained some blood. It was an opportunity for the bold.
The bold were not disappointed. Below are the total returns for Morgan Stanley Institutional Emerging Markets (MGEMX) - one of the industry’s early diversified emerging-markets stock funds, and among its most typical - and Vanguard 500 Index (VFINX) from January 1999 through March 2021. Vanguard’s fund performed well; those who held blue-chip US stocks almost quintupled their money. However, emerging-markets equities fared better yet.
So far, this has been a predictable story. Not all higher-risk securities deliver higher returns; were that to occur, those securities would no longer qualify as “higher risk.” But when the fundamental outcome exceeds even the optimists’ forecasts, we expect the brave to prosper. They had the courage of their convictions. Consequently, by the theory, they received their just rewards.
Not so fast
All fine and good. But as you may have noticed, much of emerging markets’ performance arrived early. After the early 2000s, it’s not clear that emerging-markets stocks continued to outgain the S&P 500, nor that their total returns were particularly impressive. Their success appears to have been transient.
Such was the case. The next graph is identical to the previous version, except that it begins in 2004 rather than 1999. Bumping the buy decision by five years flips the outcome. Now, Vanguard 500 Index enjoys the stronger return, with Morgan Stanley Institutional Emerging Markets’ annualized gain registering a moderate 6.5 per cent, below that of the relatively conservative Vanguard Balanced Index (VBINX).
Notably, this revised period includes emerging markets’ best stretch, from 2005 through 2007. Move the calculation forward another three years, to January 2008, and the Morgan Stanley fund is barely in the black, posting an annualized return of only 0.8% from 2008 until the present.
A common justification for emerging markets’ recent struggles - if 13 years can be called “recent”--is that such issues have become unpopular. By this explanation, the problem lies not with emerging markets’ businesses, but instead with reduced investor expectations. Emerging-markets stocks have become value investments. When they return to fashion, their price multiples will expand, permitting them to lead the way once again.
Perhaps. However, while there’s no doubt that emerging-markets equities have lost their US buzz, their global appeal does not appear to be diminished. By Morningstar’s calculations, emerging-markets stocks have not become relatively cheaper than American equities. Rather, the ratio of the S&P 500’s price/earnings multiple to that of MSCI Emerging Markets Index has remained virtually unchanged. Year in and year out, the P/E ratios on US equities are about 50% higher than those of emerging-markets stocks.
Switching from price/earnings to price/book ratios yields an even stronger conclusion, because the valuation gap between the two indexes has narrowed. The S&P 500 currently trades at a price/book ratio that is 25 per cent above 2004’s level, whereas over that same period the MSCI Emerging Markets index’s price book ratio has increased by 50 per cent. By that measure, emerging markets have become less attractive to value investors, not more.
The fundamental problem
Regrettably, the reason that emerging-markets stocks have lagged has been fundamental. Although the countries have grown impressively, the per-share earnings of their publicly traded companies have not followed suit. As outlined in a 2019 report by Aoris Investment Management, “The Emerging Market Fallacy,” there have been three major slips ‘twixt the cup of GDP growth and the lip of shareholder returns.
- GDP growth has exceeded the growth in corporate profits.
- Not all of the most profitable companies are publicly traded.
- New share issuance has severely diluted shareholder returns.
To the third point, consider the annualized rate of new share issuance in the five BRICS countries, as well as the United States, from 2008 through 2018.
That is a very large disparity! While 2018 China was unquestionably larger and wealthier than the 2008 version of the country, it also had floated 3 times as many shares. Consequently, if aggregate profits for all publicly traded companies in China had tripled during those 10 years, shareholders wouldn’t be better off at the end of the decade than they were at the start.
In emerging markets, outside shareholders typically place low on the corporate totem pole. Whereas in the US the precept of shareholder value largely holds, most emerging-markets companies have other priorities. Management often consists of family relationships. In addition, government officials are far more involved than in the US (In 2018, reported The New York Times, China’s parliamentary members had an average net worth of $4 billion. Note: Upon further review, that estimate overstates the matter, but their average net worth is still well above that of developed-country legislators.)
What’s more, emerging-markets firms are more willing to sacrifice profitability to maintain employment than their US counterparts. For example, China and India recorded only slight rises in unemployment during the 2008-09 global financial crisis. While those governments’ official figures should be taken with a heaping of salt, the fact remains that during a severe slowdown, emerging-markets CEOs are less likely than American executives to preserve profitability by slashing costs.
Ten years ago, many pundits foresaw a rebound in emerging-markets stocks, on the theory that they were worthy investments that had temporarily lost popularity. This “fashion argument” has failed the test of time. Such stocks have languished for good reason. Emerging-markets countries have treated their insiders much better than they have their outsider shareholders. For their stocks to appeal to long-term global investors, that habit must change.
John Rekenthaler (firstname.lastname@example.org) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.