Morningstar Investment Management analysts explain why they prefer emerging market investment opportunities in Europe and Asia, and why investors need to be cautiously selective.

Almost 80 per cent of the emerging market index is made up of countries that weren’t even investible 30 years ago. It shows how far emerging markets have come in a short space of time but also offers a warning to investors that history is unlikely to repeat itself.

Countries such as China, Russia and Taiwan have opened up and taken a large amount of market share since 1988, when it was Malaysia that dominated the index.

These drastic changes are also notable by industry: US tech may have gained world attention, but it has been a big mover in emerging markets too and now accounts for around 24 per cent of the emerging market index – and around 33 per cent in Asian emerging markets – up from just 5.5 per cent in the late 90s.

EM tech

Developed market equities may have outperformed emerging markets over one, three, five and even 10 years, but this hides many of the interesting stories – and opportunities – beneath the surface.

Emerging markets are diverse

Morningstar Investment Management continues to like parts of emerging markets – both stocks and bonds. It’s important to remember that emerging markets are comprised of different regions; including Asia, Africa, Eastern Europe and Latin America. Consequently, the economic and fundamental drivers of performance can be quite diverse.

But because emerging markets are not homogenous, they represent fertile ground for valuation-driven investors to pick investments that can add value over the long-term, while avoiding those assets with poor reward for risk. Reflecting this, our order of preference within the emerging market equities gamut is EM Europe, then EM Asia, with EM Latin America our least favourite.

We need to assess emerging markets in both absolute and relative terms. The underperformance in parts of the emerging markets equity universe through 2011 to 2018, for example, is a relative development – with external concerns such as trade wars and rising US interest rates impacting these regions more than developed markets. This has made emerging market valuations more “normal” than developed market valuations, even if the block doesn’t stand out in aggregate.

Said another way, a few bad apples and a solid dose of fear have unfairly dragged down fundamentally healthy markets, leaving an opportunity to be selective going forward. To be fair, emerging markets' prospective returns aren't nearly as attractive as they were a few years ago, so our constructive views should be understood relative to the wider opportunity set. And that, we believe, is a pretty dismal picture, unless one decides to get granular.

Remember risk versus reward

As advocates of valuation-driven investing, we must also consider emerging markets on a risk-adjusted basis. This requires one to think carefully about the expected returns—comprising the payouts (yield and buybacks), underlying cashflow growth and any valuation change over time—as well as any fundamental risks that could meaningful cause a drawdown.

Under this lens, perhaps it is easiest to address the key fundamental risks first: We know that since the 2008 financial crisis, Chinese banks have grown their assets significantly by lending to local governments and households. This impacts emerging market financials, where the largest country exposure is unsurprisingly China, accounting for 29 per cent of the index, with the next 42 per cent spread reasonably evenly between India, Brazil, Taiwan, South Africa and South Korea. Therefore, while emerging market financials are certainly not isolated to the China story, they are heavily influenced by it.

As long-term investors, we are not in the business of predicting if or when a Chinese debt crisis may flare, however, we do know that as the government looks to tighten liquidity, banks face the prospect of holding more capital while potentially incurring higher bad-debt provisions. Over the long-term that means one should expect a negative impact on profits and a knock-on effect to return-on-equity.

Looked at this way, we don’t see much attraction in the emerging market financials sector given current pricing and the potential downside risk. However, we don’t agree that the full-blooded contagion fears are justified, as many regions and sectors still look fundamentally healthy and are expected to deliver positive outcomes.

Currency Volatility

Another key risk is currency, especially given most emerging market products are only offered in unhedged terms. For example, while the emerging markets benchmark slipped 4.5 per cent in local currency terms in the year to September 2018, it sank 10.2 per cent for US dollar investors.

This highlights the fact that much of the underperformance was driven by emerging markets currencies losing ground to the US dollar, rather than the performance of the actual underlying basket of companies.

EM currency

Investors appear to be pessimistic about the entire market because of a few troubled emerging markets such as Turkey, despite the fact its impact on the market is insignificant compared with that of China and, to a lesser extent, countries like South Korea, South Africa, and Brazil.

Any assessment of the evolution of emerging markets is further confused by a need to be “macroconsistent”. Take India, for example, where real economic growth is very healthy and will progressively lead to a more affluent middle-class. The link between that economic growth and the growth of corporate pay-outs is subject to widespread error.

While there are no easy answers to solve such an issue, logic implies that conservatism is warranted when implying a pay-out growth rate for emerging market companies. To do so, we tend to use sectoral crossover by assessing pay-out growth by sector group and applying this to the emerging market composition, as well as qualitative overlay to ensure pay-out growth rates are represented fairly.

Investors must be selective

When combined into a broader conviction, we find that the attractiveness of emerging markets as a whole is somewhat waning, but the investment case strengthens when we are selective about which regions to invest in.

Here, we find EM Europe and Asia the better valued regions, with opportunities in Korea and Russia in particular. As with any market that exhibits unusual risks, sizing is important —where one must understand the role any exposure is playing and its relationship to other assets. Emerging markets may not be for the faint hearted, but if used correctly they can help an investor achieve healthy risk-adjusted rewards over the long-term.

This article is based on a monthly series compiled by Morningstar Investment Management's Suzanne Ramadan, Dan Kemp and Leslie Alba.