Emerging market pioneer Sir John Templeton set out the case for contrarian investing with one of the most oft quoted truisms of investment: “If you want to have a better performance than the crowd, you must do things differently from the crowd.” Following Sir John’s logic, emerging market equities appear to be a classic contrarian opportunity. Once a favourite of asset allocators looking to tap into the rapid development and growth of these economies, emerging market equities have more recently fallen out of favour as investors focus on the short-term ills affecting these markets.
This has led to capital flight from funds investing in this part of the capital markets.
While acting differently from the crowd is a pre-requisite for long-term investment success, fundamental analysis is equally important, as those wishing to adopt a contrarian approach need to establish a sound rationale for opposing the consensus view. For most contrarian investors, this rationale typically rests upon constructing an accurate assessment of the ‘fair value’ of the asset, which itself rests on expectations of the future cash flow of an asset and the likely variability of that cash flow. For investors in emerging markets, this latter step is especially challenging due to the breadth of the opportunity set.
Despite often being represented in portfolios by a single fund or portfolio allocation, the emerging markets are a huge and diverse investment area. In terms of size, emerging economies account for approximately 80% of the global population and 45% of global output when adjusted for purchasing power. From a diversity perspective, the MSCI Emerging Markets index comprises 838 companies from 23 countries with a market capitalisation of $3.4 trillion. It is therefore overly simplistic to consider these markets as a homogenous block and expect to develop a coherent expectation of fair value sufficiently robust to support a contrarian investment case.
Evidence for this diversity is abundant and encompasses all aspects of both the emerging markets and the economies in which they reside. Perhaps the most obvious current fault line in emerging markets is between the key resource producers and consumers. While investors in Russia may be rightly concerned about the negative impact of falling oil prices on both the Russian economy and stock market, the reverse is true for India, which is one of the world’s largest importers of oil and a net beneficiary of a falling oil price. Equally, a decline in the economic growth rate in China is having a negative impact on commodity-producing stocks in South America while lowering the input prices and supporting profitability for Chinese manufactures.
Consequently, when seeking to adopt a contrarian approach in these markets, we must first acknowledge that opportunities are unlikely to be uniform but rather focused in certain unpopular sectors, markets or regions. Second, we need to recognise that we do not invest in economies but rather in the securities of companies and governments. These must be valued using a consistent framework if we are to identify attractive opportunities within this broad swathe of investment options.
When viewed in this way, it is striking that the key value-driven opportunities appear to be concentrated in a small number of markets and sectors. Of the eleven emerging equity markets for which we compile bottom-up valuation models, only five appear sufficiently attractive to deliver positive real returns, in local currency terms, over the next seven years. Of these, the two most attractive markets, Taiwan and Russia, are both highly concentrated with the largest holding in each country accounting for more than 18% of the index. This concentration is also evident at the sector level with the dominant sector (IT in Taiwan and Energy in Russia) accounting for over 50% of the index in each case.
There are three clear messages to be drawn from this concentration. The first is that a broadly diversified emerging markets portfolio may not be able to fully capture the current value available in emerging markets. The best value opportunities often stem from economic concentration in key industries at the country level. In order to fully access these opportunities it is necessary to adopt an unconstrained approach.
Second, short term investment trends are by their very nature driven by behavioural rather than fundamental factors and, consequently, can become surprisingly extreme. Therefore, contrarian investors wishing to access the value in unpopular markets must adopt a long-term approach and accept shorter periods of underperformance as opportunities to acquire additional holdings more cheaply.
Third, we must appreciate that assets are seldom cheap without reason and acknowledge the existence of systemic, geo-political and institutional risks in emerging markets. As a result, the expected returns from companies operating or listed in these markets is subject to greater uncertainty than equivalent companies in developed markets. Investors can address this greater level of uncertainty in several ways. One of the most common is to adjust the discount rate used to determine the value of future cash flows. This approach naturally leads investors towards higher-quality holdings and quality orientated strategies have prospered within these markets. As a result, many of these funds have become extremely popular and large.
While we would expect a focus on quality to continue to deliver superior returns as these economies and their institutions continue to mature, it is important to note that quality stocks and defensive industries can become relatively overvalued during periods of market stress and negative investor sentiment.
It is therefore important that investors in emerging markets consider lower-quality industries such as energy and basic resources when the implied returns from these investments more than fully compensate for the likely downside risk. This willingness to investigate areas of the market that are deeply unappealing to the majority of investors is the true mark of the contrarian.