By Sujata Rao
LONDON Aug 18 If the popping of the dot-com
bubble in 2000 spelled the demise of growth-at-any price
investment strategies in the West, 2013 may be the year for this
to happen in emerging markets.
Emerging market investors, just like their dot-com
predecessors of the 1990s, are learning the hard way the risks
of paying higher and higher prices for assets in the hope that
turbo-charged future growth will deliver the payoff.
Now an emerging equity collapse, coming amid a steep growth
decline, may have put paid to the so-called growth investing
model that has for years blinded fans of the sector.
Counting from end-2010, emerging equity returns stand a
thumping 50 percent below U.S. markets. And this year may be
final straw - as a growth slowdown gathers pace in the
developing world, share prices are lagging developed peers by
over 20 percent and U.S. stocks by a third.
Time, many say, for a shift to value-based investing -
buying shares which are deemed to be trading at a discount to
their fundamental worth. In other words, eschewing some of those
Indian or Russian retail stocks that trade at 50 times forward
earnings on the premise of explosive future consumption growth.
"We are injecting elements of value investing in our
emerging market portfolios," Giordano Lombardo, CIO of Pioneer
Investments in Milan, told Reuters.
"Investors are in a conundrum, on one hand they need to
factor in worsening fundamentals and on the other valuations are
looking more attractive," he said. "A good strategy at such a
time could be to play more on the value side and avoid some of
the stories in countries and stocks that still look expensive."
Most emerging shares indeed seem very cheap. Average
valuations are down more than 25 percent from 2009, Deutsche
Bank says, while U.S. and European markets are mostly unchanged.
And a comparison with 2007 peaks makes their case even more
compelling. The sector has de-rated by 50 percent, Deutsche data
shows. Developed valuations meanwhile are 28 percent off peaks.
On a book-value basis, almost every emerging market looks
vastly cheaper than its history. Brazil, Poland and India for
instance show a 30 percent discount to their own 10-year history
and South Korea is a quarter under its historical average.
The vaunted link between fast economic growth and stock
market returns has been discredited by many a study - most
notably by a 2005 report by London Business School academics
Elroy Dimson, Paul Marsh and Mike Staunton.
A more recent Lombard Odier study applied this to China,
finding that despite 15 percent annual growth between 1993-2005,
compounded stock market returns languished at minus 3.3
Indeed, double-digit returns on emerging stocks before 2008
stemmed not from fast growth but from the market's cheapness
back in 2000 when the developing world was just recovering from
crisis, Societe Generale analyst Albert Edwards says.
"Valuation is what matters for investing in emerging
markets, not their superior growth story," Edwards told clients.
Growth and value are of course not mutually exclusive - a
company's growth prospects are part of its value. The problem
arises when those valuations run far ahead of future growth,
often exaggerated by new players keen to join the party.
That's what happened to the dot-coms in the late 1990s and
possibly to emerging markets in the years after 2007.
Edwards is notorious for his gloom-ridden investment outlook
but emerging equity prices are looking so beaten down that even
he reckons a valuation gap is opening up. The sector trades at
less than 10 times forward earnings or 30 percent below
developed stocks. Edwards describes this as "very reasonable".
Another example of the relative valuation gap - two U.S.
banks, Wells Fargo and JPMorgan, with a joint market cap of $440
billion, now have a higher value than the entire energy and
materials sector in Brazil, Russia, India and China.
Less than three years ago these banks were worth half the
BRICs' commodity sectors, Bank of America/Merrill Lynch notes.
Deutsche Bank analyst John-Paul Smith, long bearish on
emerging stocks, says only his conviction of a looming financial
crisis in China keeps him from advising clients to buy.
"Were it not for the China factor, for a long-term value
investor, emerging equities could be tempting," he said.
It could prove hard to immediately apply the concept to
emerging equities however. In a relatively young sector, value
investors could find that long-term historical data on
valuations, debt or normalised earnings are elusive.
And many shares will be cheap for a reason - weak profit
growth, poor corporate governance or excessive state meddling
are all issues that dog companies in the developing world.
It can be tough therefore to find stocks that have both
cheap valuations and strong fundamentals.
"Value is a good strategy for emerging markets provided you
don't make the mistake of falling into value traps," says
Pioneer's Lombardo, who is still invested in some expensive
stocks such as consumer goods because of long-term potential.
"Playing fully on the value side can be risky," he added.