CPD: Strong growth opportunities in Emerging Markets equities

The important skill is being able to discern between the good companies – those that can sustain strong, positive returns – and the rest.

The complexities exhibited by Emerging Markets creates significant market inefficiencies and strong potential for meaningful alpha generation. EM specialist Ashmore Investment Management, a PAN-Tribal Asset Management investment partner, examines the benefits of exposure to emerging market equities and explores how these markets perform during US rate cycles.

The one constant of Emerging Markets is change. These markets typically have complicated governance structures, evolving macroeconomics and immature institutions, resulting in markets that are dynamic and complex. Consequently, Emerging Market companies often exhibit share price volatility.

At the same time, these complexities create significant market inefficiencies and strong potential for meaningful alpha generation. The important skill is being able to discern between the good companies – those that can sustain strong, positive returns – and the rest.

The Emerging Markets opportunity

Emerging Market countries continue to develop and reform their economies, policies and market structures. This builds increased confidence among investors, which buoys returns. Improved returns drives market liberalisation and improves market depth, which in turn drives further investment.

Despite this, Emerging Markets exhibit notable inefficiencies due to their varied governance systems, dynamic macroeconomic conditions and fledgling institutions. This often results in heightened share price volatility; and while this volatility can pose challenges, it also presents significant opportunities for active investors to generate alpha.

Companies of superior quality that offer compelling growth prospects are poised to capitalise on the secular growth drivers within Emerging Markets, to better navigate the economic fluctuations and market downturns.

The potential for alpha generation is further magnified by the inadequate research coverage of Emerging Market companies, particularly concerning their medium-term fundamentals. Insufficient research often results in undervaluation of high-quality businesses, with their stock prices failing to reflect their capacity to sustain robust returns over the longer term. This underscores the importance of active management in Emerging Market equities.

The characteristics of quality Emerging Market companies

Successful investment in Emerging Market equities results from a consistent approach to identify quality companies. Such companies typically exhibit four important characteristics:

1. High and sustainable return on capital

• Superior returns can be eroded by competition over time. Only a small number of companies will have structural competitive advantages that can sustain high returns on capital.
• High returns can arise for a short-term period during industry or macro upturns. Successful investors can identify those few companies that can sustain strong returns through the cycle.

2. Strong predictable cash flow generation

• Strong and predictable cash flow provides the foundation for a company to make the appropriate investment decisions over a cycle.
• Reported earnings can be subject to accounting presentation; however, cash generation provides an honest view and ultimately determines the value of a business.

3. Robust balance sheet

• A quality Emerging Market company is one that prioritises balance sheet strength to withstand challenging domestic conditions, so it can emerge stronger than its less resilient peers. For example, a healthy balance sheet enables a company to improve its competitive position during a macro downturn; it’s able to invest in its brands, technology, distribution and growth while others are cutting expenses and laying off staff.
• An over-reliance on debt has the potential for negative outcomes for equity investors and can destroy even the best business models.

4. Skillful management and good governance

• Capital allocation provides the link between business value and shareholder value. It enables a company to expand its competitive advantage.
• A skilled management team is able to reinvest cash at high rates of return and grow the underlying earnings power of a business.
• Good governance is crucial to a company’s valuation; it enhances transparency, accountability and trust, thereby reducing risk and attracting investors, and ultimately boosting the company’s market value.

Finding Emerging Market companies with unique attributes – a network effect, an ecosystem to maintain a competitive advantage or a sustainable runway of growth – can be the difference between a profitable Emerging Market investment and one that disappoints.

Integrating ESG assessment into the investment approach is vital to identify quality companies, as this directs investors towards management teams that are proficient in managing significant business risks and opportunities within their markets.

Sustainable growth characteristics of Emerging Market companies

By investing in Emerging Market companies with varied growth profiles, the risk/reward opportunities are better diversified and more able to sustain alpha generation. The factors that investors need to consider when targeting companies with sustainable growth characteristics include the following:

Sustainable growth over high growth

While many companies are predicted to generate high growth, only a select few actually deliver. Consequently, it is important to be selective and focus on identifying realistic and sustainable growth drivers.

Compounding growth through reinvestment

Growth is most attractive when combined with quality, as this enables a virtuous cycle whereby free cash flow can be re-invested at higher rates of return. Taken in combination with a long runway for high return investment opportunities, capital can be compounded over many years.

The power of compounding earnings is not perceptible in the short term. Instead, the majority of shareholder returns are reflected via changes in earnings multiples. However, over the longer term, it is growth and the compounding of cash flows and earnings that can lead to excess returns.

Preference for diversified growth drivers

Growth drivers can include price increases, entering new markets, new product development, cost reduction and operating leverage.

Cyclical growth is that which is driven predominantly by economic expansion and external factors that cannot be relied upon. It is uncontrolled (and uncontrollable) by management and can quickly change course. Consequently, a company that relies on cyclical growth requires additional analysis to determine the sustainability of its growth profile.

Conversely, growth that is driven by market share gains, product innovation, pricing power and other initiatives is more sustainable. Such growth is independent of the economic climate and inherently more controllable by a company’s management team.

The perils of low growth

Beyond a lack of compounding, a limited growth opportunity can often be value destructive. Low growth can lead management teams under pressure from shareholders to make poor investment and/or business decisions.

Emerging Market performance during US rate cycles

Investors often look to US rate cycles when making investment decisions. In the case of Emerging Market stock market performance, there is no strong historical correlation between it and the US rate cycle, either absolute or relative to the MSCI World Index (figure one).

The impact of US rate cycles on Emerging Market equities is highly dependent on other key variables in play at the time. Such variables may include:

• the US growth outlook
• inflation dynamics
• market expectations for the path of US and domestic monetary policy
• the trajectory for Emerging Market corporate earnings.

These variables could have ramifications for the speed and magnitude of US rate easing, the behaviour of USD global liquidity, as well as investor sentiment.

These factors could, in turn, impact Emerging Markets via:

• global trading activity, where Emerging Markets are typically a beneficiary
• the strength of the USD as a persistently strong USD tends to weigh on Emerging Markets’ relative performance as liquidity drains from Emerging Markets
• how Emerging Market stock markets are traded, given that these stocks are typically treated as a high risk asset.

All else being equal, if the US rate cutting cycle is taking place during a backdrop of sharply deteriorating ‘recessionary’ US economic growth, such as that experienced in 2000-2001 and 2008-2009, this is likely to be a headwind to Emerging Market equities. In contrast, in times of supported US economic growth, stable inflation dynamics and an anticipated managed rate easing cycle – such as 2016-18, possibly 2024 – Emerging Markets are likely to be much less impacted (figures two and three).

Emerging Markets typically price global risks much more quickly than is the case in developed markets, and then subsequently correct once the perceived risk has been better quantified by the market. For example, Emerging Markets underperformed developed markets on the prospect of the US tapering its QE program in 2013 before recovering strongly.

US rate cycles also have differing impact on different Emerging Markets, reflecting their heterogeneity and fundamental health. Recall the ‘Fragile 5’ Emerging Market economies called out in 2013 for being vulnerable to a removal of USD liquidity given the need to finance their current account deficits. Emerging Markets now have, on aggregate, a trade surplus. Therefore, such concerns are no longer valid (with certain exceptions).

In anticipation of a US rate cutting cycle in 2024, Ashmore believes the impact on Emerging Market equities could be strongly positive, primarily through improving the visibility of several Emerging Market tailwinds and by seeing market leadership change to Emerging Market’s favour.

Positive characteristics in play for Emerging Markets include:

• Emerging Market macroeconomic fundamentals – economic growth, fiscal and external balances – are generally in good health, more so than developed economies.
• Emerging Market policy makers have already begun easing monetary policy, buoying domestic activity. This would likely broaden to more countries and accelerate when the Fed does the same.
• Emerging Market currencies are cheap and the USD expensive, which reduces the risk of a return to persistent USD strength.
• Emerging Market earnings expectations are robust and well placed to grow.
• Investor positioning in EM is light
• Emerging Market equity markets trade at undemanding valuations and at a historically wide ~40% valuation discount to developed markets (twice the long run average).

Investing in Emerging Market equities offers a compelling opportunity for investors seeking diversification, higher growth potential and access to dynamic economies. Despite the inherent risks, the benefits of exposure to rapidly expanding markets, favourable demographics and untapped opportunities outweigh the challenges. By carefully navigating these markets, an active investor can capitalise on the potential for alpha generation and long-term wealth creation, making Emerging Market equities an essential component of a diversified investment portfolio.

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The information included in this article is provided for informational purposes only. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Ashmore Investment Management, PAN-Tribal Asset Management Pty Ltd, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article.