Emerging markets are on fire. With regional stocks rising by 28% to end-September, momentum and forward-looking growth have been the leading investment styles behind this surge. And stocks with high 12-month growth and forecast revisions are at the head of this pack. (See Figure 1.)
A closer look at the performance of the FY1 estimate revisions factor reveals the importance of China, the world’s second largest economy, whose revisions account for more than half of the factor’s return across emerging markets. Stocks such as Alibaba, China Evergrande and Country Garden Holdings have all contributed to this factor’s success. And though the factor has been pervasive across sectors, it has been most effective in Consumer Services, with stocks like JD.com and Geely Automotive at the fore.
So will the trend continue? And where should you be investing? Money continues to flow into emerging markets, with indexes hitting highs not seen for six years, as investors see better value in these economies than in developed markets.
Other notable factor successes include low foreign sales (domestically oriented stocks), low beta, momentum, and some profitability measures. Manager Style Tilts™ have been favorably positioned to benefit from this factor backdrop. Figure 2 shows the Peer Skyline™ for retail funds benchmarked against the MSCI Emerging Market Index.
Have investment managers taken advantage?
Manager Style Tilts™ are spread evenly across the peer group, with the number of funds biased to high levels of a given factor roughly balanced by those with lower exposures. But there are several interesting exceptions. For example, most funds are biased towards smaller caps, and to stocks with low gearing. With larger emerging market stocks outperforming this year to date, this would have provided a headwind for such managers. But funds have been better aligned with higher profitability measures and particularly with revisions and momentum: 70% of funds have a pro-momentum bias, and two thirds are tilted towards earnings revisions.
Such positioning would also have fared well over longer periods.
Could there be another EM Value rally?
Over the past five years many popular factors have delivered attractive returns in emerging markets, again led by revisions and momentum. But other styles deserve attention, including value and quality, where returns have been almost as good. And looking back over the last two decades, the performance rankings have been dominated by value and profitability factors, whereas momentum has been much weaker historically. Strategies based around high cashflow/price and earnings yield have proven to be quite resilient over that period.
If these patterns were to recur, and value stocks started to rally (as witnessed in 2016), many of the funds in this peer group would miss out. Currently, at least half of the funds are biased towards higher multiple stocks, and closer to 70% have tilts away from book-to-price.
What might be the catalyst for such a resurgence? The recent episodes of weaker performance for value factors have tended to coincide with market rallies, when cheaper stocks have been left behind by more glamorous growth stories. Any short-term corrections would likely hit over-promoted growth stocks hardest, leaving value stocks as the beneficiaries. On the other hand, despite the sabre rattling in the Korean Peninsula and the possibility of political and credit issues impacting China, many investors see the bull run extending into the mid-term. After all, emerging markets still lag developed stocks post-financial crisis. If such equities are supported by strong corporate earnings, then that too could be good for value factors; when earnings are plentiful investors often start shopping around for bargains.
Either way, funds with a nod to valuation alongside profitability and forecast revisions would be well placed to benefit. Around a quarter of the funds in our Emerging Market Peer Group have above-benchmark biases to valuation, profitability and revisions.
It’s decision time, as emerging markets investment opportunities are still drawing investor interest. Factor-based analysis reveals detailed insights into style and factor performance to position portfolios effectively and seize the expected continued growth in emerging markets.