Market Perspectives

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Emerging markets: A re-emerging opportunity


It is hard to ignore the returns provided by the U.S. equity market in recent years. Equity has advanced at an incredible pace and provided a tailwind that most market experts agree is likely to slow in the coming years. Massive amounts of liquidity, declining interest rates and robust economic growth combined to fuel this historic run. Where will the next generation of investors find such potential returns?

Investors may be wary of emerging markets

The U.S. economy expanded steadily for many years on the strength of population growth, a position as the world’s leader in innovation and technology, and an ever-wealthier consumer base. We believe the U.S. and other developed economies still offer potential investment opportunities, but many of the underlying structural growth drivers are slowing. By contrast, emerging markets still are early in their development. A growing consumer population with increasing wealth, improving economic and corporate fundamentals and an explosion of new industries offer the potential for investment in a wide range of companies. The U.S. and China offer an example of the differences in growth rates over time, as shown in Chart 1.

Despite some of these well-documented trends, there still is negative sentiment among many investors toward emerging markets. It’s common for individuals to take recent events and extrapolate them to the future. This behavioral tendency, known as “recency bias,” is prevalent in investing. A common recency bias today has led many investors to believe that they can’t “make money” in emerging markets. The volatility of recent years has caused those investors to overlook longer-term returns in emerging market equities. For perspective, Chart 2 shows an investment during the 2000s in emerging market equities would have had an 8.82% annualized return, exceeding developed market returns in that period.

Chart 1: China per capita GDP forecast to grow 7.82% annually while U.S. growth slows

Source: International Monetary Fund, per capita gross domestic product, 1988–2018, *2024 forecast. CAGR = compound annual growth rate. Past performance is no guarantee of future results.

Chart 2: Emerging market equities outperformed developed market equities since late 2000

Source: Morningstar Direct; annualized returns for period 01/01/2001 to 10/31/2019; emerging market equities represented by MSCI Emerging Markets Index, large-cap U.S. equities represented by S&P 500 Index, small-cap U.S. equities represented by Russell 2000 Index, and international equities represented by MSCI EAFE Index. It is not possible to invest directly in an index. Past performance is no guarantee of future results.

Volatility can be expected in emerging market equities because those countries generally are earlier in their lifecycles and often are less stable and prone to political and economic shifts. However, the fact that they are earlier in their lifecycles leads us to believe they present opportunity. Recently, geopolitical events and a barrage of negative headlines have caused many investors to lose their long-term perspective on emerging markets and sell the asset class. Misguided human behavior often can create opportunity, particularly in investing. We believe this has the potential to be such a situation.

Strong fundamentals prevail over time

As global economic growth decelerates, we think the long-term fundamentals of emerging markets look more attractive. There are clear and visible drivers of this growth:

  1. Innovation: Investing in emerging markets, for the greater part of the last 20 years, was largely focused on a narrow universe of state-run energy, financials, utilities and telecommunications companies — essentially, the basic needs of a country. In recent years, there has been a dramatic shift in the profile of emerging market industries, as shown in Chart 3. Technology, consumer and other “new economy” companies have grown in quantity and size. Much of this growth is attributable to China, whose large economy has provided the capital and scale for many of these innovative companies to grow into some of the world’s leading businesses.
    Chart 3: Emerging markets shifting to new economy sectors

    Source: FactSet; percent of the MSCI Emerging Market Index represented by each sector. It is not possible to invest directly in an index. Past performance is no guarantee of future results.

    • Mobile technology: The buck stops with China when it comes to mobile. It is home to nearly 800 million mobile internet users¹ and is the world’s largest manufacturer of smartphones.
    • Memory chips: Memory chips are crucial in a datadriven world. South Korea is home to Samsung Electronics Co. Ltd. and SK Hynix, Inc., two of the world’s largest memory chip manufacturers.
    • Semiconductors: 40% of the world’s semiconductors are made by three major emerging market-based producers.
    • Mobile payments: China’s mobile payments industry is 50 times that of the U.S.1
  2. Consumption: Export-led growth has been the foundation of many emerging markets, but consumption is the new paradigm. At the peak in 2006, China’s exports as a percent of gross domestic product was 36%, but as of 2018 had dropped to 19.5 %.² Less reliance on exports is an important economic shift, particularly in times of global trade uncertainty.
  3. Valuation: Because the underlying structural factors driving emerging market growth remain solid, we believe the valuation gap between companies in emerging markets and the U.S. is likely to narrow. Emerging market valuations are at a discount to the U.S., as shown in Table 1. Valuation alone will not support price appreciation in emerging market equity, but we also expect earnings-per-share growth to reaccelerate. Earnings growth in emerging markets trailed the U.S. in 2018 and 2019, but there are market expectations for it to regain a higher rate of growth.
  4. Table 1: Emerging markets valuations below U.S.
    CAPE Ratio P/E Ratio P/B Ratio P/S Ratio 2020 EPS Growth Estimate







    Emerging Markets






    Sources: Valuations, Star Capital AG; Earnings data, FactSet. Emerging market equities represented by MSCI Emerging Markets Index, U.S. equities represented by S&P 500 Index. It is not possible to invest directly in an index. CAPE = cyclically adjusted price to earnings, which uses real earnings per share over a 10-year period to smooth fluctuations in corporate profits over the business cycle; P/E = price to earnings; P/B = price to book; P/S = price to sales; EPS = earnings per share. Past performance is no guarantee of future results.

  5. Reform programs: Reforms have been positive catalysts in many emerging markets and we think this will continue. Recent examples include Brazil and India, where both are focused on structural reforms. We believe these measures in both countries are likely to reshape fiscal imbalances and support sustainable economic growth. In addition, we think these combined actions make their banks much better positioned to weather future credit events or market shocks.

The investor's dilemma: Active or passive?

The debate between proponents of active and passive investing styles may never be settled. The recent period of cheap money has distorted many fundamental characteristics of companies and led many to question the growing dominance of passive investing. We believe there are asset classes in which investors may benefit from an active management approach, and emerging markets is one such asset class. We think there are fundamental problems with passive investing in emerging markets:

  1. State Owned Enterprises (SOEs): We recognize that all SOEs are not bad. Some are longstanding, well-run companies with dominant market share. Because these companies typically are so mature and have high market share, they are large companies with big market capitalizations and large allocations in the major emerging market index. However, they can be inefficient capital allocators and often are not good stewards of shareholder capital. We therefore think many of these companies should be avoided. There are six SOEs in the top 20 holdings of the MSCI Emerging Market Index, meaning passive investors can’t avoid investing in them.
  2. Chinese A-Shares: By November 2019, the MSCI Emerging Market Index will include 253 large-cap and 168 mid-cap China A-Shares stocks. These are the domestic shares that trade on the Shanghai and Shenzhen stock exchanges. As the index increases the allocation to China A-Shares, it opens a new potential risk to passive investors. The China A-Shares market has many highly indebted and poorly run companies with governance and transparency issues. Shares in some of these companies also tend to be volatile. In our view, these are companies that many investors would not want to own. However, it is important to note that there are well-run China A-Shares companies, too. An active strategy based on fundamental research can analyze each holding and be selective, unlike a strategy that simply tracks the index.
  3. Governance: Less transparency among companies in the emerging markets requires expertise and due diligence to recognize those with potential and avoid the poor ones. Exchange traded funds (ETFs), driven by quantitative metrics and market capitalization, are disadvantaged when it comes to discovering key company characteristics that are important for investment success. Active strategies can avoid governance issues that can result in value destruction.
  4. Country/currency risk: The immature nature of emerging market economies can lead to progress as well as disruption. Being aware of these changes and having the ability to manage these risks can provide value over time.

Changing landscape can present opportunities

We believe emerging markets present an important opportunity for investors. The landscape has changed dramatically and we think there are abundant opportunities. Emerging market equities remain relatively cheap on a valuation basis when compared to developed markets, and we think a likely reacceleration of earnings growth will support a valuations increase. While many investors have been reluctant to invest in this asset class, we believe most fundamental and investment characteristics argue in favor of a strategic allocation to emerging market equities. In our view, exposure to these regions through an experienced active manager has the potential to generate attractive long-term returns.

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Key Takeaways

  • Emerging markets historically have generated attractive returns for investors (with generally more risk than developed markets) and we believe they have good prospects going forward.
  • We believe the fundamentals of emerging markets make them more attractive for investment in the next 20 years than the past 20 years.
  • Emerging markets are at the forefront of tech innovation, but many still show signs of “inefficient” investment markets. That may provide advantages for active management.

Investment Team

Jonas M. Krumplys, CFA

Portfolio Manager

Aditya Kapoor, CFA

Portfolio Manager

Mr. Kapoor is assistant portfolio manager of the firm’s Core Equity investment strategy and assists the co-portfolio managers in idea generation, research, portfolio construction, and risk management efforts. He has been a member of the team since 2014. Mr. Kapoor is also a member of the firm’s equity research team, covering large cap core securities, consumer discretionary (cable, media, internet, internet and catalog retail), and health care (health care providers and services, health care technology).

Prior to joining Waddell & Reed in 2008 as an equity investment analyst, Mr. Kapoor was a summer associate at JPMorgan Chase & Co. in 2007 and from 2002 to 2006 he was affiliated with Sapient Corp. as a technology consultant.

Mr. Kapoor earned an MBA from The Johnson School at Cornell University and a Bachelor of Technology from the Indian Institute of Technology (IIT-Delhi). He is a CFA charterholder.

Brian Landy, CFA

Client Portfolio Manager

1 Source: The Economist, “Why Americans are warming to mobile payments,” 06/26/2018

2 Source: World Bank

The MSCI Emerging Markets Index is an unmanaged index comprised of securities that represent large- and mid-capitalization companies within emerging market countries. The S&P 500 Index is a float-adjusted market capitalization weighted index that measures the large-capitalization U.S. equity market. The Russell 2000® Index is a float-adjusted market capitalization weighted index that measures the performance of the small-capitalization segment of the U.S. equity universe and includes approximately 2,000 of the smallest securities. The MSCI EAFE Index is a free float-adjusted market capitalization weighted index designed to represent the performance of large- and mid-capitalization securities across 21 developed market countries in Europe, Australasia and the Far East. It is not possible to invest directly in an index.

The opinions expressed are those of the Ivy Investment Management Company and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through November 2019, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.