Actively investing in emerging market equities

Gordon Fraser
Co-head of the Global Emerging Markets Equities team, Blackrock fundamental active equity

Cycles matter more than stories

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

Many investors turn to emerging market (EM) equities seeking exposure to topical trends ― or stories. They buy into ideas such as “India has a growing middle class” or “Asia is the world’s fastest-growing region.” While many of these storylines may bear out in the long run, they tend to lack predictive power for asset returns. And investors focused on these less potent drivers may be missing the larger but more opaque risks associated with the various stages of the economic cycle.

Risk: Emerging market investments are usually associated with higher investment risk than developed market investments. Therefore, the value of these investments may be unpredictable and subject to greater variation.

Hook, line … and potential sinker

Buying into any EM “story” means finding stock expressions to ride that narrative out to its conclusion. But investors can be disappointed when the classic buy-and-hold strategy fails to meet their return expectations.

The truth is: It’s hard to find long-term winners, especially in emerging markets. We looked for companies that could consistently beat our assumptions for annual nominal gross domestic product (GDP) growth (5% in the U.S. and 10% in EM) over 10 years. Factors we considered were sales, net income, earnings per share and EBIT. Less than 5% of companies met the criteria on any one of these metrics.

Risk: There can be no guarantee that the investment strategy can be successful and the value of investments may go down as well as up.

Some may read this to mean there is limited potential in EM stocks. For us, to the contrary, this suggests that active, bottom-up stock selection can make a meaningful difference in EMs ― where country- and security-level dispersion in great, as is the potential for skilled managers to add alpha.

When short-term growth is above trend, many investors extrapolate the higher trajectory and buy aggressively. Conversely, they often sell when growth is below trend. Our experience shows that cycles typically revert to their mean level of growth. For that reason, we are often selling late in the cycle when others are buying ― and buying in the early cycle when others are selling.

No single cycle

We believe economic cycles, not trends, reveal opportunities in EM equities. Yet there is no single EM economic cycle. The more than two dozen countries in the popular EM universe are heterogeneous, idiosyncratic and often at different stages in their economic cycles. They also have their own currencies, can be large commodity exporters, such as Brazil and Russia, or commodity importers, such as Turkey. The fact that EMs are such a varied set means there is ample opportunity to add value through asset allocation.

To assess a country’s economic trajectory, we monitor shifts in external accounts, fixed income, liquidity supply and economic activity. We have found these macro indicators to be reliable predictors of equity returns, historically contributing 20%-30% of alpha in our EM strategy (Source, BlackRock RQA, Nov 2020). We consistently move capital from countries we believe are in a later stage of the economic cycle (activity surge) to those in an earlier stage (healing). We would rather be long a country with poor but improving macro conditions than one with a good but deteriorating economy.

Understanding where countries are in their economic cycles also helps us decide whether the risk-reward favours buying the dips. Our macro research is critical to navigating EM “heart attacks” — sharp sell-offs in one or more countries. We typically see two to three heart attacks in any given year. The coronavirus pandemic may test those limits, but our research framework helps us to gauge how a country’s economy may cope with the virus and its economic fallout.

Risk: There is no guarantee that research capabilities will contribute to a positive investment outcome.

No single cycle

Source: BlackRock, as at end October 2020, for illustrative purposes only, not meant to depict actual data. Country placement is not indicative of where these countries are in their actual economic cycles.

Exploiting, not avoiding, volatility

 Alongside the significant country-level dispersion in EMs is a high degree of individual stock variation ― and volatility. Consider that roughly 65% of stocks in the MSCI EM Index moved at least 40% annually over the past decade (Source, Bloomberg December 2019). This can be off-putting to many investors, yet volatility has two sides. “Bad volatility,” the big up and down benchmark moves, can be painful. “Good volatility,” however, is the enormous dispersion among stocks and countries, which can be fertile ground for active investing.

The coronavirus shock has ensured the continuation of EM volatility into 2020. The swings have been evident not only at the broad EM index level, but in the styles within it, as shown below.

Flexibility matters in EMs

On average, most EM managers tend to perform best when the growth style is in favour, as in 2019, and underperform when it is out of favour, as in 2018 (Source, Morningstar December 2019). Our combination of bottom- up stock selection and style flexibility allowed us to achieve return consistency regardless of broad market leadership. Stark country dispersion offered tactical opportunities to adjust our portfolios in pursuit of alpha. Our team of analysts examine and parse roughly 3,500 liquid EM stocks (Source, Bloomberg, November 2020), focusing on companies where our view on earnings or cash flow differs from that of the broader market over a one- to two-year horizon.

Flexibility matters in EM

The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results and should not be the sole consideration when selecting a product or strategy. Source: BlackRock, as of end September 2020. Factor returns are based on BlackRock’s Fundamental Equity Risk model. 2020 returns are year-to-date through March 31. Returns are based on BlackRock Global Emerging Markets GIPS Composite, alpha is relative to MSCI Emerging Markets Index. Net of fees $USD. Note: Gordon Fraser took over management of the portfolio in March 2017.

Beyond COVID-19

In the economic transition to a post-COVID 19 world, we will likely revisit a low-growth, low- return environment globally. Yet the sheer scale of monetary and fiscal support should underpin strong liquidity. Against this backdrop, we believe EMs can offer attractive relative growth and return potential.

EM equity valuations remain compelling compared to developed markets having, in March 2020 hitting their lowest level on a price-to-book basis since the tech bubble of the late 1990s (Source, Bloomberg November 2020), as shown in the chart below. Currencies have adjusted and large-scale stimulus should put a cap on the U.S. dollar, historically a positive for the asset class. And in a world of increased dispersion, we see EMs offering more diversification benefits as correlations with DMs decline. An EM-to-DM stock correlation of 79% in the past decade represents a decline from its mid- 2000s peak. The inclusion of China A shares in the MSCI EM Index, a process begun in 2018, could help to further lower these correlations. MSCI data shows the China A shares correlation to developed stocks at just 57% over the past three years (Source, Bloomberg Nov 2020). As China A shares become a larger portion of the broad EM index, this could enhance the diversification potential of EM stocks.

Risk: Diversification and asset allocation may not fully protect you from market risk.

We believe China has provided strong relative performance among EMs during the COVID-19 crisis. While we expect the Chinese market can show continued resilience in the short term given the government’s unprecedented stimulus package, we are looking for future market outperformance to come from other countries. In all, we remain optimistic and actively engaged to capitalise on all the emerging world may have to offer.

Attractive entry point

Price-to-book value of EM stocks (based on MSCI EM Index), 1995-2020

Attractive entry point

The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results and should not be the sole consideration when selecting a product or strategy. Source: BlackRock, with data from Bloomberg, as at end Nov 2020. The price-to-book ratio compares a company’s market value to its book value, or the net assets of the company. Based on data from the MSCI Emerging Markets Index. Indexes are unmanaged and one cannot invest directly in an index.