Take the hand of an active manager, and venture into emerging markets.
Does value investing pay? The idea is simple enough. Invest in decent businesses with sound balance sheets and unloved share prices. The strategy was best articulated by the great Benjamin Graham in his books on investing. While his ideas are more than 80 years old, plenty of fund managers still use them, largely because they have been proven to work in the past.
A legion of studies back this up. London Business School (LBS) professors Paul Marsh and Elroy Dimson regularly crunch the numbers for the Credit Suisse yearbook – buying “cheap”, good-quality stocks tends to beat a standard benchmark over ten to 25 years.
Now, value investing doesn’t always make sense. Sometimes – in certain sectors, or at certain times – it’s better to buy the hyped-up momentum stocks beloved of growth investors. Even the LBS academics’ latest tome notes that buying into the technological “bleeding-edge” sectors systematically has substantially outperformed at the sector level.
But in general, over the very long run, if you buy a decent stock at a low price with a hefty margin of safety, you should make a more-than decent return.
The emergence of the Brics
However, it’s worth remembering that Graham and his post-war contemporaries were working in a particular universe of shares – consisting solely of what we now call developed-world equities. Emerging markets didn’t really emerge until the mid-1980s.
Of course, some people have long been putting money into Latin America and Africa – this global diversification was very much at work in the Victorian era, in which many of our oldest investment trusts have their roots.
But for most investors, it was the rise of the Brics (Brazil, Russia, India and China) that redrew the mental map of global investing. Within the space of a few decades huge new capital markets emerged, with tens of thousands of newly listed businesses vying for our attention. Emerging-market investing was born, and it has produced impressive returns, even allowing for the volatility of investing in places with less well-developed corporate governance and legal structures.
In fact, emerging-market equity and bond investing is now so mainstream that it’s worth asking whether “traditional” investing principles – especially those based on “value” – have relevance to the developing world. In short – does value investing work in these markets?
You’d think that it should. Much of the power of value investing is based on two simple insights. Firstly, that investors are influenced by their (sometimes irrational) behaviour. Secondly, if a business is well run, then it should start to behave in a sensible and prudent fashion in terms of cash flow and profits.
Let’s start with investors’ behavioural biases. In the developed world, the boom/bust cycle is very familiar to us. Investors get terribly enthusiastic about some stock/idea/theme/sector. They bid prices up too high.
They turn profoundly sceptical once the bubble pops. At the point of maximum cynicism and despair, value investors start to emerge. They argue that investors overreact both on the way up and on the way down – they overbid prices in the bubble, then undervalue stocks in the bust. So if an investor is willing to do the hard work of due diligence and financial analysis, they’ll find good-quality businesses that have been unfairly oversold.
This is where the second part of the process comes into play – the behaviour of the businesses themselves. History suggests that firms are just giant capital-allocation machines. Investors give businesses their money.
They expect that capital to be wisely allocated in the form of new investment and hiring staff. Businesses grow, then produce capital, and eventually an inflection point emerges. Growth rates may start to slow, and the managers conclude that maybe they can’t quite find enough opportunities for investing new capital. But all that money flowing into the business needs to find a home.
Some new capacity might make sense, but paying off the debt might also be a good idea. The managers may start to repay money to shareholders in the form of dividends. In the best of all worlds, the business will keep growing, profits will keep rising, and the cash will keep mounting up – with a progressively increasing dividend the net result.
This logic should apply to businesses listed in the emerging world. Investors might, for instance, worry about state interference in big Chinese-listed businesses. But their most powerful owner – the Chinese state – might want to see a return on its investment via a dividend. This is exactly what has been happening across the developing world.
Dividend payouts have been rising – not necessarily because managers are becoming more munificent to their Western shareholders, but because local strategic investors want some cash back. So at this point, value investing in emerging markets should become a smart idea, especially if the focus on dividends becomes prevalent.
Disappointing performance
Yet the reality, judging by numbers from the UK funds in this sector, suggests a different story. Over the last five years, I’ve seen several emerging-market dividend-focused exchange-traded fund (ETFs) and traditional unit trusts launched. I keep an eye on about six ETFs and three actively managed funds (including one investment trust).
By and large, the ETFs haven’t produced the returns I’d have hoped. Take 2014. All of the ETFs (issuers include First Trust, iShares, PowerShares, and State Street, with Wisdom Tree emerging late in the year) produced losses in the year.
To be fair, the MSCI Emerging Market index, the key benchmark, returned a loss of about 1.8%, which the Invesco PowerShares RAFI tracker slightly bested. But overall, the ETFs haven’t produced the results I’d have hoped for.
This is pretty much true for the last few years in general, with emerging-market value trackers something of a disappointment. The story is largely the same in much of the actively managed space, although a few funds have bucked the trend – notably Thomas Naughton’s Prusik Asian Equity Income fund and Edward Lam’s PFS Somerset EM Dividend Growth fund.
These two have built a competitive edge in terms of dividend-orientated value investing, with no evidence of that skill flagging in recent months. Both funds are up by more than 6% year-to-date against a small gain for the MSCI EM index.
Beware the value traps
Dig beneath the surface and we can start to piece together a fascinating story. Many of the most interesting dividend-orientated companies in emerging markets are in fact what we call “value traps”. In other words, they look cheap, their shares have crashed and the yield is chunky – but that’s because the market has rightly decided that the business/sector is a no-hoper.
It might be too focused on businesses in places like Taiwan, for instance, that are struggling to produce enough growth to keep up the dividend cheques. Or it might be in the oil sector in Russia, where yields are big but no one wants to own the stock, given the macro/political risks.
In simple terms any mechanical strategy bundled into a cheap tracker structure, which in turn focuses on yield and a low share price, runs the risk of making frequent cock-ups – ie, buying the wrong stocks with poor balance sheets at the wrong prices.
Active managers in this area charge a lot more for their stock screening and due diligence – a total expense ratio (TER) of 1.2% to 1.3% a year is fairly standard – but I suspect it’s probably worth it for the next few years.
So if you are going to track the ongoing growth of emerging markets, you’ll probably do no better than to invest in the Somerset EM Dividend Growth fund and the Prusik Asian Equity Income funds already mentioned. Both are well run, neither charges too much, and I think they are both in the sweet spot for the long term.
Just as it has worked in developed markets, I suspect value investing will be the big outperformer in emerging-market equities in the next 20 years. Growth managers will continue to make money in some markets, but the patient application of value ideas, using dividend payouts as a core corporate discipline, will be the greatest source of outperformance.
Keep an eye on this ETF
Meanwhile, the rise of ‘smart beta‘ (and other more sophisticated ways of filtering stocks) will make the ETFs on offer more compelling. Keep an eye on Wisdom Tree’s Emerging Markets Smaller Cap ETF (LSE: DGSE).
This very new, small fund marries together value ideas based on dividends, with a focus on smaller businesses (which history suggests also tend to outperform). It’s way too early to say whether this will be a future star – but it’s one to watch.
| Selection of emerging-markets dividend income ETFs and funds | |||
|---|---|---|---|
| Fund | TER | 2014 return | Assets |
| First Trust EM Alphadex ETF | 0.80% | -4.3% | £4.4m |
| iShares EM Dividend ETF | 0.65% | -7.5% | £265m |
| SPDR State Street S&P EM Dividend ETF | 0.55% | -2.4% | £63m |
| PowerShares FTSE RAFI EM ETF | 0.65% | -1.6% | £8m |
| WisdomTree EM Equity Income ETF | 0.46% | N/A | £12m |
| WisdomTree EM Smaller Companies Income ETF | 0.54% | N/A | £2m |
| PFS Somerset EM Dividend Growth fund | 1.33% | 8.1% | £927m |
| Prusik Asian Equity Income | 1.21% | 24% | £850m |
| JPMorgan Asian Equity Income investment trust | 1.32% | 6.6% | £344m |