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WITH emerging markets having underperformed developed markets substantially over the past three years, they are once again trading at a justified discount.
And while the discount isn’t yet extreme enough to get as excited about prospective investment returns from these markets as we were in the early part of the century, what does pique our interest is the level of neglect among global investors of emerging markets.
The chart below show how underweight investors are in emerging markets generally, and South Africa specifically.
This is a major sea change from three years ago. It appears that, from a combination of general neglect and a discount valuation, a buying opportunity in emerging market equities – and by implication also South African equities – could happen within the next couple of years.
This current situation is a complete turnaround since South Africa’s inclusion in the BRICS in 2010.
At the time, emerging markets were tremendously popular with investors – especially the so-called Bric (Brazil, Russia, India and China) markets.
There was a lot of noise and excitement about South Africa joining this "select" club of fast growing economies and investors thought that such economic growth would possibly also presage fast growth in stock market prices as well.
However, what was actually happening – as with so many market fads – was that market excitement merely reflected what had already happened – a peek into the rear-view mirror, so to speak.
Table 1 below shows how well the stock markets of the Bric countries and South Africa had performed in the preceding years.
We argued at the time that South Africa had benefitted from its status as an emerging market, but with a "twist".
After the emerging market crash of 1998 and during the tech boom that followed in 1999 no one wanted to know anything about emerging markets.
These markets were at that time neglected, unloved and cheap.
We argued that they benefitted in the decade that followed from the (not so) virtuous cycle of attracting more of the big global indexed – or quasi indexed – money the better they did.
The "twist" part of the argument referred to the historical scarcity of capital in South Africa, due initially to sanctions and then to the desire of locals to move their capital abroad, almost at any cost.
This meant that capital invested in South Africa had earned very high returns.
At the time, we said that we guessed that emerging markets would earn less going forward than the consensus believed as competition increased, driving down returns for all concerned.
What’s happened since then?
Table 2 updates the figures in Table 1, showing returns from select emerging markets in the 10 years before admission to the Brics club (from Table 1), and compare these to the 12 months and three years to August 2013.
It’s clear that the excitement in 2010 around these markets was informed mainly by what had happened in the previous 10 years and had no predictive power.
Valuation is a better predictor of returns than economic activity
One of the interesting points to note is how little correlation there is between economic growth and market returns.
So, if economic growth rates can’t be used to predict market returns, what can?
We’ve found over time that valuation matters much more than economic activity when determining future returns.
By 2010, emerging markets were trading at a premium to developed markets on a Price-to-Book (P/B) basis.
Of course, the corporate governance, juristic and political environments of emerging markets relative to developed markets has historically justified a discounted rating.
So when emerging markets started trading at a premium from 2008 to 2010, alarms bells started to ring for value investors such as ourselves. The returns over the past three years in Table 2 therefore came as no surprise.
There are some good lessons that can be learned from all this:
- Don’t confuse excitement about a particular market sector or region with a good investment opportunity.
There’s normally a strong inverse correlation between the level of excitement and the level of returns of any prospective investment.
- In fact, excitement is normally based on historic returns. Over time, returns tend to regress to the average, so particularly strong periods are generally followed by weak periods.
Investors who recognise this will save themselves a lot of pain.
- Stock market returns have almost nothing to do with economic growth rates and everything to do with valuation levels.
* Piet Viljoen is the chairperson of RE:CM value based asset manager. Views expressed are his own.
And while the discount isn’t yet extreme enough to get as excited about prospective investment returns from these markets as we were in the early part of the century, what does pique our interest is the level of neglect among global investors of emerging markets.
The chart below show how underweight investors are in emerging markets generally, and South Africa specifically.
This is a major sea change from three years ago. It appears that, from a combination of general neglect and a discount valuation, a buying opportunity in emerging market equities – and by implication also South African equities – could happen within the next couple of years.
This current situation is a complete turnaround since South Africa’s inclusion in the BRICS in 2010.
At the time, emerging markets were tremendously popular with investors – especially the so-called Bric (Brazil, Russia, India and China) markets.
There was a lot of noise and excitement about South Africa joining this "select" club of fast growing economies and investors thought that such economic growth would possibly also presage fast growth in stock market prices as well.
However, what was actually happening – as with so many market fads – was that market excitement merely reflected what had already happened – a peek into the rear-view mirror, so to speak.
Table 1 below shows how well the stock markets of the Bric countries and South Africa had performed in the preceding years.
We argued at the time that South Africa had benefitted from its status as an emerging market, but with a "twist".
After the emerging market crash of 1998 and during the tech boom that followed in 1999 no one wanted to know anything about emerging markets.
These markets were at that time neglected, unloved and cheap.
We argued that they benefitted in the decade that followed from the (not so) virtuous cycle of attracting more of the big global indexed – or quasi indexed – money the better they did.
The "twist" part of the argument referred to the historical scarcity of capital in South Africa, due initially to sanctions and then to the desire of locals to move their capital abroad, almost at any cost.
This meant that capital invested in South Africa had earned very high returns.
At the time, we said that we guessed that emerging markets would earn less going forward than the consensus believed as competition increased, driving down returns for all concerned.
What’s happened since then?
Table 2 updates the figures in Table 1, showing returns from select emerging markets in the 10 years before admission to the Brics club (from Table 1), and compare these to the 12 months and three years to August 2013.
It’s clear that the excitement in 2010 around these markets was informed mainly by what had happened in the previous 10 years and had no predictive power.
Valuation is a better predictor of returns than economic activity
One of the interesting points to note is how little correlation there is between economic growth and market returns.
So, if economic growth rates can’t be used to predict market returns, what can?
We’ve found over time that valuation matters much more than economic activity when determining future returns.
By 2010, emerging markets were trading at a premium to developed markets on a Price-to-Book (P/B) basis.
Of course, the corporate governance, juristic and political environments of emerging markets relative to developed markets has historically justified a discounted rating.
So when emerging markets started trading at a premium from 2008 to 2010, alarms bells started to ring for value investors such as ourselves. The returns over the past three years in Table 2 therefore came as no surprise.
There are some good lessons that can be learned from all this:
- Don’t confuse excitement about a particular market sector or region with a good investment opportunity.
There’s normally a strong inverse correlation between the level of excitement and the level of returns of any prospective investment.
- In fact, excitement is normally based on historic returns. Over time, returns tend to regress to the average, so particularly strong periods are generally followed by weak periods.
Investors who recognise this will save themselves a lot of pain.
- Stock market returns have almost nothing to do with economic growth rates and everything to do with valuation levels.
* Piet Viljoen is the chairperson of RE:CM value based asset manager. Views expressed are his own.
