The unappreciated evolution taking place in emerging markets

By any measure, emerging market equities look cheap, and they have significantly underperformed their developed peers in the past decade. But over the longer term it is a different story. Since 2001 the MSCI Emerging Markets index¹ has generated an annualised return of 7.4%, compared with 6%² from the MSCI World index³.

Falling interest rates in China and supportive measures from the government could see a return to form for the sector in 2024 and lead shares to rerate higher.

To my mind, too many investors have an insufficient exposure to this unloved asset class. I believe the low valuations and the dividends being generated mean it could be a good time to review that position. Emerging markets have evolved considerably in recent years, but many investors may not have noticed.

Emerged markets?

Fifteen years ago when I began working in this area, around 60% of the market was in natural resources, industrial materials and financials³. Emerging markets were the mine and factory of the world. But they depended on global economic growth. When the US sneezed, Asia and Latin America caught pneumonia.

Today I would argue that you have a much more diverse group of companies and sectors in emerging markets – around 20% is in technology and 15% is in consumer goods shares. Energy and natural resources make up just over 10% of the market⁴.

Historically, investors preferred to enjoy exposure to fast-growing emerging economies through companies such as Louis Vuitton, Diageo and Unilever – quality businesses from the West with developed market standards of governance.

Today, powerful brands are appearing in many emerging market countries. The top three Chinese phone manufacturers now sell more units in China than Apple⁵. The Chinese car manufacturer BYD has just overtaken Tesla as the biggest global seller of electric vehicles (EVs)⁶ – 64% of total EV production is now in China⁷.

Global giants

Emerging markets are home to some global giants. Korea’s Samsung is the world’s biggest manufacturer of smartphones⁸. The rapid growth of artificial intelligence will depend on the world producing enough high-quality chips; TSMC – the Taiwan Semiconductor Manufacturing Company – is one of the most successful manufacturers of these. The clue to its origins lies in its name, but it is now a multi-national company and is currently building a plant in Arizona⁹.

In short, manufacturing quality has improved substantially. So have accounting standards¹⁰. Meanwhile, the economic growth of areas such as Asia means there is less dependency on the US. So the best companies are less exposed to the changing circumstances of the western world and are therefore more robust.

We should also mention dividends. Tough experience has taught Asian management teams to be conservative. We see little evidence of reckless expansion or M&A (merger & acquisition) activity. Instead, we find lots of companies using the cash they generate to pay out dividends or buy back shares – a sensible strategy when valuations are depressed. Ultimately, of course, share buybacks drive dividend yields upwards.

Opportunity in distress

The general perception of emerging markets is of higher risk. I have established that it is possible to find companies that look as strong as any in the developed world. But we should not ignore the rest of the market. Some of our best opportunities last year came from countries in distress.

Turkey has been an outstanding equity market in the past three years. Inflation there has been well over 50% in this time¹¹ , while political risk and unconventional monetary policy have triggered further warning alerts. Yet despite this, share prices have surged¹².

One of our best investments of the past three years has been Sinotrans in China – a logistics and freight company akin to DHL. At the time of our first investment, the world was in lockdown, with no clear sign of when activity would resume. Since then, it has delivered a total return of more than 50%¹³. Dividends have generated over half of the return for shareholders. The broader Chinese equity market is down 25%¹⁴ in the same period. Distressed investing can lead to great outcomes for the patient and selective.

The message for investors is a positive one

The IA Global Emerging Markets sector is a fifth of the size of the IA Global sector¹⁵ and yet emerging market countries account for at least 50% of global GDP and will drive economic growth in the coming decades¹⁶.

This market has evolved. This is too big an opportunity set for investors to be excluding from their portfolios because of dated perceptions. There is a strong argument to be made that many countries defined as emerging markets deserve promotion out of that league. Even within countries that most of us would consider still emerging – and maybe even in distress – there are outstanding opportunities for the smart investor.