✔ The stabilization of commodity prices and cyclical improvement in the Chinese economy have driven a recovery in emerging-market stocks.
✔ Improving earnings and low valuations suggest this trend may be in the early innings.
✔ Defensive sectors are more expensive than cyclicals.
Interest rates: Higher, but still historically low
After struggling for years, emerging-market stocks posted strong returns in 2016 and have kept moving higher this year. The performance is thanks in part to the continued stabilization of commodity prices and an improving Chinese economy. How likely is the rally to continue—and have recent gains pushed valuations too high?
Viewpoints posed these and other questions to Sam Polyak, Jim Hayes, and Greg Lee, portfolio managers of the Fidelity® Emerging Markets Discovery Fund (FEDDX) and Fidelity® Total Emerging Markets Fund (FTEMX). The short answer: Despite the recent run-up in emerging markets, there are plenty of attractive values—if you know where to look.
Viewpoints: What’s been happening with emerging-market stocks?
Jim Hayes: Coming into last year, emerging markets had endured several years of slowing GDP growth, negative earnings revisions, and valuation compression, along with significant currency depreciation. Now GDP is finally rising—thanks in part to stabilization in the Chinese economy following last year’s fiscal and monetary stimulus from the Chinese government—and emerging-market stocks are recovering. These changes have begun a virtuous cycle of positive estimate revisions, stronger currencies, and expansion in stock valuations. I think we’re still in the relative early innings of that cycle.
Are you seeing attractive valuations among emerging-market stocks?
Sam Polyak: Valuations still look very good to me. There wasn’t much growth in the last few years due to the difficult economic environment, but it looks like earnings growth has bottomed, or come close to it.
Hayes: I agree that valuations remain very attractive. The gap between valuations in emerging and developed markets is toward the wide end of its historical range. Meanwhile, I believe earnings growth in emerging markets is likely to accelerate and eclipse earnings growth in developed markets. This is the kind of scenario in which investors typically want to own emerging markets.
Greg Lee: In some parts of the cycle, the businesses I like are too expensive, and in other parts everything appears to be cheap. At the moment, we are somewhere in the middle, but a good indicator that valuations are generally attractive is that I am not having too much trouble finding companies I like at palatable valuations. For example, I have found the industrials sector offers plenty of opportunities to own good companies with solid growth outlooks and decent management teams at reasonable valuations.
Are valuations attractive across the board?
Hayes: I tend to find better opportunities in value sectors. We’ve recently seen a rotation in global markets, and emerging markets are no exception. Relatively safe sectors such as telecom and real estate investment trusts (REITs) have gotten quite expensive as investors have sought out defensive stocks. I prefer the cheaper, more cyclical sectors such as financials and utilities. Although utilities generally are considered defensive in developed markets, they’re considered cyclical in emerging markets. The average price-to-earnings ratio for the MSCI Emerging Markets Index is about 15. The index for my fund, the MSCI Emerging Markets SMID Cap Index, is focused on smaller companies and the price-to-earnings ratio is roughly 12; utilities are trading at nine times earnings and financials at less than nine times. By contrast, telecom stocks are trading at 14.5 times earnings. At the country level, Russia’s market is at an average price-to-earnings ratio of six, and Korean stocks are trading at less than nine times earnings.
Lee: Defensive companies are still pretty expensive, while cyclical stocks are definitely cheaper—particularly in the industrials sector and especially among companies that are levered to a sustained upturn in global growth. There are reasons they’re cheap. For some capital goods companies, such as shipbuilding, the end market is oversupplied, and I think it will take several years of growth to drive a meaningful uptick in orders for new equipment. These companies remain cheap because investors are skeptical about whether we’ll see a sustained upturn in growth. In the shipbuilding industry, demand is driven by global trade, and there was a lot of overinvestment during the China boom. Another example are engineering and construction companies, where a lot of investment was driven by high oil prices. So if we see a sustained upturn in oil prices, we should see capital expenditures come back in the Middle East as economies there improve.
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What impact has the rebound in commodity prices had in emerging markets?
Lee: I believe that oil prices will continue to move higher but that the sharpest part of that rally has already occurred. At this point, oil prices still aren’t high enough to support full-cycle investment in enough oil and gas projects. But they’re close enough to avoid deep distress in the shorter term, which we would have seen if oil had stayed at $30 a barrel.
Polyak: There’s a difference between oil and commodities in general. Many companies involved in other commodities such as iron ore, steel, and copper cut investments in production capacity aggressively. Now the big question mark—as with oil—is demand. Demand has been relatively stable, but because supply has been cut so much for many commodities, there are shortages in these markets. These shortages are causing prices to move higher than they probably should be in a balanced supply-demand environment. While stock prices have moved higher, they’re still well below where current commodity prices would justify. If commodity prices can stay at these elevated levels, it would provide an underpinning for the shares.
Where are you finding opportunities these days?
Polyak: I see the most opportunity in e-commerce—particularly e-commerce platform companies, which tend to be relatively stable businesses. These companies continue to take market share from traditional retail and media. In emerging markets, consumers may not have developed the habits of going to a Walmart or turning on a cable TV and are much more likely to purchase goods or consume media via a smartphone or tablet computer. It’s a powerful force, and I believe there are some really good companies in this space. One of the largest e-commerce platforms, Naspers, is based in South Africa but is really a global company. It has a very strong presence in China and India. And there are very strong e-commerce companies in China, Korea, Brazil, and Russia. Many of these companies would trade much more expensively if they had a U.S. ZIP code. But because they’re in emerging markets, they tend to trade at a discount.
Lee: I tend to look for one-off opportunities—companies where I believe the merits of the business are being underappreciated by the investment community—more so than anything thematic. This is particularly the case in the industrials sector, where I own a wide array of companies. Some of these are cyclical businesses and some are defensive. Some look relatively cheap, while others may look a bit expensive but have hidden value, in my view. In all cases, I aim to pay less than I think the company is worth. Within energy, I think the better opportunities lie in companies with relatively strong cash generation, structural growth opportunities, and higher-quality management teams, all of which should allow these companies to outperform their lower-quality and less efficiently run peers over time.
Hayes: In financials, I see particular value among smaller banks in Korea and the frontier markets, as well as stock-specific opportunities in Brazil and India. On the utilities side, I see value in Russia and Brazil, with a focus on secular subsectors such as water and transmission rather than coal and generation, which face greater threats from alternative energy sources and regulation over the medium term. For instance, water utilities in Brazil remain largely off the radar from global investors and still trade at a big discount to global and emerging-market water utility peers.
What risks do you see for emerging-market stocks?
Hayes: I see two main risks: The first is an increase in protectionist trade policies, or trade barriers, which would especially hurt the larger export-oriented markets. The second risk is the potential for greater global inflation and rising interest rates, which could be particularly problematic for China and for other emerging markets that have recently added significant leverage or could face significant economic risk due to changes in the value of their currency.
Polyak: A stable-to-growing U.S. market and a recovery in Europe has been good news for China. But trade protectionism is a risk for a place like China that relies so much on exports. There is political uncertainty in Brazil and South Africa, and Mexico could be affected by U.S. policies. Fortunately, many of the risks in emerging-market stocks tend to lie in the big, government-run companies, whether Chinese banks or state-owned Russian oil companies, where decisions tend to be made at the government level. Among small and mid-sized emerging-market companies, there are opportunities to find businesses with good managements and good products, where the market may not fully appreciate their growth outlooks or the value of their assets.
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