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Figure 1: The Value Advantage in Emerging Markets: 1988 - 2013 Annualized Excess Return of Low Price-to-Book Quintile vs. Broad Market Index* 25 20 15 10 5 0 1988 - 2013 Emerging Markets 2000 - 2013 Developed Markets
*MSCI Emerging Markets Index for Emerging Markets and MSCI World Index for Developed Markets Source: Sanford C. Bernstein & Co., Morgan Stanley Capital International, Inc., Pzena Analysis
are the desperate rush towards, and the panicked ee from risk more apparent than in the emerging markets. Value Cycles in Emerging Markets In previous articles we presented our research on value investing cycles in the U.S. dating back to the 1960s. Studying periods when a portfolio of low price-to-book stocks either outor under-performed the market index - in this case the S&P 500 - we found that there are discreet periods to values relative performance. Yet over full cycles, which tend to last almost ten years on average, value outperforms the broad market by approximately 4.8% per annum. Recently, we extended our research to see if similar cycles exist in the emerging markets. We examined data back to 1993, and were able to identify cycles over which value had distinct periods where it lagged and outperformed the MSCI Emerging Markets index. On average, value outperformed the broad market by 8.0% per annum over the entire cycle (Figure 2). Where We Stand Today As shown in Figure 2, we are currently in the anti-value portion of the emerging markets value cycle that started in April, 2011. A nave low price-to-book strategy has underperformed the MSCI Emerging Markets index by 10.8% over the last 30 months, a period punctuated by knock-on effects of the European recession, slowing emerging markets growth, and the
Figure 2: Value Outperforms Over the Cycles in Emerging Markets Capitalization Weighted Low P/B Portfolios vs. MSCI EM Index
MSCI Low Price-to-Book Emerging Markets Difference Index ce 19.6% 109.1% 25.8% -66.2% 1556.9% 19.2% -11.4% 67.0% 11.3% -19.5% ? 15.1% 32.6% -0.1% 7.3% -50.9% 479.0% 11.2% -0.4% 15.4% 3.9% -8.8% ? -3.6% 7.1% -13.0% 109.3% 18.5% -15.3% 1077.9% 7.9% -11.0% 51.6% 7.4% -10.8% ? -4.7% 8.0% # Months 3 45 48 11 107 118 11 33 44 30 ? 30 240
impact of potential Fed tapering. We are not surprised by this result; the data in both developed and emerging markets suggest that value strategies typically underperform toward the end of an economic cycle, resuming their out-performance once the impact of an economic slowdown is discounted in valuations and investors start to look forward toward recovery. When we look at what is happening across emerging markets today, we see signicant pain in many industries, as evidenced by the underperformance of low price-to-book stocks. That said, when we examine the returns on equity in those businesses, despite precipitous declines over the last few years, returns appear to have returned to about average (Figure 3), with some industries still above levels we would expect in a normalized environment. In many cases where the returns are indeed below normalized levels, we are cautious about the path back to normal, as in many industries vast supply was added during the boom and, frequently, in so doing, so was leverage. As such, we continue to take a business-by-business approach to building our portfolios, as all cheap stocks are not created equal in such an environment. For example, while book values of commodity businesses have grown rapidly during the boom period, book value can be a poor indicator of intrinsic value. Thus, our focus on understanding earnings power can help us reduce downside risk versus a nave price-to-book portfolio. In addition, although some value strategies place a signicant emphasis on predicting macro country factors, it has been our experience that focusing research at the company level is effective even in the face of country-level headwinds. We construct portfolios in this manner, which is likely why our approach has worked well during this period of normalization, and why we believe it can continue delivering the value advantage in the future.
Oct 93 - Dec 93 Jan 94 - Sep 97 Full Cycle Annualized Oct 97 - Aug 98 Sep 98 - Jul 07 Full Cycle Annualized Aug 07 - Jun 08 Jul 08 - Mar 11 Full Cycle Annualized Apr 11 - Sep 13 ? Oct 93 - Current
Figure 3: Emerging Market Return on Equity Normalizing MSCI EM Return on Equity 18% 15% 12% 9% 6% 3% 0% 1992 Average
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References Fama, Eugene F., and French, Kenneth R., The Cross-Section of Expected Stock Returns, The Journal of Finance, June 1992 2 Fama, Eugene F., and French, Kenneth R., Value versus Growth: The International Evidence, The Journal of Finance, December 1998 3 Rouwenhorst, K. Geert, Local Return Factors and Turnover in Emerging Market Stocks, The Journal of Finance, August, 1999 4 Barry, C.B., Goldreyer, E., Lockwood, L. and Rodriguez, M., Robustness of Size and Value Effects in Emerging Equity Markets, 1985-2000, Texas Christian University, May 2001 (subsequently published in Emerging Markets Review 3 (2002), 1-30) 5 Pitkanen, Marjo-Riitta Elisa, Value Investing in the Emerging Markets, Master Thesis, Copenhagen Business School, December 2011
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DISCLOSURES
Past performance is no guarantee of future results. The historical returns of the specic portfolio securities mentioned in this commentary are not necessarily indicative of their future performance or the performance of any of our current or future investment strategies. The investment return and principal value of an investment will uctuate over time. The specic portfolio securities discussed in this commentary were selected for inclusion based on their ability to help you understand our investment process. They do not represent all of the securities purchased, sold or recommended for our client accounts during any particular period, and it should not be assumed that investments in such securities were, or will be, protable.