Fast reading
- Emerging market (EM) growth stocks have underperformed EM value by 23.8% from end-2020 to October 2023. EM value’s outperformance comes despite the fact that it carries almost twice the amount of leverage compared to EM growth1.
- In the face of rising costs of capital, there is a reduction in operating profits available for distribution to shareholders; and higher interest payments have an impact on companies’ ability to invest in the business.
- High leverage and moderate growth prospects could present an issue for EM value stocks going forward. It is one of the reasons that supports our view that the recent outperformance of value stocks compared to growth is unsustainable.
- EM growth stocks are trading at 17x PE for 2024 vs. value at 9x. While growth is still almost twice as expensive vs. EM value, it is also expected to grow at almost twice the rate of value sectors over 2023-2025 (23.5% vs. 13.8%) with approx. 300bps better ROE and approx. 54% lower leverage2.
The years that led up to the global financial crisis (GFC) in 2008-09, were extremely supportive for value stocks in emerging markets. Global gross domestic product (GDP) was expanding at 4-5% per annum, particularly after the dot-com crash in 2000 (the US federal funds rate increased from 1% in2004 to more than 5% in 20063).
During this period, credit expanded and there was a boom in leveraged activities, particularly in the western world. Commodities and energy investments did well.
In the aftermath of the GFC, value stocks proved particularly attractive on the back of huge stimulus spending led by the Chinese government. However, by 2012, global GDP struggled to grow much beyond 3% and the performance of value stocks disappointed.
Figure 1: MSCI Emerging Markets Growth Index vs. MSCI Emerging Markets Value (1996-2023)
The underperformance of value stocks vs. growth was exacerbated further during the Covid-19 crisis as global GDP growth declined by 3.4%4. In response, sweeping government stimulus around the world propelled a rebound in global GDP growth (5.8% in 2021) helping value stocks to overperform growth5.
In light of these trends, we can summarise that for value to outperform growth it needs:
- A benign global GDP growth environment (c.4-5%)
- Rising interest rates or record levels of fiscal stimulus
The post Covid-19 rally was always likely to be a 12-18 month phenomenon because the 2021 global GDP growth rate of 5.8% was unlikely to sustain. And while global GDP growth did moderate to around 3% in 2022, the world economy struggled with the fallout from the Russia-Ukraine conflict which pushed oil prices above US$100 a barrel and exacerbated global inflationary pressures. In addition, several supply constraints emerged as a fallout from the imbalances caused by the pandemic:
- A shortage of shipping/logistics capacity resulting in elevated freight rates;
- A shortage of microchips which curtailed automobile production;
- A shortage in manpower availability leading to large wage hikes, fuelling inflation.
These factors led to a surge in interest rates around the world, and pushed the US federal funds rate above 5%.
Value has done well (vs. growth) primarily on the back of the performance of the energy sector – the MCSI EM Energy Sector Index (+7.7% from January 2021 to October 2023) – compared to the MSCI Emerging Markets Value Index (-9.5%) and the MSCI Emerging Markets Growth Index (-33.3%) over the same period6.
Growth sector risks
Growth sectors, in particular, have been hit by rising interest rates – and the resultant de-rating and unwinding of excess valuation during Covid-19.
In addition, the specific issues within the Chinese economy further accelerated the de-rating of several growth sectors (for example, internet retail).
The sharp pull back of growth vs. value is largely behind us. Growth is trading at 17x PE for 2024 vs. value at 9x. While growth is still almost twice as expensive vs. value, it is also expected to grow at almost twice the rate of value sectors over 2023-2025 (23.5% vs. 13.8%) with approx. 300bps better ROE and approx. 54% lower leverage7.
We believe that investors should not look at valuations in isolation, but look at them in the context of global growth prospects, interest rates, government fiscal spending, and leverage on the balance sheet.
In most instances, the indicators are flashing ‘red’: global growth is c.3% (1.5% in developed markets); interest rates are at pre-GFC levels (5%); fiscal spending power is limited as governments around the world grapple with rising interest payment burdens; small and medium-sized enterprises (SMEs) are struggling with rising borrowing costs; and large corporates are beginning to see the impact of higher interest rates as refinancing activity (from end-2023 onwards through to 2025) squeezes growth prospects8.
While neither growth nor value has delivered a positive absolute return post-Covid-19, emerging market (EM) growth has underperformed EM value by a staggering 23.8% from end-2020 to October 20239.
Figure 2: EM growth vs. EM value indices (since January 2021)
EM value’s outperformance comes despite the fact that it carries almost twice the amount of leverage compared to EM growth10.
Figure 3: Total debt-to-equity (EM value vs. EM growth)
</div
In the face of rising costs of capital, there is a reduction in operating profits available for distribution to shareholders; and higher interest payments have an impact on companies’ ability to invest in the business.
As a result, leveraged companies will likely suffer from limited funds for future growth initiatives.
While investors have rightly penalised growth companies trading at excessive valuations, we believe that many investors have not yet considered this fundamental balance sheet/cash flow issue within the value space. As companies look to refinance their credit lines in the coming quarters and years, the full impact of rising borrowing costs is likely to be felt.
The near-term outperformance of value compared to growth has been primarily driven by the market expectation of stable earnings for specific value sectors, contrasting with a mid-single-digit decline for growth sectors in 2023. However, the market seems to overlook the medium-term growth prospect at +23.5% vs. 13.8% for value sectors EPS CAGR 23-2511. On a price/earnings-to-growth (PEG) basis, EM growth is in-line compared to value. On a risk-adjusted basis, EM value has a greater scope for disappointment in light of the abovementioned leverage issue.
For growth stocks, high valuations have been an issue, but the market has adjusted its expectations. For value and cyclical stocks, however, high leverage and moderate growth prospects remain an issue and the market has not fully adjusted its expectations. As a result, we believe the recent outperformance of value stocks compared to growth is unsustainable.
To read the full Global Emerging Markets Equity: Outlook 2024 report, please click here.
For further information on Global Emerging Markets Equity please click here.
Share:
1 Bloomberg as at October 2023 – comparing MSCI EM Growth vs. MSCI EM Value Index.
2 Bloomberg as at October 2023. EPS CAGR 2023 to 2025 based on consensus estimates.
3 Bloomberg as at October 2023.
4 Ibid.
5 Ibid.
6 Bloomberg as at October 2023. EPS CAGR 2023 to 2025 based on consensus estimates.
7 Ibid.
8 World Economic Outlook, October 2023: Navigating Global Divergences (imf.org).
9 Bloomberg as at October 2023 – comparing MSCI EM Growth vs. MSCI EM Value Index.
10 Bloomberg as at October 2023 – comparing the total debt to equity ratio for MSCI EM Value and Growth indices.
11 Bloomberg as at October 2023. Comparing the EPS CAGR of MSCI EM Value and Growth indices for 2023-2025 estimates.
