SUHAIL SULEMAN: Don’t turn your back on emerging-market equities now

The past decade has not been kind to emerging-market investors. In the 10 years to end-March the asset class returned less than 3% a year, which contrasts starkly with the returns of broader equity indices such as 8.7% with the MSCI all country world index (ACWI) and 13% with the US S&P 500.

To illustrate the disparity in returns, consider that $100 invested in emerging markets 10 years ago would have grown to $134 today and the same investment would have yielded $229 in MSCI ACWI and $338 in the US equity market. 

The primary driver of emerging markets’ underperformance has really been the strength of the US market, in particular, tech stocks whose names have given rise to acronyms such as “Faang” and more recently, the “Magnificent Seven”. The tech-heavy Nasdaq outperformed the S&P 500 by a large margin, such that your $100 investment 10 years ago would be worth $562 now. 

Given the experience over the past decade, it is understandable that many investors have given up on the asset class. Yet we remain constructive on a long-term allocation and believe that the factors that led to the underperformance are unlikely to persist going forward. Here’s why. 

Looking at the last decade 

The absolute return generated from the MSCI’s emerging-markets equity index has been poor for a variety of reasons, not least the poor returns of several of the top countries that were a significant part of the index over the past decade. For instance, Brazil started the decade at a 10% weight and returned only 1.8% a year in the past decade, well below the 14% generated in the prior 10. SA, with a 7% weight a decade ago, returned -1.1% a year in the same period. 

Even China, the past decade’s economic powerhouse which made up 20% of the index, managed a paltry 1.2% a year. Finally, Russia comprised 6% of the market a decade back, saw its weight fall to about 3% when it invaded Ukraine just over two years ago, and has since been removed from the market entirely. 

With four of the top seven countries performing so poorly, the outcome of the past decade is not surprising in absolute terms. In addition, the strong returns from the US market and the strong dollar contributed to huge differences in relative performance with broader world indices. In the cases of SA and Brazil, much of the poor returns came from dollar strength and the poor performance of commodity exporters in general.

China is a bit more complicated. There have been several drivers of underperformance, including many self-inflicted setbacks by the government in regulatory matters. These have had a major effect on the country’s attractiveness as an investment destination by Western investors. 

It is important to highlight that without the strong US market returns (driven largely by a handful of companies), broader world markets would have returned figures that were more in line with those we have seen from emerging-market equities. 

Looking at the historical context, we believe emerging markets look quite cheap at about 15 times historical earnings relative to the broader MSCI ACWI at 21 times. The two US-only indices look particularly frothy with the S&P500 at 25 times and the Nasdaq 100 at 34 times earnings respectively. The last of these indices is showing metrics similar to early 2000, the peak of the technology bubble.

The shifting landscape 

Markets can be cheap for valid reasons, yet we believe the shifting landscape of emerging markets is poised to drive more compelling returns going forward. We have witnessed a total transformation in the MSCI emerging-markets index, with less commodity-dependent countries such as China, India, Taiwan and Korea now comprising in excess of 70% of the market. 

India stands out as the most exciting large economy in the world today, reminiscent of where China stood 15 years ago on most development metrics. With India now accounting for 20% of the emerging-market investment universe and experiencing rapid growth, it is likely to take a disproportionate share of capital flows as valuations in developed markets look relatively high. 

Another significant change is that many of the larger emergingmarket investment opportunities today are simply better businesses than those that were dominant 20 years ago. It’s hard to imagine that state-owned oil producer Petrobras in Brazil was the largest company in the emerging-markets index 20 years ago, with similar state-owned telecommunications company China Mobile running second. Today they have been replaced by great businesses like Taiwan Semiconductor Manufacturing Company (TSMC) and Samsung Electronics.

Another key driver for emerging-market investment opportunities is the greater opportunities for wealth creation compared with developed markets. By way of example, in the developed world banking is largely a utility with little opportunity for meaningful earnings growth from loans and credit (investment banking remains the main attraction). However, for many emerging-market countries credit penetration is low now, the savings culture is still being established, and few people have credit cards. The banks therefore offer an excellent opportunity for sustained earnings growth as this industry develops.

Equally, some of the best investment opportunities we are finding globally in retail, construction, household products, white goods (appliances) and manufacturing are all in emerging markets. 

Positive outlook 

The emerging-market universe offers exciting and compelling opportunities for investors today. The asset class is extremely disliked, driven by weak sentiment. But we believe the fundamentals of many emerging-market businesses remain strong and current times represent a great time to buy. In contrast, developed markets, and the US in particular, appear expensive and performance has largely been driven by a narrow range of stocks.

• Suleman is  portfolio manager at Coronation Fund Managers.