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Investing in EMs through DMs

Wietse Nijenhuis

By Wietse Nijenhuis

Head - Equity Strategy

November 21, 2018Posted InInvestments and Investment Strategy

As we have previously noted, a historically large under-allocation to emerging markets (EM) equities by global equity funds, coupled with a 20% valuation discount to long-run averages, make the asset class too cheap to ignore in our opinion.

Even in the absence of improvements in US-China trade relations, we believe EM asset prices have diverged too much from fundamentals. And that’s not to mention the strong demographic tailwinds that should propel Asian growth in the decades to come. We see many ways to play this space beyond just buying a passive EM index.

EMs’ lower corporate governance standards relative to developed markets (DM) are a key reason why global investors can be hesitant about investing in the asset class. Factors such as varying reporting standards by country, complex ownership structures, and risks of government intervention in the private sector all give reason for investors to pause before diving into these markets. Investors often require significant valuation discounts to mitigate these factors. In addition, EM names are in many cases less liquid than their DM counterparts.

One way investors can gain exposure to EM but still have the comfort of developed market (DM) governance standards is to focus on DM stocks with high EM exposure. We identified DM-listed stocks with the largest EM exposure (and over $5 billion in market cap) and found that these firms earn over 69% of their revenue from EM countries on average, which is more exposure to EM than the average MSCI EM constituent.

Intriguingly, these DM companies have in fact underperformed EM shares since June (-17.5% vs. -13.1% for EM), a point at which EM weakness and worries about US-Chinese trade relations really came into focus. Given our view that the EM selloff presents a long-term opportunity, developed market investors may want to consider allocations to some of these names that offer attractive valuations, solid dividend yields, and strong expected cash flow growth.

Clients can read our fuller thoughts in the latest Global Equity Strategy bulletin: Going on a More Liquid (EM) Diet: Investing in EM Through DM.