The two most popular trades in Emerging Markets today are “long India, short China.” The subsequent valuation spread between these two markets is as wide as it’s ever been, which implies that the market has broadly priced in the perceived divergence in the attractiveness of the two markets.
Given this dynamic, exploring the drivers for prospective alpha through a Brinson attribution points to stock selection, over the already tapped-out allocation lever, as the key determinant of future returns. We explore the key criteria that we feel require deep fundamental understanding in order to generate alpha in these two markets, which together account for almost half of the benchmark weight.
China
There is a lot of ‘bad news’ currently priced into China, with the market-implied equity risk premium at levels approaching the 11.1% global financial crisis peak, as seen in figure 1. This extreme valuation scenario is also reflected in the spread between Chinese equities (earnings yields) and bonds (bond yields), which are at 15-year highs, in favour of equities.
Figure 1 - China’s market-implied ERP approaches the global financial crisis 11.1% peak
Source: : Ninety One, CLSA, Bloomberg, IBES, MSCI, Refinitiv, 22 July 2024.
“Investors need to consider the political landscape, geopolitical relations, as well as the fast-evolving regulatory landscape in China. There are two questions to consider when investing in any company in the region. First, how will/could geopolitics affect a company. Once that question is answered, you must then ask, what social purpose does the business serve in China, which is the foundation for successful Chinese corporations, in light of China’s Common Prosperity agenda. If a prospective investment can pass these two barriers, it reduces the risk of potential challenges in the future, such as sanctions.” said Laijawalla.
Current policy measures only scratch the surface for the key issues China is facing, namely a weak property market, with almost a decade’s worth of unsold inventory, coupled with multi-year low consumer confidence that has led to a build-up in savings, at the expense of spending.
Laijawalla said: “A bottom up approach is key. China operates within differentiated social nuances, and investing in the region requires boots on the ground. People who are there, speak the language, who kick the tyres, and are established in local networks. I think China will have its day in the sun. There have been a few false starts. However, companies focused on business fundamentals have realised that to generate stakeholder value they need to strategically allocate capital, - it’s why we’re seeing a record level of share buyback and dividends today. When the exogenous factors start becoming tailwinds, China will be in a different mind space than it is today.”
India
India is unique to Emerging Markets at this juncture, in that you get what you pay for. There are a number of factors for this, not least the domestic flows, which has seen an increase to $29bn from $12bn, between 2021-23 vs 2016-20, respectively. As domestic stakeholders have reduced their holdings through recent secondary stake sales, the increase in free float of their stock has resulted in a mechanistic increase of India’s weight in the Emerging Markets benchmark.
Laijawalla noted: “We believe that there are three key considerations for India at this stage - Modi, the market, and the money flow. The key to investing in a market like India, where valuations are optically elevated, is to invest in companies that can exceed market expectations. We have spent the last several years searching for phenomenal businesses that can beat expectations, across the country. We have found, and invested, in a range of businesses that span technology, real estate, industrials, healthcare, and consumer sectors.”
Active management and governance
When distilling down the active vs passive debate, the key argument in favour of the former, is the scope for generating alpha. Beyond alpha, the key reason to look to active over passive funds is governance.
Investing in a passive fund or ETF tracker can provide access to a range of underlying securities. However, not all Emerging Market companies are created equally. Investing in a broad index makes it impossible to understand each company’s governance, by way of board composition or related party transactions, for example. In comparison, active investors have the capacity to individually assess and evaluate each prospective company’s annual reports, director proposals, and key stakeholder drivers. This provides the basis to better evaluate financial as well as reputational risk.
Laijawalla concludes: “There is a traditional underlying perception that governance is of a lower quality in Emerging Markets. This is not true, but there are pockets in the market where active investors need to operate and deploy extra attention. The principles to apply governance are simple, but in practice it’s not necessarily easy. We play every ball on its merit. We want to understand our companies deeply to ensure we’re investing in strong management teams that are keen to grow the pie.”
1 Please note that this chart has been redrawn by Ninety One.