At a time of rising valuations and lower expected market returns, are investors missing out on opportunities by sticking to traditional developed market equity allocations? In this Q&A, Research Affiliates’ Chairman Robert Arnott and CIO Christopher Brightman, portfolio managers of the PIMCO RAE strategies, provide their views on how widening price gaps between growth and value stocks and among equity sectors are creating value opportunities in emerging markets – and why long-horizon investors should consider systematic value strategies that look beyond the developed world borders.
Q: In what regions are you finding the most appealing opportunities for the RAE portfolios today?
There is a lot of talk today about how expensive stocks have become. Certainly there are some markets where this is true. However, a closer look at the broad equity landscape highlights significant dispersion across geographies and market segments. US stocks are expensive – both relative to other markets and compared to their own historical levels. Outside of the US though, valuations are cheaper. On top of this, the valuation dispersion between cheap and expensive companies is also more pronounced outside of the U.S., particularly in emerging markets.
RAE has a strong value bias, and we designed the RAE strategies to seek to outperform by taking advantage of mean reversion. Because non-U.S. stock markets are cheaper and due to the gap between value and growth being greater outside the U.S., we estimate the RAE portfolios will offer more attractive performance potential outside of the U.S. We believe this performance advantage will be most pronounced in emerging markets.
Research Affiliates creates 10-year real return estimates for asset classes using a “building block” approach. If we know the yield, growth in income and changes in valuation multiples on any investment, we can gauge the potential total return. This is a powerful tool both for attribution of historical returns, and in seeking to forecast future returns. v
We calculate point estimates for equity returns by combining observed dividend yield, historical real earnings growth, mean reversion in valuation and mean reversion in foreign currencies. It’s important to note that for both valuations and currencies, we do not assume full mean reversion back to historical norms. Perhaps there’s a new regime and there will be no mean reversion, or perhaps the markets are stretched and full mean reversion will occur. Recognizing that either may be possible, we are assuming mean reversion halfway toward historical norms over the coming 10 years. This simple and intuitive model currently suggests a significant advantage for equities in emerging markets relative to the U.S. (see Figure 1).
Current valuations suggest U.S. equities will generate negligible real returns over the next 10 years (full mean reversion would take us to a −3% real return, roughly matching the 2000–2009 experience). Valuations outside of the U.S., where we find equities to be far more attractive, paint a far less dire picture. And note that this does not account for any potential alpha generated from value-beating growth or from mean reversion in RAE strategies relative to conventional value strategies.
Not only are equities cheaper outside of the U.S., but the dispersion between value and growth is greater outside of the U.S. as well. Many of us are familiar with the expensive mega-cap stocks that have come to dominate U.S. stock markets. As companies such as the “FANGs” – Facebook, Amazon, Netflix and Google (now Alphabet) – soared, their impact on market benchmarks grew. Simultaneously, inexpensive commodity-related stocks have lagged the market, creating a widening spread between the most and least expensive companies This spread is most pronounced in emerging markets (see Figure 2).
Note that value stocks are priced at 24.6% of growth stocks in the U.S., compared with 22% in emerging markets (see Figure 3). Valuation dispersion outside of the U.S. creates a tremendous opportunity for a contrarian rebalancing strategy such as RAE. Value stocks in the U.S. would need to outperform growth stocks by 1.9% annualized over the next five years in order to return to their median valuation. While this would represent healthy excess returns for value, it pales in comparison to the 6.4% annualized excess return value stocks would need to post in emerging markets in order to return to their median valuation levels.
Value investing has hurt investors over the past decade, and U.S. stocks have trounced non-U.S. stocks over the past decade. It’s difficult for investors to want to buy what has inflicted losses and pain, but anything that’s newly cheap will likely have inflicted losses and pain. Past is not prologue. Chasing U.S. growth stocks may be comfortable and fun – but watch out below!
The RAE Fundamental Emerging Markets strategy no longer offers the extreme bargains of January 2016, when the price/earnings ratio was at 6.3 times (close to the Depression-era lows reached in May 1932!) and the price/sales ratio was at 0.48 times. However, those valuations were lower than any seen in the U.S. in the past quarter century, after trading 40% rich relative to U.S. valuations 10 years ago. No wonder EM value stocks hurt investors so badly from 2007 to 2015, as they went from extreme high multiples to extreme lows.
In our view, emerging markets value stocks are a bargain. The five-year cyclically-adjusted price/earnings (CAPE) ratio (or Shiller P/E) for the Russell 1000 Growth is now 51 times; the five-year CAPE ratio for RAE Fundamental Emerging Markets is now 8.1 times. U.S. growth is at 3.0x sales, while RAE Fundamental Emerging Markets is at 0.6 times sales.
We explicitly designed the models that inform the RAE strategy to take advantage of mean reversion. The potential for mean reversion is greatest when valuation dispersion is also greatest – today this is in EM. We believe that long-horizon investors would be well-served by considering a contrarian strategy such as RAE Fundamental Emerging Markets, to take advantage of this opportunity.
Q: What created this opportunity for value in emerging markets?
Brightman: Today’s opportunity starts with a vast pricing disparity between different industry sectors. Markets have long forgotten the peak of oil prices and the rise of China as a growth story. As in the late 1990s, attention has shifted to network effects and the potential “winner takes most” monopoly pricing power of mega-cap tech companies. In the U.S., the glamorous FANG tech stocks trade at four times higher price/sales multiples and double the price/cash flow multiples of mega-cap global resource stocks (see Figure 4).
This disparity between the market prices for different industries is magnified in the less mature and more volatile emerging markets. Like the FANG stocks in the U.S., their “BAT” counterparts in China (Baidu, Alibaba and Tencent) sport bubble-level valuations. The BATs trade at an average sales multiple of 15.5 times and a cash flow multiple of 43.5 times! At the same time, EM resource stocks trade at sales and cash flow multiples of 1.3 times and 4.5 times, respectively. In EM, glamorous tech stocks trade at sales and cash flow multiples 10 times higher than resource stocks.
Finally, this disparity in sector pricing is more important in the relatively more resource-heavy emerging markets (see Figure 5).
As I’ve written many times, we are firm believers that the price you pay for the cash flows you buy determines the return you may expect. The growth prospects of the FANG stocks in the U.S. may or may not justify paying double the multiple of cash flow of out-of-favor resource stocks. But we believe it defies common sense to think the growth prospects of the BAT stocks in China justify paying 10 times the cash flow multiple of EM resource stocks.