For two years, emerging markets companies have delivered inferior earnings growth and investment returns compared to peers in sluggish developed market economies. Now, the consensus is that earnings growth will catapult from near-zero in 2012 to 13 per cent in 2013. Hopes were high at the end of 2010 and 2011, too, yet analysts were then forced to revise down their earnings estimates. Will 2013 represent another triumph of hope over experience?
To answer that question, let’s look at what investors got wrong about emerging markets in recent years.
In 2010 and 2011, many investors correctly anticipated that economic growth in emerging markets would be much faster than in developed countries, where the after-effects of the global financial crisis left a wake of worry about sovereign risk, banking system risk and structural economic impairment. Yet they failed to foresee that, although the rate of economic growth would be higher than in developed countries, it would also decelerate more sharply.
That miscalculation had a disastrous effect on earnings forecasts. Economic deceleration translated into top line deceleration at emerging companies. Revenue deceleration outpaced the rate at which companies could contain cost growth. So bottom line profit growth became very challenging, particularly because emerging companies faced greater labour-cost pressures than peers in developed countries, while their inputs are also more sensitive to commodity prices, which remained elevated.
Consequently, earnings expectations had to be ratcheted down, and this weighed on stock performance.
These negative earnings revisions made their investors even more fearful, especially in sectors that are more exposed to the economic cycle, such as energy, materials and consumer discretionary. Many of these companies had their multiples pushed down disproportionately, even though these sectors already traded at a bigger discount than others. For investors focusing on lower-priced stocks, this was an additional headwind.
The mistakes of the last two years suggest that in 2013 we are likely to finally see a resurgence of emerging markets’ company earnings growth. And history tells us earnings growth is tied closely with stock market returns. Indeed, the 20% rally in emerging market stock prices from a bottom on June 4, 2012, suggest that conviction is building. What’s interesting about the potential turn is that it is not rooted in expectations of a dramatic acceleration in overall emerging markets economic growth. The IMF expects emerging market economic growth to rise from 5.3% in 2012 to 5.6% in 2013. Rather, it is that a mere change in direction from the deceleration of the last two years to just a modest acceleration should underpin a meaningful improvement in bottom lines across emerging markets. In other words, just “muddling through” could be quite good.
What’s even more provocative is that some of the stocks most sensitive to an improvement in sentiment—the “high beta” companies—are priced at valuations embedding such extreme pessimism that they might deliver double-digit outperformance versus the market. By contrast, many of the “lower beta” names that investors have tended to favour in recent years because they were less exposed to the economic cycle—think beer companies and soap—are now trading at such magnificent multiples that they could be left well behind in a 2013 rally. Historically, when differences in valuation reach extremes such as what we have today, the outperformance of the lowest priced stocks versus the most expensive ones has been 27% over the subsequent year.
So just how strong could emerging market stock returns be in 2013?
For index investors, we think a 16% return can easily be expected, assuming 13% earnings growth is achieved and they collect a dividend yield of nearly 3%. But for investors willing to take a more contrary view and focus on the discounted names in emerging markets, we believe that even a modest multiple expansion from today’s low levels could easily translate into returns well in excess of 20%. It surely won’t be a smooth ride, but it never is in emerging markets, which is precisely why the potential rewards can be so attractive.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Morgan Harting leads the Emerging Markets Multi-Asset portfolio team at AllianceBernstein