Profitability should be a key focus for investors seeking investment in emerging market equities, notes PIMCO in its recent research report.

PIMCO analysts led by Masha Gordon analyzed the performance of a quality investment style that consists of systematically overweighting stocks that display high profitability.

Profitable firms outperformed in developed markets

PIMCO analysts point out that empirical evidence has so far focused on developed markets, particularly the U.S. The empirical evidence corroborates the view that in these developed markets, profitable firms tend to consistently outperform unprofitable ones.

The analysts point out that profitable firms tend to remain profitable over time, and this phenomenon is as true in emerging markets as it is in developed markets.

Gross profitability attracts premium in Emerging Market equities

PIMCO analysts believe the performance of gross profitability attracts a significant premium in Emerging Market equities. However, the analysts also examined more traditional profitability measures such as ROE and ROIC.

By considering ROE as a measure, the analysts have estimated transition probabilities for MSCI Emerging Market constituents at the annual frequency using data from January 1998 until September 2013. At the end of each month, they formed quintiles by sorting stocks on ROE from lowest (Q1) to highest (Q5).

As can be deduced from the following table, if a stock is currently in quintile Q5, the estimated probability that it will remain in Q5 until next year is 58.3%. PIMCO analysts point out that it will be demoted to Q4 with a probability of 18.7%

Estimated probabilities Emerging Market

The analysts also repeated the above analysis over a three-year interval and found the same conclusion.

Performance of long/short gross profitability strategy

PIMCO analysts also analyzed the performance of a long/short gross profitability strategy, which is long the top quintile and short the bottom one. This is encapsulated in the following graph:

Long-short gross profitability strategy Emerging Market

 

The analysts note the Sharpe ratio is 0.71, higher than the ones obtained by the ROE and ROIC strategies. The average excess return is also substantially higher compared to the other quality strategies considered by the analysts. The market displayed a Sharpe ratio of 0.27 over the same period.

PIMCO analysts also simulated a modified version of the long/short strategy by restricting the universe to the largest 125 stocks in the MSCI Emerging Market universe and observed the resulting Sharpe ratio is remarkably close to the one obtained by selecting stocks from the full universe. The analysts note both average return and volatility are slightly higher for the large-cap version.

The analysts point out that these findings suggest that the profitability premium is not concentrated in the smaller stocks of the Emerging Market universe.

PIMCO analysts conclude that profitability should be a key focus for investors in Emerging Market equities. The analysts note in the long run, highly profitable firms outperformed those with inferior profitability overall in Emerging Market. They point out that by holding high-profitability names in his portfolio today, a portfolio manager can expect to end up with a high-profitability portfolio at the end of the investment period.