Does Stock Picking Still Work in Emerging Markets? by Sammy Suzuki, AllianceBernstein
Many things have changed in emerging markets (EMs) over the last two decades. Markets are more efficient than they used to be. But we believe that developing countries still provide fertile ground for finding stocks poised to outperform.
In the past, emerging markets were typically considered to be much less efficient than their developed-market peers. Companies weren’t very transparent. It was hard to get access to management. There wasn’t enough data available. Investors who surmounted these obstacles had a big advantage in finding stocks that could generate alpha (market-beating returns).
Analyst Gap Has Closed
In a rare interview with Harvard Business School that was published online earlier this month, (it has since been taken down) value investor Seth Klarman spoke at length about his investment process, philosophy and the changes value investors have had to overcome during the past decade. Klarman’s hedge fund, the Boston-based Baupost has one of Read More
Today, emerging markets are more efficient. For example, there’s much more analyst coverage of EM companies. In the past, it was common to attribute EM alpha potential to a lack of analyst coverage, since the resulting knowledge deficit created opportunities that resourceful stock pickers could exploit.
Not anymore. Today, each stock in the MSCI EM Index is covered by roughly the same number of analysts as each in the MSCI World Index of developed markets (16 and 17, respectively), according to data from FactSet.
The closing of the analyst gap may lead investors to conclude that it will be harder to outperform in EM than in the past. But broader evidence suggests otherwise. For example, the median EM manager has continued to beat their benchmark over one-, three- and five-year periods. The magnitude of the outperformance over rolling three-year periods suggests that EM is still less efficient than the US market and similarly inefficient versus developed markets excluding the US (Display).
Earnings revisions provide even stronger evidence of inefficiencies in EM. We analyzed a portfolio construction that included the top 20% of stocks by monthly consensus earnings revisions over the past 20 years in EM, Europe, the US and Japan (Display). This naïve strategy hasn’t worked well in the developed markets for nearly a decade, yet it has remained remarkably successful in EM, suggesting that alpha potential is still higher in EM than in rich-world markets.
In addition, analysts revised their estimates less frequently for EM stocks than for DM stocks, with EM stocks getting 14% fewer changes than DM stocks, on average. However, for the 50% of both EM and DM stocks with the fewest number of changes, the coverage gap widened materially. EM stocks in that category got between 25% and 40% fewer revisions than their DM counterparts. Overlooked companies in EM are really overlooked.
Reliable Information Is Still Harder to Get
Why do these inefficiencies persist in EM? Though analyst coverage in EM has reached DM levels, reliable information about government actions and corporate performance is still harder to come by in the emerging world. Investors frequently struggle to find enough historical data to analyze multiple business cycles, and it tends to take longer for crucial information on companies to reach the market.
Lower disclosure standards, a lack of long-term corporate track records, more limited access to management and language barriers compound the problem. When there is a lack of transparency, investors are more prone to miscalculation and overreaction.
Fundamental Research Is Vital
Fundamental analysis can overcome these barriers. Critical qualitative issues must be assessed, including corporate governance, the sustainability of a company’s competitive advantages, the caliber of its management team and the quality of its capital stewardship. It’s also important to look at historical examples from developed markets, other emerging economies or even different industries with similar fundamentals to understand earnings drivers.
This can be particularly important for evaluating relatively young companies and immature industries that haven’t yet endured multiple business cycles, conditions which are more common in developing countries. So although broad-market returns are likely to be more muted than in the past and efficiency may be improving, we believe a disciplined, active investing strategy can still capture the power of stock picking in emerging markets.
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.
Sammy Suzuki is Portfolio Manager for Emerging Markets Core Equities and the Director of Research for Emerging Markets Value Equities at AllianceBernstein (NYSE:AB).