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‘Common, observable and exploitable’: Value distortions and the emerging market advantage

The functionality of value investing hinges on one important and fundamental premise: that humans are fallible and emotional operators that over-react, misjudge and fall victim to overconfidence in their own assessment abilities.
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While emerging markets may be typically associated with growth-style investing, and some have suggested that the sector isn’t a natural environment for a value-style investment philosophy, the reality is that using a valuation-based approach in emerging markets is a “superior” strategy according to Pzena Investment Management.

In fact, with academic research indicating that GDP growth and stock performance are not reliably correlated, it doesn’t really make sense to apply a growth philosophy to the kind of economic development investors are looking for in emerging markets.

Pzena’s investment team recently analysed the returns delta between cheapest quintile stocks (ie low price-to-book) and the broad market as represented by the MSCI Emerging Markets Index over a 32-year period. And while that index returned an 6.7 per cent annualised return, the low price-to-book holdings returned 16.45 per cent, suggesting a significant advantage for value stocks in emerging markets.

  • How well these stocks can perform when portfolios are constructed through a value lens will depend on the manager’s level of expertise, but data shows that when deep value stocks (ie the 20 per cent of cheapest shares in the universe) are held over five-year rolling periods, they beat the MSCI emerging markets index 75 per cent of the time, resulting in average annualised outperformance of 7.88 per cent.

    Why value works

    The functionality of value investing hinges on one important and fundamental premise: that humans are fallible and emotional operators that over-react, misjudge and fall victim to overconfidence in their own assessment abilities. People often react to events or indicators that affect stocks, sectors or the market itself more dramatically than they should, because they’re human with ungovernable patterns of thinking.

    This range of deficiencies, combined with the increased access to investing on all levels that technology has made possible, produces myriad opportunities for market mispricing.

    “The history of investing demonstrates that valuation distortions are common, observable, and exploitable,” the Pzena article states, noting that emerging markets, being “less well understood and mature than their developed world counterparts”, are as susceptible to overreaction as any sector. “Therefore, it should come as little surprise that a valuation-based approach has worked as well, if not better, in the emerging markets as the developed world.”

    When mean reversion eventually kicks in, alpha is generated for those that have accurately identified and acted upon the value distortion. This works from both a long and short approach, Pzena says.

    “As for company performance, we believe that very high levels of profitability or earnings growth usually are not sustainable and tend to be overvalued. The odds are against the sustainability of perfection, but the price of the stock is often set by investors whose confidence that their company will beat the odds is too high,” Pzena states.

    “We also believe that very poor profitability can be temporary. Over time, cycles turn, management takes actions, costs are cut, and excess industry capacity diminishes. The odds favor improvement, but investors often cannot look past near-term problems. With fewer than 20 per cent of emerging markets strategies identifying as value, chances are you are underexposed to this compelling opportunity set.”

    Staff Writer


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