David Stevenson: How to find value in emerging markets

The words “good” and “value” rarely appear together when describing emerging markets (EMs). But I think adventurous investors might be missing a trick or two. So, it seems, does Invesco Powershares. This week, the fund provider relaunched an exchange traded fund (ETF) tracking a fundamental index: the FTSE-RAFI emerging markets index (for details, see www.invescopowershares.com ).

Fundamental indices contain shares ranked according to their cashflow, sales, book value, and dividends – rather than their market capitalisation, which is just a product of their price. As a result, they are less likely to become overweight in over-valued shares.

In theory, this should help to address the classic problem for EM investors: most companies in China and India are growth stocks – they are highly rated because the market thinks their earnings will grow faster than boring old value stocks from the developed world.

Why is this a problem? Because the investment case is predicated on forecasts of future growth (how else can you sustain price/earnings (p/e) ratios in the 40s and 50s?), but analysis of growth stocks shows that a) those forecasts are frequently wrong, b) growth is, in fact, fairly cyclical, especially in resources sectors, and c) growth usually falters as competition increases.

So can value investing work better in EMs? Rob Arnott, the analyst who set up the RAFI fundamental indices, has just written a paper on why his EM fundamental index has outperformed the ordinary cap weighted EM index. Arnott and his colleague Shane Shephard say that, between 1994 and the end of 2009, their EM index produced an extra annualised return (over and above the capitalisation weighted index) of 9 per cent a year.

They conclude that the main cause of this outperformance (with almost the same level of volatility) is that EMs are less efficient at setting sensible prices. They argue that “in less efficient markets . . . prices are more likely to be ‘wrong’”, which means that “a traditional capitalisation weighted index approach to investing may leave a great deal on the table”, whereas a fundamentally weighted index biased towards
value stocks “adds the most value in the noisiest of spaces, emerging markets”.

Arnott and Shephard are basically saying that these less efficient markets have rewarded investors for taking the risk of holding value or momentum stocks.

Traditionally, you would access those stocks through active funds, such as Slim Feriani’s Advance funds or the Templeton funds run by Mark Mobius. But, with these, you always run the risk that the fund manager will switch to the wrong style at the wrong time.

Fundamental index funds, by contrast, are mechanistic and, by definition, focused on value. They should always pick the cheapest, or at least cheaper, stocks in what are expensive markets. You can see this in the underlying index holdings replicated by the ETF: the p/e ratio is one point lower than the wider market, and the price-to-book value is substantially lower.

However, I worry that you are still basically buying the same mega-cap stocks, just with a value-investing weighting.

So I have been exploring an alternative, contrarian approach: investing in the most beaten-up markets. At a recent Advance event, the firm’s fund managers identified geographical pockets of value, such as Russia (still dirt cheap), Turkey (a long-term play easily accessed by the iShares MSCI Turkey ETF, ticker ITKY) and Qatar (apparently trading on just 9.4 times 2010 earnings).

In fact, Qatar is an interesting contrarian play, accessible via specialist funds such as the Epicure Qatar London-listed fund (ticker EQEQ). Clearly, there is a massive oil price factor here – but I just don’t think oil is about to crash in price.

adventurous@ft.com