One of these is the difference between the perception of the relationship between GDP growth and equity returns and the reality thereof, says Henry Wigan, a member of BlackRock's specialist emerging markets team.
Wigan explained that one of the primary arguments for investment in emerging markets in recent years has been the long term secular growth trends visible in countries like China where a new middle class is emerging – a trend that investors want to gain access to through those companies that stand to benefit from it.
“While the first part of that argument is hard to refute, if one looks over the last thirty years, the correlation between GDP growth and equity returns across the globe is actually negative,” he says.
Part of the reason for this is that there is often a great deal of dilution within these markets over the years as investors caught up in the hype of the story are happy to fund what turns out to be poor-quality growth.
"Aware of the hype"
“There is a lot of emotion in this trade from investors who want to get exposure to these big secular growth trends and so are willing to pay up for the growth. It is very important to be aware of the hype factor and where one is within that emotive cycle,” Wigan said.
Another perception, related to this, is the willingness to pay up for growth.
“Because there is a lot of growth expected from emerging markets, investors have been happy to pay up for that growth, but the empirical evidence shows us that value has tended to outperform growth stories,” he said.
According to Wigan, a focus on valuation is essential because the difference between a good stock and a good company often lies in the price you pay for it.
“Empirical evidence shows that even poorly run state-owned enterprises, for example, have outperformed so-called stories, themes and dreams, because of the initial under valuation,” he adds.
In order to combat this, Wigan says it is important to place the emphasis less on the top line growth expected and more on how those earnings are going to be returned to shareholder.
“We take it as given that the top line is going to grow, instead we are looking at what the government take is currently and, importantly not imputing that too far into the future because it can change fairly quickly. It is also important to look at both the levels of working capital that the business is going to need and what its capital expenditure plans are.”
