Value or growth? The dichotomy of emerging market shares

November 5, 2013

Investors in emerging markets are facing a tough choice. Should one buy cheap shares in the hope that poor corporate governance and profitability will improve some day? Or is it better to close one’s eyes and buy into expensively valued companies that sell mobile telephones, holidays and handbags — all the things high-spending emerging market consumers hanker after?

At the moment, investors are plumping for the latter, growth-at-any price investment strategy. Result: a lopsided emerging equity index in which consumer discretionary shares are up more than 5 percent this year, energy shares have lost 7 percent while MSCI’s benchmark emerging equity index is down 3 percent.

All markets have their share of cheap and expensive. But the dichotomy in emerging markets is especially stark. Analysis by Bank of America/Merrill Lynch of the biggest 100 emerging market companies revealed last week that the 20 most expensive stocks in this bucket are trading 11 times book value and 31 times earnings (both on trailing basis) while forward earnings-per-share (EPS) is seen at almost 30 percent. The top-20 companies all belong to the private sector and most are in the consumer-facing industries.  This year they have gained more than 50 percent.

Meanwhile the bottom 20 companies in the top-100 are mostly state owned enterprises and they come from the “old economy” — banks, energy and materials. They are also cheap, trading less than 1 time book value and around 8 times trailing earnings. BofA/ML equity strategist Ajay Kapur writes:

So the key differential in the big 100 in emerging markets is between fast growing expensive private sector firms and sluggish generally state-owned cheap laggards.

Kapur is of the view that the outsized preference for expensive high-growth emerging market companies is risky. He points out first of all that anyone wanting to buy the EM consumer story can easily find more powerful global brands in the West and at cheaper prices. On the face of it at least,  global giant Unilever, trading at 18.6 times earnings, sounds like a better deal than Indian household goods provider Dabur whose shares are valued at 30 times earnings .

Second, Kapur is optimistic that things will improve at state-run firms and wide-ranging reforms are likely in many emerging markets. Elections or political changes are due in a raft of emerging countries including China, India, South Africa, Brazil and Indonesia and these could prove the catalyst for changes to how state-owned enterprises (SOEs) are run, he says:

Privatisation and/or significant reform is demanded by disgruntled populations and frustrated investors, is made imperative by worsening fiscal and current accounts and made possible by political change.

So investors should be snapping up cheap SOE shares, Kapur says, recommending buying shares in Russia’s Sberbank, Gazprom and Rosneft; China’s PetroChina, China Construction bank and China Unicom; Brazil’s Petrobras and India’s Bhartat electronics and ONGC.

What do others think? Deutsche Bank strategist, John-Paul Smith, a long-standing emerging markets pessimist, says that while valuations on SOE shares have indeed improved, governance has not. In his words, buying SOE shares on the basis of future reform means essentially that “you are punting on the results of elections”. He says:

Investors are being asked to make an impossible choice. On one hand you have companies that are at least for the time being, structurally un-investable. On other other hand you have companies that are outrageously overvalued.

It’s a tough one. At Mirae Asset Global Investments, co-CIO Rahul Chadha is not buying into the SOE argument yet. He points to iron ore producers which have cheap share prices but lousy prospects to match.

Will value get unlocked in the next 2-3 years or is it going to be a value trap for 5-10 years? So there is a part of the market that is cheap but it is unlikely you will see much earnings growth here for the next few years and we are happy to stay out of this part of the market.

Nor is he excited about paying 35 times earnings for a company with 15-20 percent EPS growth. He says:

Equity investors focus on growth but to make money you need to find growth at reasonable valuations. So the idea should be the find the strongest business model, there has to be justification for these valuations.

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