In 2014, emerging market stocks posted a loss of 4.6%, capped off by the fourth quarter’s loss of 4.9%.1 This underperformance was driven by deterioration in the macro economy, as well as a poor corporate earnings trend. As bottom-up investors, however, my team looks past these macro trends and focuses on finding high-quality growth companies that are trading at attractive valuations (a process we call Earnings, Quality, Valuation — or EQV).
Emerging market economies are trending downward
2014 was a rough year for emerging market economies. Brazil, Latin America’s largest economy, entered into recession. China continued its slowdown, and we expect the government’s focus on rebalancing the economy will resettle the growth rate at a much lower level versus previous cycles. Russia’s economy has been hit by falling oil prices, and it is expected to fall into recession this year.
In response to slow economies, China, India, Korea and Peru cut interest rates, while the economies with currency and inflation problems, such as Russia and Brazil, raised interest rates.
Corporate earnings continue to deteriorate
The key that has held back emerging market performance is the continued deterioration in the corporate earnings trend and the decline in return on capital. Emerging markets saw another year of massive earnings disappointment in 2014: At the beginning of 2014, the consensus for emerging markets’ earnings per share growth was 12%.2 This forecast declined steadily and ended last year at just less than 1%.2 Corporate earnings were revised downward throughout the year, and for the first time in the past decade, emerging markets’ return on capital has dropped below that of the developed markets.3
Looking at 2015, the reversal of emerging markets’ weak performance depends on a return to a stronger trend in corporate earnings. There are downside risks that could lead to another year of disappointing earnings growth: the downturn of the commodity cycle, weak currency, tight lending conditions, and a slowdown in China.
We see some positive fundamentals unfolding
Lower commodity prices benefit countries that are commodity consumers, such as China, India and many other Asian economies that are net commodity importers.
Lower commodity prices are also feeding into lower raw material costs, which allow businesses to improve profit margins.
Weaker currencies benefit exporters. We expect the economies of Korea, Taiwan or Thailand to see benefits from improving trade.
Valuations are getting attractive. Emerging market price-to-earning and price-to-book multiples are trading at a large discount to their own history, and at a 30% discount to the developed world.3
What did we do during the fourth quarter?
During the quarter, Invesco Developing Markets Fund added to its allocation in China, Brazil and Russia, taking the opportunity to buy stocks at cheaper valuations.
We agree that Russia carries lot of risks, and that the short-term earnings outlook will be pressured for many companies. However, we believe our holdings have strong business models and will be winners in the long run.
For example, Yandex (1.03% of Invesco Developing Markets Fund as of Dec. 31, 2014) is a leading Russian Internet search company that holds a dominant position in the industry. Yandex benefits from structural growth drivers given its low online ad penetration. While the company would be affected by softening advertising revenue in a recession, we believe it will be the main beneficiary of the ongoing structural shift of ad budgets toward online outlets. It is a well-run company and its balance sheet is healthy with net cash.
- Source: Lipper Inc. As represented by the MSCI Emerging Markets Index.
- Source: UBS
- Source: Morgan Stanley
Important Information
Earnings per share (EPS) is total earnings divided by the number of shares outstanding.
Profit margin measures the profitability of a company. The ratio is calculated as net income divided by revenues.
Return on capital measures the profitability of a company. The ratio is calculated as earnings divided by capital employed.
Price-to-book ratio is the ratio of a stock’s market price to a company’s net asset value.
Holdings mentioned are subject to change and are not buy/sell recommendations.
Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks. An investment in a derivative could lose more than the cash amount invested.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
Depositary receipts involve many of the same risks as a direct investment in foreign securities, and issuers of certain depositary receipts are under no obligation to distribute shareholder communications to the holders or to pass through to them any voting rights with respect to the deposited securities.
Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.
Growth stocks tend to be more sensitive to changes in their earnings and can be more volatile.
The fund is subject to certain other risks. Please see the prospectus for more information regarding the risks associated with an investment in the fund.
Shuxin (Steve) Cao, CFA, CPA
Senior Portfolio Manager
Steve Cao is a Senior Portfolio Manager for Invesco international/global growth strategies. He began his investment career in 1993 as an international equity analyst specializing in Asian securities at Boatmen’s Trust Co. In 1997, he joined Invesco and continued as an international equity analyst with a focus on Asia and Latin America until assuming his present duties in 1999.
A native of Tianjin, China, Mr. Cao earned a Bachelor of Arts degree in English from the Tianjin Foreign Language Institute and an MBA from Texas A&M University.
He is a Certified Public Accountant (CPA) and a CFA charterholder.
Read more articles by Steve Cao on Invesco blog
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