“Value” is an over-utilized term within the investment management industry. A wide range of fund managers employing disparate strategies claim to utilize “value disciplines” or to follow a “value approach.” In truth, there is no standardized definition for the notion of “value investing.” The progenitors of the value discipline, Benjamin Graham and David Dodd, never themselves used the term to describe their work.1 Instead, they explained an investment process that they believed to be both coherent and capable of producing attractive returns. A critical feature of the discipline was that it sought securities of a deeply discounted nature. Later, other investors sought to claim reference to Graham and Dodd’s work; they developed the term “value investing” as a means to describe their efforts.

In our view, “value investing” is an investment approach that seeks to purchase a security at a discount to its intrinsic worth. We believe there is considerable theoretical and empirical evidence to support the idea that a value discipline generates attractive returns for long-term investors. However, the best support for a value-oriented discipline rests on a simple and elegant first principle: investment returns are inversely proportional to the price paid relative to intrinsic worth. This practice accounts for the “discount” embedded in the definition of value investing.

Defining the second element of our definition, “intrinsic worth,” is significantly more complex. The identification of “value” has evolved over time and varies by practitioner, making a systematic, empirical study of its historical returns problematic. Nevertheless, the most comprehensive empirical study of the subject of which we are aware is a paper called “What Has Worked in Investing” by Tweedy, Browne Company, LLC.2 The paper represents a collection of studies through the decades that have measured the returns corresponding to discrete investment characteristics - such as price-to-book value , price-to-earnings, or dividend yield, among others - associated with a value discipline. The paper’s conclusion is that there is a recurring pattern of positive correlation between these characteristics and excess return when measured over long periods of time. This conclusion confirms what we intuitively knew based on the first principle stated above.

Investors in the United States have long recognized and exploited this association, as evidenced by Morningstar’s mutual fund data. That database indicates that approximately 481 U.S. mutual funds, or 21% of the total, are self-identified as value strategies.3 The number of U.S.-based mutual funds investing in developed market (ex-U.S.) equities, as defined by Morningstar’s “Foreign” fund categories, that self-identify as value strategies is approximately 55, or 11% of the total.4 Clearly, value-oriented strategies comprise an important component of the global investment universe. We presume that this is because investors recognize that over long periods of time, “value” provides attractive returns.

Oddly, though, the merits associated with “value” have not translated to emerging markets. It is quite rare to observe emerging market funds that deploy value-oriented investment disciplines. Using the same Morningstar data, we note that only six U.S. mutual funds in the “Diversified Emerging Markets” category pursue value strategies – only 3% of the total.5,6

What is striking about the paucity of emerging market (EM) value strategies is that one might think the approach would yield superior returns in this universe given the more inefficient nature of developing economies and financial markets. One example of this inefficiency is the higher cost of capital in emerging markets. The higher interest rates associated with EM are indicative of the higher return accorded to capital in these markets. As the cost of capital is relatively high, one might reasonably theorize that the present discount to intrinsic value should be substantial, in corresponding fashion. The compounding of such interest over the long time horizon characteristic of a typical value discipline illustrates the potential remuneration to the approach in this universe – put differently, it illustrates why one is likely to find significant discounts to intrinsic worth.

With such apparent advantages for a value investment discipline, why do so few strategies exist? Is there an impediment to profitable value strategies in EM that is absent from developed markets? Is the opportunity set too small, or insufficiently attractive despite the higher discount rates employed in these markets, or are value traps simply too complex to unravel? It is with this sense of opportunity and curiosity that Seafarer decided to explore the emerging markets and look for answers.