Seizing the Opportunity in Emerging Markets

Valuations alone are not the sole reason to consider emerging markets. From a macroeconomic perspective, these markets continue to contribute substantially to the global economy and exhibit robust growth potential. Over the next three to five years, analysts project emerging market companies to achieve significantly higher earnings growth compared their developed markets peers, particularly in countries such as Taiwan, India and Korea. As shown in the right panel of Exhibit 1, analysts predict that corporate earnings growth in key emerging economies will exceed those of developed markets. We think this growth potential, combined with attractive valuations, makes emerging markets a compelling investment opportunity.

EXHIBIT 1: The emerging market opportunity

Emerging market equity valuations, as represented by the price-to-book ratio, are about 40% lower than that of developed markets (3.2 for developed markets versus 1.8 for emerging markets as of March 31, 2024), well over the historical average even as earnings growth appears attractive.

Share Issuance: An Emerging Market Malady

No matter the valuations, the prospects of higher returns in emerging markets have lured investors for decades. The MSCI Emerging Markets Index produced a robust annualized return of 8.3% from January 2001 to March 2024, outperforming the 7.1% annualized return of developed markets, as represented by the MSCI World Index.1 However, the last 10 years have proven a deep disappointment, as shown in the left panel of Exhibit 2, prompting investors to reconsider their emerging markets allocations.

Our research shows that the disappointing results have largely stemmed from excessive share issuance by emerging market companies. While the contribution to returns from earnings growth in emerging markets over the last decade has been higher than in developed markets, a large volume of share issuance has consistently reduced earnings per share and lowered equity returns. Emerging markets companies have been issuing shares and diluting earnings primarily to raise capital for expansion, reduce debt and improve their balance sheets. Regulatory pressures and government policies encouraging debt reduction and financial stability further drive these companies to raise funds through share issuance.

The right panel of Exhibit 2 shows that share issuance reduced emerging markets returns by 6.2% compared to a 0.5% reduction for developed market returns. Consequently, share issuance dragged down the annualized return for emerging market equities to 6.1% from what would have been 12.3% gross of share changes. Over the same period, developed market equities maintained a return of 10.5% a year.

The right panel of Exhibit 2 highlights the return drag of share issuance in the largest five emerging market countries over the past 10 years. China’s substantial share issuance represents the highest dilution among emerging markets. Even moving forward, China is expected to continue issuing shares, albeit to a lesser extent, and many companies are even expected to increase their share repurchase activity. This emphasizes the need for investors to manage risks appropriately with emerging markets investments.

EXHIBIT 2: THE DAMAGE OF SHARE ISSUANCE IN EMERGING MARKETS

The issuance of new shares across emerging markets, especially over the past decade, lowered investor returns.

Factor Investing: Enhancing Opportunity, Mitigating Risks

We believe that the resilient performance of style factors such as quality, value, momentum and low-volatility over time underscores the potential of factor investing as a powerful solution to capture alpha in emerging markets and to make the most out of the current opportunity. Style factors have historically delivered consistent sources of excess and risk-adjusted returns in emerging markets, paralleling trends seen in developed markets. Exhibit 3 shows that all factors, as well as a multi-factor portfolio that combines these factors, have delivered consistent outperformance versus the emerging markets index since 2000 and over the last decade.

EXHIBIT 3: THE RESILIENT PERFORMANCE OF STYLE FACTORS

Style factors have historically delivered consistent excess and risk-adjusted returns in emerging markets.

In the previous section, we discussed how extensive share issuance in emerging markets has been a significant factor in explaining the low returns realized by investors. Our research indicates that these results also hold on a company level within emerging markets. In particular, companies that issue shares extensively tend to underperform companies that repurchase shares.

One way to address this dynamic at the stock level is to identify companies with more conservative approaches to capital management and consideration of total shareholder returns. Net share issuance (new issuance minus buybacks) is one approach that provides investors with good insight, but we prefer a more comprehensive measure that considers the full return to shareholders from capital activity. A measure that combines share issuance, repurchases and dividend payments is more strongly related to future stock returns. As part of our proprietary quality factor definition, we apply this comprehensive approach to create a composite equity issuance (CEI) score. A lower CEI score indicates better capital management and potentially higher future returns.

Exhibit 4 demonstrates the performance of two portfolios based on CEI from January 31, 2001 to March 31, 2024. A portfolio of stocks with the lowest 20% of CEI scores significantly outperformed a portfolio with the highest 20% of CEI scores. Notably, the high issuance portfolio has not shown growth for over 15 years. This finding emphasizes the importance of managing equity issuance risk in factor portfolio construction.

EXHIBIT 4: THE POSITIVE IMPACT OF EFFICIENT CAPITAL MANAGEMENT

Companies with high composite equity issuance (CEI) scores, which represents inefficient capital management, have not only underperformed companies with low composite equity issuance. They also have not generated returns for investors in more than 10 years.

Investors should exercise caution when constructing factor portfolios. Simple factor definitions and portfolio construction techniques can introduce significant unintended and uncompensated risks and leave unaddressed other risks, such as the increasingly important risk of return dilution. In emerging markets, where numerous extraneous risks are present, effectively managing multiple risk dimensions and exposures is crucial.

A Purposeful Approach to Emerging Markets

Despite recent underperformance relative to developed markets, emerging markets continue to offer compelling opportunities due to their strong outlook in corporate earnings growth and attractive valuations. Thoughtful and purposeful factor-based strategies can provide emerging markets investors with opportunities to improve their investment outcomes. These strategies not only have the potential to enhance returns but also address unique risks in emerging markets, such as earnings dilution.

¹Source: FactSet, returns in U.S. dollar terms from January 31, 2001 to March 31, 2024.

IMPORTANT INFORMATION

Northern Trust Asset Management (NTAM) is composed of Northern Trust Investments, Inc., Northern Trust Global Investments Limited, Northern Trust Fund Managers (Ireland) Limited, Northern Trust Global Investments Japan, K.K., NT Global Advisors, Inc., 50 South Capital Advisors, LLC, Northern Trust Asset Management Australia Pty Ltd, and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.

Issued in the United Kingdom by Northern Trust Global Investments Limited, issued in the European Economic Association (“EEA”) by Northern Trust Fund Managers (Ireland) Limited, issued in Australia by Northern Trust Asset Management (Australia) Limited (ACN 648 476 019) which holds an Australian Financial Services Licence (License Number: 529895) and is regulated by the Australian Securities and Investments Commission (ASIC), and issued in Hong Kong by The Northern Trust Company of Hong Kong Limited which is regulated by the Hong Kong Securities and Futures Commission.

For Asia-Pacific (APAC) and Europe, Middle East and Africa (EMEA) markets, this information is directed to institutional, professional and wholesale clients or investors only and should not be relied upon by retail clients or investors. This document may not be edited, altered, revised, paraphrased, or otherwise modified without the prior written permission of NTAM. The information is not intended for distribution or use by any person in any jurisdiction where such distribution would be contrary to local law or regulation. NTAM may have positions in and may effect transactions in the markets, contracts and related investments different than described in this information. This information is obtained from sources believed to be reliable, its accuracy and completeness are not guaranteed, and is subject to change. Information does not constitute a recommendation of any investment strategy, is not intended as investment advice and does not take into account all the circumstances of each investor.

This report is provided for informational purposes only and is not intended to be, and should not be construed as, an offer, solicitation or recommendation with respect to any transaction and should not be treated as legal advice, investment advice or tax advice. Recipients should not rely upon this information as a substitute for obtaining specific legal or tax advice from their own professional legal or tax advisors. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. Indices and trademarks are the property of their respective owners. Information is subject to change based on market or other conditions.

All securities investing and trading activities risk the loss of capital. Each portfolio is subject to substantial risks including market risks, strategy risks, advisor risk, and risks with respect to its investment in other structures. There can be no assurance that any portfolio investment objectives will be achieved, or that any investment will achieve profits or avoid incurring substantial losses. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Risk controls and models do not promise any level of performance or guarantee against loss of principal. Any discussion of risk management is intended to describe NTAM’s efforts to monitor and manage risk but does not imply low risk.

Past performance is not a guarantee of future results. Performance returns and the principal value of an investment will fluctuate. Performance returns contained herein are subject to revision by NTAM. Comparative indices shown are provided as an indication of the performance of a particular segment of the capital markets and/or alternative strategies in general. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index. Net performance returns are reduced by investment management fees and other expenses relating to the management of the account. Gross performance returns contained herein include reinvestment of dividends and other earnings, transaction costs, and all fees and expenses other than investment management fees, unless indicated otherwise. For U.S. NTI prospects or clients, please refer to Part 2a of the Form ADV or consult an NTI representative for additional information on fees.

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