The premium you pay for developed markets hasn’t been this high in 20 years. Here’s what you need to know

This interview was recorded on Wednesday 16 October 2024.

It’s been an extraordinary year in developed markets with both local and US markets hitting record high after record high. But record highs correspond with extreme valuations, causing investors to start questioning whether they might need to start looking elsewhere.

According to John Stavliotis, Portfolio Manager at Antipodes, you are currently looking at a 55% premium for developed markets over emerging markets. It’s the highest level in 20 years and a significant leap from the 16% average.

While emerging markets traditionally operate at a discount because they move with the broader market risk appetite, it’s a misconception to think of these assets as cyclical and low quality.

“There are many companies like that, but we also find many companies that have got a very high return on equity, they’ve got globally leading management teams and corporate governance, high barriers to entry,” says Stavliotis.

He notes that many of these are not fully correlated with US markets and have strong exposure to structural economic drivers.

In this episode of The Pitch, Stavliotis shares his definition of emerging markets, the benefits they can offer investors and the trends he likes across emerging markets. He also discusses the valuation premium and debunks a common misconception about emerging markets.

Edited transcript

There are a lot of definitions thrown around about emerging markets, such as BRICS. What is your definition?

An emerging market is a country that is in that earlier stage of development where effectively they're transitioning to be a modern industrial economy and you're seeing improvements in the standard of living.

Some countries are defined as emerging because of less developed capital markets and regulations. And an example would be South Korea where their GDP per capita is quite high, but things like market access and other regulations hold it back from being developed. I think it's worth adding as well, geographically, if you look at the EM universe, about 70% is in Asia, and Latin America is the next largest area. And then you've got countries in the Middle East, Eastern Europe, and Africa.

What does an allocation to emerging market equities offer investors that is different to developed market equities?

In the short term, EM is a risk asset.

 It moves with a broader market risk appetite, but in the medium term, emerging market companies or investing in equities gives you exposure to that structural opportunity of development in these underlying countries.

In the medium term, that structural opportunity is quite strong and the cycle is uncorrelated to what you find in the US over the medium term because of that cycle driving it. For example, in the Philippines, one in two people have a bank account. So, if you're investing in a bank in the Philippines, that growth has a very long, long period to run and it's not going to change much in the short term if there's weaker growth in the US for example.

How do valuations in emerging market equities compare to developed markets?

EM historically trades at a discount, which is quite understandable. If we look at it the other way, the DM premium over emerging markets over the last 20 years has averaged around 16%.

At the moment, we're at pretty much an extreme level. 

The premium for developed markets over emerging markets is currently 55%, which is the highest level over the last 20 years. And that's been driven by that crowding into the large-cap US tech sector. 

But we think that presents an opportunity for investors.

What are the key trends that excite you the most over the EM landscape?

There are cyclical and structural trends and I think they’re really interesting right now.

Firstly on the cyclical side, there are countries that have been going through a cyclical slowdown that are now stimulating and potentially coming out of that. For example, China. That’s a really interesting opportunity now and it’s not just China. There are other emerging markets in a similar position.

And the other opportunity, which I think is more long-term, is the structural opportunity of investing in a developing market. I’ll give you a few examples because I think it’s worth running through them from a higher level.

As people get wealthier, consumer premiumisation and modernisation are strong examples. The example there that we out is Femsa (BMV: FEMSAUBD) in Mexico which is rolling out modern convenience stores taking share from traditional ‘mum and pop’ retailers.

A similar opportunity related to people getting wealthier is finance and credit penetration. I’ve already mentioned in the Philippines, one in two people have a bank account. As the country becomes wealthier, that will grow. So, investing in a bank there makes sense.

The manufacturing supply chain is a huge industrial opportunity for EMs and we’ve seen that for a long time in China. But, there’s growth in – for example – Mexico with nearshoring, Vietnam with very cheap productive labour that is taking share there.

Lastly, I think a really interesting one at the moment is in North Asia. We’re seeing social governance changes in companies driven by the government. What I’m referring to there, it started with Japan, it’s happening in Korea and China where the government and regulators are pushing companies to focus on return on equity, returning capital to shareholders and becoming more efficient. That’s a reflection of these economies moving from early-stage development to a later stage.

That’s really interesting for us as investors because many of these companies have big cash balances and higher cost bases that if they can focus on returns, will generate a lot of alpha for investors. 

These are just a few of the high-level opportunities that we see that we’re pretty excited about at the moment.

What is one misconception about investing in emerging market equities that you’d like to clear up?

I think a common misconception about emerging markets investing is that the companies are cyclical and lower quality. 

There are many companies like that, but we also find many companies that have got very high return on equity, they've got globally leading management teams and corporate governance, high barriers to entry, and they're exposed to those structural drivers of an economy that is developing and the cycle they're exposed to is also not fully correlated with the US. 

So, for that reason, that is something that I think people don't really realise and strengthens the case for an emerging markets allocation in your portfolio.

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For more information on the Antipodes Emerging Markets fund, including where John in finding the most attractive opportunities today, please visit the Antipodes website or fund profile below.

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