Now, more than ever, our focus should turn global, as we should look for strong ESG performers that trade at attractive valuations, a task that has become exceedingly difficult in the domestic market. Emerging markets, despite their unique challenges for ESG investors, demand special attention due to their deep undervaluation relative to the U.S. stock market.
Famed investor Warren Buffett generated fantastic returns over the course of his life by following a strategy of making investments in deeply undervalued companies when nobody else was interested in them. Mr. Buffett’s strategy is not complicated, but it seems that many investors, including (and maybe especially) those interested in sustainability, have forgotten this simple concept. Indeed, the S&P 500 Index currently trades near its all-time high, at multiples that will likely make it difficult for investors to generate attractive returns over the coming decade. At the same time, interest in emerging market stocks appears almost non-existent and is worsening as the coronavirus pandemic continues to put downward pressure on those economies where fiscal support has been less forthcoming than in G20 economies. This divergence is exactly the type of opportunity our “go anywhere” investing strategy is designed to capture.
There is no doubt that emerging markets have historically presented an added challenge for investors focused on sustainability factors. However, the encouraging growth in ESG disclosure by emerging market companies and the ever-widening coverage of emerging market companies by ESG data providers has dramatically lowered this hurdle, giving sustainability-focused investors far more opportunities to invest in deeply undervalued companies in the Buffett fashion. You could even suggest that sustainable investors may stand to benefit more than investors who simply allocate to traditional emerging markets equities.
Your approach to investing in emerging markets is the same as it is in any other market: look for companies with strong ESG performance trading at attractive valuations. Set forth below are some of the key considerations that should inform your current interest in emerging markets.
Although the rest of the world continues to generate faster economic growth than the United States, investors seem convinced that the United States is in much better shape than the rest of the world. We believe this consensus view is incorrect, as there is little to suggest that the United States has fewer problems than the rest of the world. Between 2018 and 2050, the working age population in the emerging markets is expected to increase by 135%, even while the working age population in the developed world is expected to decline by 7%.2 Population growth in emerging economies, along with productivity improvements which correlate to many of the UN Sustainable Development Goals, should lead to far better growth in emerging markets over the next thirty years relative to the United States and other industrialized countries.
Evolution of Emerging Markets
The world has changed considerably as a result of the growth of emerging markets over the past 20 years. Emerging markets represent a greater share of the global economy today, while the United States’ share of the global economy has decreased. Emerging market countries have become richer, and their middle-classes have increased commensurately; China and India are home to two of the top three largest middle-class populations in the world. At the same time, emerging market economies are evolving away from low cost, labor- and resource-intensive industries and towards technology, services, and consumer-driven industries. This evolution not only helps to make emerging markets more attractive to investors generally, but it also provides greater opportunity for sustainability-focused investors.
The valuation discrepancy between U.S. stocks and emerging market stocks is currently larger than at almost any time in recent history. As of September 10, 2020, the U.S. stock market is trading at a cyclically-adjusted P/E (CAPE) multiple of 31.2x earnings. The only two times in history when the S&P 500 Index was more expensive by that measure were 1) the peak of the Dot-Com bubble in 2000 and 2) the stock market peak in 1929. Investors would be wise to remember how poor stock returns were subsequent to those valuation peaks. Emerging market stocks trade at a CAPE ratio of just 15.8x; put simply, emerging market stocks are currently trading at a 50% discount to their U.S. counterparts.
The U.S. Dollar is Overvalued
When the U.S. dollar appreciates relative to the currencies of other countries, the U.S. stock market tends to outperform the stock markets of other countries. Similarly, when the U.S. dollar depreciates versus the currencies of other countries, the U.S. stock market tends to underperform. Several important fundamental factors should lead to a weaker dollar in the years ahead (e.g., fiscal and monetary stimulus, trade imbalances), and that dollar weakness should fuel earnings growth and share price appreciation in emerging markets.
ESG Outperformance in Emerging Markets
Over the past 10 years, the MSCI EM ESG Leaders Index has outperformed the MSCI Emerging Markets Index by more than 3.5% per annum while also experiencing less volatility and smaller drawdowns. This outperformance dwarfs that of the MSCI EAFE ESG Leaders Index vis-à-vis the MSCI EAFE Index (0.87% per annum), and in the U.S., the MSCI USA ESG Select Index has actually underperformed the MSCI USA Index by a small margin. This strongly suggests that ESG-focused investors can earn a material premium investing in emerging markets – one that can be elusive in developed markets.
The opportunity for ESG investors in emerging markets is clear. There are unique challenges that emerging markets investing poses for SRI investors, but you should also recognize that SRI investors who are willing to go against the grain stand to benefit greatly from deep undervaluation and an ESG premium. While countless ESG investors crowd into the same flashy U.S. technology stocks, paying multiples that all but guarantee poor forward returns, value conscious investors who are willing to do the more difficult work of understanding the ESG risks and opportunities of emerging market companies should be rewarded with attractive long-term performance.