“Emerging Markets!” ™

Readers of our past notes on emerging market equities know that deep inside we feel a visceral mix of disdain and injustice at the use of the term “emerging markets”. Injustice because it glosses over the heterogenous nature of these countries, people, cultures and markets and bundles them into a single basket (i.e. “not developed”), disdain because it is simultaneously untrue (again, there’s nothing “emerging” about China, for example) and is in reality just another meme in the market’s never-ending metagame.

Let’s call it “Emerging Markets!” ™

The fact that it is a meme, however, doesn’t make it invalid: everything is a meme, but in a meme driven world, the memes drive the decisions (knowingly or otherwise), and decisions drive trading flows, so understanding the memes is essential to having a chance to make money.

The meme of the past decade or so has been some combination of “Growth!” “Internet!” and “Buy US Stocks!”, driven by the underlying meta-meme of “money printer go brrr”. Indeed, hindsight does allow us to look back on all of this and conclude that it was all pretty obvious.

We now find ourselves at the point where it is common knowledge that the underlying meta-meme of “money printer go brrr” has expired. Growth? Having +100% YoY revenue growth forecasts years into the future, fuelled by constant reinvesting of revenues and seemingly never-ending series of funding rounds was the name of the game for the past decade. But will it be for the years to come?

The past few weeks have shown that the meta-narrative in the markets is shifting: some call it growth-to-value, and to some extent that is true, although that misses out quite a bit of nuance in our opinion.

As it stands, it seems like the market is now looking for something different from what it has sought in the preceding decade: cashflows, strong underlying demand growth stories, profits and reasonable valuations.

If the past few months were the initial tremors – of the early movers starting to get a sniff that things are starting to change – then the months, and even years, to come could well be years of tectonic shifting.

The dominant meme seems to be changing. If so, we must change too.

Hello again, boring.

Exciting as it is to talk about unicorns (even decacorns) and charismatic founders who raised insane amounts of capital to build imaginative businesses that inspire endless wonder, turning off the supply of unending liquidity simply makes such narratives untenable. And with rate hikes now firmly on the table, the cost of capital is going to face a hurdle again: profits need to be generated, and they need to be bought at a reasonable price.

Growth is always nice, but certainly not “at any price”. It does feel like a repeat of something from a different age to talk about “growth at a reasonable price” aka “GARP” ™, but it would not surprise us that these terms start reappearing in the market lexicon.

As the hurdles returns start being raised, sexy narratives give way to a need to make a minimum return – whether for investors looking at an increasingly attractive risk-free rate or simply to repay debt, the required risk/reward balance becomes much more onerous than the “YOLO” strategies of yesteryear.

And so, “boring” comes into play. And the best part is, these “boring” businesses don’t even need to be sexy, innovative or brilliant, they just need to be profitable – if they’re all of that, all the better, but even then, the multiple can’t be too demanding because multiple contraction = negative returns even if underlying earnings are growing well.

Even at the top of the food chain, where the best businesses in the world play, share prices have run far ahead of earnings growth i.e. multiples have expanded. And expanded multiples have room to contract – therein lies the problem.

It’s not about just being good. To be desirable in this new set up, you need to be profitable AND attractively priced.

The “Emerging Markets!” ™ meme

Memes and narratives play out in many different ways, and there are multiple ways to get to a destination, but we’ll have a go at trying to articulate one possible narrative that may come about: “Emerging markets have been oversold but growth is there and demographics are favourable, setting them up for a period of outperformance as they play catch-up. Valuations are undemanding and there are national champions which are under-owned.”

A fun exercise would be to put some of those terms into a Bingo grid, and tick them off as we look at research notes published over the coming months and years to see how much of that comes to pass.

In general – as much as we are continually annoyed by the generalisation of “Emerging Markets” as a term – there is truth in the argument that these markets are severely under owned. The end of the EM buzz in the early 2010s saw a decade-long exodus of capital from these markets, flowing back to the US as the key beneficiary of QE.

Could there be a reversal? Possibly, with no small number of exceptions. China, for one, while still termed an “Emerging Market” exists in a completely different realm. It faces drastically different economic and even political scenarios, so we’d be hesitant to bundle Chinese equities in the same sentence as everything else.

Turkey is another exception, with the political situation on the ground making it challenging for new capital flows to enter, although if that did come to pass that would be great victory for the incumbent establishment.

And of course, Russia is in a rather unique situation right now but as we know, markets do forget as time passes.

But for everywhere else in “traditional” emerging market land: South Africa, Brazil, Indonesia, Philippines, Thailand, India etc things could start getting interesting. When was the last time anyone talked about a new mine being opened, or “same store sales growth” for a department store chain, or “RevPAR” for hotels? It’s been a while.

It’s probably time to dust off the glossary, wake the non-internet sector analysts and reload the old watchlists, sorted by country and sector: banks, consumers, energy, industrials, mining – cash generative and profitable businesses that for years have been kept under pressure from unending outflows of capital.

Just as it didn’t matter how good these businesses were when passive allocators were selling these stocks on the way down, moving money out, it likely doesn’t matter how good they are now, so long as allocations are flowing in.

Will it be the same game all over again? Probably not – businesses change, investor appetites and preferences change (think ESG etc) but it’s unlikely they change too drastically.

Same-same but different.

Rotations and structures

Perhaps the years of frustration are coming to an end? Who can tell, really?

One final point which might be helpful in contextualising our thinking is that of market structure.

The way we’ve evolved our thinking around the US equities markets especially is to really start taking into consideration the structure of the market: options, dealers, hedges, passive ETFs, retail flows etc. all feature when trying to work out what really goes on.

To the credit of the US markets, this is an impressive level of sophistication – and many around the world have looked upon what has happened in the US and watched in awe. Some may even seek to emulate it, if given the chance. That said, at least on the derivatives front, the lack of depth and volumes in local derivative markets in most “emerging” markets precludes this extent of drama. Nonetheless, retail flows are not to be underestimated – especially so in domestically-driven markets.

However, when it comes to passive flows and the impact of top-down flows driven by macro allocators, market structure is critical. Neglecting to take these flows into consideration before would have left many participants confused as to why top-performing businesses with strong earnings growth were being sold day after day.

In all likelihood, incoming allocations to “Emerging Markets!” ™ this time round will also come in the form of ETFs, which themselves mirror the index. But a rising tide lifts all boats, especially from a dry seabed, and strong headline index performance from domestic megacaps would do wonders for the retail community, too.

In the end, it’s all about the flows.

Perhaps reprieve is on the way.

Perhaps it’s time for “Emerging markets!” ™, round two.

But if it is, it’s likely less for fundamental reasons, and much more because, well, it’s just a meme.