Thinking strategically about value allocation to emerging markets

John Goetz

Pzena Investment Management

A hallmark of emerging markets is growth. Some, therefore, suggest that these markets are not a natural habitat for valuation based investing. In fact, our own research, along with that of many theoreticians, has demonstrated that using a valuation-based approach in the developing world has been a superior strategy. Research has also shown that there’s no reliable correlation between GDP growth and stock performance — so the rapid economic development of the emerging markets isn’t an argument for applying the growth investment style.

Figure 1 examines the return difference between low price-to-book stocks (Cheapest Quintile*) and the broad market over the period 1992 through 2020. As can be seen, we were able to confirm a significant premium for value stocks in emerging markets.

A Research-Driven, Long-Term Approach is Key

Picking from the cheapest stocks within an investment universe, we rely on detailed research to distinguish companies facing near-term distress that’s reparable from those that may subject investors to the permanent impairment of capital. While poor short-term earnings visibility can continue to weigh on these companies’ stock prices, the longer the holding period, the greater the prospect of earnings improvement and subsequent returns for a stock. Over five-year rolling periods, deep value stocks (the cheapest 20% of shares in the universe*) beat the MSCI Emerging Markets Index 78% of the time (Figure 2: the most undervalued stocks are displayed on the y-axis, the broad index on the x-axis; gold dots above the line reflect value outperformance), resulting in average annual outperformance of 8.80%. Because many investors are concerned about risk mitigation, we compared results when the emerging-market index posted negative 5-year returns. The cheapest stocks outperformed the broad index by an average of 14.01% annually. This illustration demonstrates what our data has shown more broadly — following extreme periods of market stress, deep value stocks tend to outperform by a wide margin.

Why Value Works

The psychological underpinnings. The history of investing is that valuation distortions are common, observable, and exploitable. A value investment style works in the emerging markets for precisely the same reasons that it works everywhere else: Human beings are emotional creatures who tend to 
  • overreact to near-term events, 
  • misjudge the likelihood of a future event, and 
  • have an overconfidence in their ability to predict outcomes 

Emerging markets — less well understood and mature than their developed world counterparts — are even more susceptible to the cycles of fear and euphoria (i.e., overreaction). Therefore, it should come as little surprise that a valuation-based approach has actually worked better in the emerging markets than the developed world. Figure 3 (which shows the spreads in relative returns between the cheapest stocks and the respective market) makes a clear case for value in the emerging markets. Over the 34-year period shown, the cheapest stocks globally have outperformed their respective markets by a meaningful amount, and to a far greater degree in the emerging world.

Reversion to the mean. Reversion to the mean exists in two key factors that contribute to stock returns — valuation and company performance. We see reversion to the mean in valuations precisely because cognitive biases cause investors to overweight information such as recent news and underweight salient fundamental data about long-term prospects, causing prices to temporarily swing away from their fundamental values. This leads investors to undervalue companies that are experiencing some form of distress. 

As for company performance, we believe that very high levels of profitability or earnings growth usually are not sustainable, and tend to be overvalued. The odds are against the sustainability of perfection, but the price of the stock often is set by investors whose confidence that their company will beat the odds is too high.

We also believe that very poor profitability can be temporary. Over time, cycles turn, management takes actions, costs are cut, and excess industry capacity diminishes. The odds favor improvement, but the stock prices of companies in pain are often set by investors who cannot look past the near-term problems. 

With fewer than 20% of emerging markets strategies identifying as value, chances are you are underexposed to this compelling opportunity set. Pzena has adhered to a classic value, research-driven approach rigorously applied since its inception more than 25 years ago.

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This document is intended solely for informational purposes. The views expressed reflect the current views of Pzena Investment Management (“PIM”) as of the date hereof and are subject to change. PIM does not undertake to advise you of any changes in the views expressed herein. There is no guarantee that any projection, forecast, or opinion in this material will be realized. Past performance is not indicative of future results. All investments involve risk, including risk of total loss. This document does not constitute a current or past recommendation, an offer, or solicitation of an offer to purchase any securities or provide investment advisory services and should not be construed as such. The information contained herein is general in nature and does not constitute legal, tax, or investment advice. PIM does not make any warranty, express or implied, as to the information’s accuracy or completeness. Prospective investors are encouraged to consult their own professional advisers as to the implications of making an investment in any securities or investment advisory services. The funds’ investment objectives, risks, charges and expenses must be considered carefully before investing. The summary and statutory prospectus contain this and other important information about the investment company, and may be obtained by calling 1.844.PZN.1996 (1.844.796.1996), or visiting Read it carefully before investing. Fund holdings, regional and sector exposure and characteristics are as of the date shown and are subject to change at any time. As a result, current and future holdings are not recommendations to buy or sell any security. Sources: [1] See, for example; Eugene F. Fama and Kenneth R. French, “Value versus Growth: The International Evidence,” The Journal of Finance, Vol. 53, No. 6 (1998), pp. 1975-99; Vladislav Kargin, “Value Investing in Emerging Markets: Risks and Benefits,” Emerging Markets Review, Vol. 3, No. 3 (2002), pp. 233-44: Christopher B. Barry, Elizabeth Goldreyer, Larry Lockwood, and Mauricio Rodriguez, “Robustness of Size and Value Effects in Emerging Equity Markets, 1985-2000,” Emerging Markets Review, Vol. 3, Issue 1 (2002), pp. 1-30. Although much of this research was published some time ago, the conclusions favorable to Value strategies in the emerging markets still apply. [2] See, for example, Jay R. Ritter, “Economic Growth and Equity Returns,” Pacific-Basin Finance Journal, Vol. 13, Issue 5 (2005), pp. 489-503. For European Investors Only: This financial promotion is issued by Pzena Investment Management, Ltd. Pzena Investment Management, Ltd. is a limited company registered in England and Wales with registered number 09380422, and its registered office is at 34-37 Liverpool Street, London EC2M 7PP, United Kingdom. Pzena Investment Management, Ltd is an appointed representative of DMS Capital Solutions (UK) Limited and Mirabella Advisers LLP, which are authorised and regulated by the Financial Conduct Authority. The Pzena documents are only made available to professional clients and eligible counterparties as defined by the FCA. The value of your investment may go down as well as up, and you may not receive upon redemption the full amount of your original investment. The views and statements contained herein are those of Pzena Investment Management, LLC and are based on internal research. For Australia and New Zealand Investors Only: This document has been prepared and issued by Pzena Investment Management, LLC (ARBN 108 743 415), a limited liability company (“PIM”). PIM is regulated by the Securities and Exchange Commission (SEC) under U.S. laws, which differ from Australian laws. PIM is exempt from the requirement to hold an Australian financial services license in Australia in accordance with ASIC Corporations (Repeal and Transitional) Instrument 2016/396. PIM offers financial services in Australia to ‘wholesale clients’ only pursuant to that exemption. This document is not intended to be distributed or passed on, directly or indirectly, to any other class of persons in Australia. In New Zealand, any offer is limited to ‘wholesale investors’ within the meaning of clause 3(2) of Schedule 1 of the Financial Markets Conduct Act 2013 (‘FMCA’). This document is not to be treated as an offer, and is not capable of acceptance by, any person in New Zealand who is not a Wholesale Investor. For Jersey Investors Only: Consent under the Control of Borrowing (Jersey) Order 1958 (the “COBO” Order) has not been obtained for the circulation of this document. Accordingly, the offer that is the subject of this document may only be made in Jersey where the offer is valid in the United Kingdom or Guernsey and is circulated in Jersey only to persons similar to those to whom, and in a manner similar to that in which, it is for the time being circulated in the United Kingdom, or Guernsey, as the case may be. The directors may, but are not obliged to, apply for such consent in the future. The services and/or products discussed herein are only suitable for sophisticated investors who understand the risks involved. Neither Pzena Investment Management, Ltd. nor Pzena Investment Management, LLC nor the activities of any functionary with regard to either Pzena Investment Management, Ltd. or Pzena Investment Management, LLC are subject to the provisions of the Financial Services (Jersey) Law 1998. For South Africa Investors Only: Pzena Investment Management LLC is an authorised financial services provider licensed by the South African Financial Sector Conduct Authority (licence nr: 49029). The Pzena Funds are distributed by Quasar Distributors, LLC. © Pzena Investment Management, LLC, 2021. All rights reserved.

John Goetz
Managing Principal, Co-Chief Investment Officer
Pzena Investment Management

John is a co-portfolio manager for the Global, International, European, and Japan Focused Value strategies.

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