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Richard Pzena's First Quarter 2014 Commentary

April 28, 2014 | About:
Holly LaFon

Holly LaFon

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Emerging market equities have struggled since their peak in April, 2011. The MSCI Emerging Markets index has lost 11% cumulatively over the last three years, underperforming the MSCI World developed market index by a whopping 40%. Investors are therefore asking: Is it time to meaningfully increase exposure to the emerging markets?

As shocking as it may seem, despite the drop in the broad index, consumer-related stocks actually went UP from the 2011 peak, with health care and consumer staples advancing double-digits, out-performing economically sensitive sectors by as much as 60% (Figure 1). All the pain has been felt in sectors such as materials and energy, which plunged 40% and 33%, respectively. So the investor who thinks this is an opportunity to invest in the developing market consumer at discount prices is in for a rude awakening. The key question is whether the stocks that have been decimated are truly cheap.

We will review the consumer staples, financial services and materials sectors to provide a contrast in opportunities, and demonstrate why a focus on specific businesses where valuations have adjusted and fundamen - tals can be well understood is critical to investing in the emerging markets today.

Expensive Consumer Staples

The consumer staples sector is one of investors' favorites – it provides access to the rapidly growing consumer econo - mies of the developing world, and is perceived to be resistant to economic cyclicality. Though valuations in the sector have corrected, the adjustment has been modest. Consumer sta - ples price-to-earnings ratio of 26.5x is at the upper end of it s 20 year range, and is also close to its highs on a relative bas is versus the emerging markets universe at 2.3x (Figure 2). Only the health care sector sells at a higher valuation.

Consumer staples companies in emerging markets have seen their profitability steadily erode since their peak. Profit abil - ity for the group, as measured by return on equity, is currentl y at 13.9%. This is below the group's long-term average of 14.8% an d is well below the 2008 peak of over 17.0%. In spite of this er osion in profitability, valuations have largely ignored the deteriorat ion. We believe this mostly owes to investors' undaunted belief that the emerging middle class consumer is an unstoppable engine of profit growth and therefore should be priced at a premium to just about everything else in the world. While fundamentals are undoubtedly good, these kinds of valuations create risk: while there is upside potential in stock prices if conditions remain sup - portive, there is uncertain downside if they don't.

Select Opportunities in Financials

Stock prices of financial companies in the developing world have been hard-hit, raising the question of whether it is time to make an outsized commitment to the sector. Though the mar - ket appears to be discounting challenges ahead, conditions vary from country to country, with caution warranted where credit has expanded most rapidly and stress is not yet apparent.

Continue reading here.


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