It has been a tough decade to be an investor in emerging market equities. Over the past ten years, emerging market stocks have risen just 10% in US dollar terms. US stocks, by contrast, have risen 300% over the same period.
Underperformance has continued this year: while the S&P 500 is remarkably now almost flat for the year despite the impact of Covid-19, EM stocks are still down around 10%.
Understandably, many investors have given up on the asset class. According to data from the Institute of International Finance, foreign investors withdrew $100bn from EM equity and bond markets between 20 January and 29 April 2020, more than four times the outflow that took place in 2008 in the Global Financial Crisis.
Emerging markets as an asset class have been comprehensively evacuated by international investors.
It is in just such capitulations that the seeds of big bull markets are sown. After a decade of handsome gains in the US and water-treading in emerging markets it is worth looking back at what happened in the previous decade. Between 2000 and 2010, the S&P 500 fell 5%, while the MSCI Emerging Markets Index more than tripled.
The strongest determinant of future medium-term returns for stock markets is starting valuation: today the price to book value multiple of MSCI Emerging Markets index is the lowest it has been since 2008 and the lowest relative to the S&P 500 since the early 2000s. From the end of 2002 and the end of 2008, when valuations were at similar levels to now, emerging markets roughly doubled within two years.
Relative valuation to large caps near 2009 levels
While we, therefore, think that this is a great time to be allocating capital to emerging markets in general, there is a particularly strong case to be made for small- and mid-cap emerging market stocks, which represent an unloved section of an unloved asset class.
This is the universe in which the Somerset EM Discovery fund invests. Small-mid cap stocks - defined as those with market capitalisations of below $7.5bn - have underperformed large cap over the last four years in EM, driven in part by the outperformance of China, which accounts for around 40% of the large cap index but less than 20% of the small mid cap index.
The price to earnings multiple for the small mid cap index is now the lowest it has been relative to the large cap index since 2008/9.
From the lows of the Global Financial Crisis, small mid caps went on to deliver significant outperformance versus large caps in EM for a number of years. Early indications suggest the same pattern may be unfolding this time around: so far in the second quarter of 2020, the MSCI EM Small Mid Cap index has outperformed the Large Cap index by around 8%.