A Top Contrarian Investment Idea for 2024

Key Takeaways

• The Morningstar US Market Index has essentially tripled in value over the past 10 years. The Developed Markets Index, of which the US is the majority but also includes Europe and Japan, is up about 2.4 times. The Morningstar Emerging Markets Index, which is about 3,700 stocks over 20 developing economies, is only up 1.5 times.
• A small cohort of tech companies has just been phenomenally successful, profitable, and fast-growing, companies like Apple, Microsoft, and Nvidia.
• Emerging-markets investing is about more than just identifying the hot growth economy. Economic growth often does not translate into investment gains. China is a case in point.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Emerging-markets stocks have dramatically underperformed both US stocks specifically and developed-markets stocks in general during the past decade. And as a result, these stocks may be catching the eye of contrarian investors. But are emerging-markets stocks opportunities or value traps today? Joining me to discuss his new research on the topic is Dan Lefkovitz. Dan is a strategist with Morningstar Indexes and a co-host of The Long View podcast. Thanks for being here, Dan.

Dan Lefkovitz: Always great to be with you, Susan.

Will Emerging-Markets Equities Ever Reemerge?

Dziubinski: Let’s dig into your new paper, which you’ve called Will Emerging-Markets Equities Ever Reemerge? That’s good. Viewers can, of course, download a copy of the paper via the link below this video. Let’s get right into it. Walk us through some of the numbers. How bad has it been for emerging markets during the past 10 years?

Lefkovitz: Pretty bad, Susan. Ugly, even. If you look at our Morningstar US Market Index over the past 10 years, it’s essentially tripled in value. Developed markets, of which the US is the majority but also includes Europe and Japan, are up by about 2.4 times. Emerging markets, our Emerging Markets Index, which is about 3,700 stocks over 20 developing economies, is only up 1.5 times. So, a massive return gap.

Emerging Markets and US Exceptionalism

Dziubinski: Now, in a recent interview on The Long View podcast, you talked with an emerging-markets fund manager who attributed a good deal of this emerging-markets underperformance during the past decade to something he called US exceptionalism. And you touched on this in your paper, too. Let’s talk a little bit about that.

Lefkovitz: Justin Leverenz was our podcast guest. And it’s interesting, we talk about how the last time we crossed paths was 2007, and the asset class was in a very, very different place. Emerging markets were booming back then. China’s economic growth was setting off a commodity supercycle that was benefiting a lot of markets around the world. The European Union was expanding eastward. And from 2000 to 2010, which is often referred to as the lost decade for US equities, emerging markets were the place to be. We even had the BRIC as a hot investment theme for Brazil, Russia, India, China, and sometimes South Africa.

But, yes, over the past 10-plus years, US equities have really dominated. And as we’ve talked about, as you’ve covered extensively at Morningstar.com, there’s a small cohort of tech companies, tech-related companies, that have just been phenomenally successful, profitable, fast-growing. Their share prices have just been gravity-defying. It started as the FAANG and it’s evolved into the Magnificent Seven, companies like Apple AAPL and Microsoft MSFT and Nvidia NVDA. And these companies have really benefited from some of the big tech themes that were sort of first envisaged during the late 1990s.

If you think about e-commerce and mobile and the cloud, and now we have artificial intelligence—there are some beneficiaries in emerging markets. The top two constituents of our Emerging Markets Index are Taiwan Semiconductor TSM and Samsung Electronics. But I’d say that the vast majority of the benefits of these trends have been reaped by US companies. And it’s interesting that the US outperformed in the aftermath of a crisis, the 2008 financial crisis, that originated in the US market.

Challenges Facing Emerging Markets

Dziubinski: But emerging markets have also, during the past decade, faced some of their own sets of challenges. So, outline some of those.

Lefkovitz: Right. I think it’s a combination of the US winning and emerging markets losing. So, let’s see. There was the taper tantrum in 2013 when the US Federal Reserve talked about withdrawing monetary stimulus, and that hit the asset class hard. That was sort of a technical sentiment thing. There was a big downturn in commodity prices in 2014 and 2015 that hit emerging markets hard. We had the rise and the fall of the Chinese equity market, which we can get into. We had the Russian invasion of Ukraine in 2022, which took it off the investment map. So, it’s really been one thing after the other for emerging markets. And then we’ve had currency dynamics working against them as well. The US dollar has been really strong.

Investing in Emerging Markets and China’s Markets

Dziubinski: Got it. Let’s talk a little bit about China, because really there’s a situation where it seems like China was the hot story for a lot of emerging-markets funds and emerging-markets fund managers, and now it seems like things have, honestly, a little bit imploded.

Lefkovitz: We talk in the podcast about how emerging-markets investing is about a lot more than just identifying the hot growth economy. And oftentimes economic growth does not translate into investment gains. China is sort of a case in point. Outstanding growth over the past few decades, but it’s been a very, very difficult place to invest. We did have several years there where Chinese equity companies, led by some internet-related businesses, were doing very well. If you look at the end of 2020, some Chinese names were actually some of the biggest public companies in the world, like Alibaba BABA and Tencent. And then there was a government intervention, regulatory action that kind of kneecapped these companies and took down their market value really substantially. And then, of course, the pandemic. Coming out of the pandemic, China was anticipated to grow economically, very strongly rebound, and that really didn’t happen coming out of the zero-covid lockdowns.

Dziubinski: Right. So, given this underperformance for a decade, one would assume that emerging-markets stocks from a valuation standpoint must look kind of attractive. True?

Lefkovitz: If you look at our indexes, our Emerging Markets Index trades at a sort of aggregate price/earnings ratio of 13.

Dziubinski: OK.

Lefkovitz: That compares to closer to 20 for developed markets and 23 for the US equity market. And just as a reminder, if you go back to 2007 and 2010, emerging markets traded at times during those years at a premium to developed-markets equities.

Long-Term Strategic Case for Emerging Markets

Dziubinski: Interesting. In your paper, you do talk about the long-term strategic case for emerging markets today despite this underperformance. So, make that case.

Lefkovitz: These are very, very rough numbers, but if you think about emerging economies, China and India and so forth, they’ve got 80% plus of the world’s population. They’ve got 70% plus of the world’s economic output, but in terms of equity market capitalization, it’s 10% to 12%. Now, these numbers don’t necessarily have to align, but they look pretty out of whack at the moment.

Catalysts for Emerging Markets

Dziubinski: You also talk in your paper about several catalysts that could help drive some improved returns in some emerging-markets stocks. One that stood out to me in your paper, and you also talked about this in the podcast, was this idea of the clean energy transition. Explain how that could be a catalyst for emerging markets specifically.

Lefkovitz: It’s a global theme, but there are several companies, several markets within the emerging world, that stand to benefit pretty dramatically from this transition. So if you think about some of the green metals that are required for the clean energy transition, copper and so forth, there are a lot of emerging-markets companies in Mexico and other markets that are exposed and potential beneficiaries. If you think about electric vehicles and clean transportation, you’ve got, Justin [Leverenz] mentioned, battery makers in South Korea. So, again, a global theme where there are going to be beneficiaries in the developed world as well as emerging.

Dziubinski: What could be some other catalysts that could really help emerging markets reemerge?

Lefkovitz: India is definitely one of the most promising emerging markets. And the Indian market has done quite well. It’s been kind of overshadowed by the US story, but the Indian market has long had some very high-quality businesses. But what’s changed in recent years is the economic backdrop, the regulatory policy backdrop, infrastructure, investment, and so forth. So, India, its growth story and businesses that are poised to capitalize, that’s definitely a potential catalyst.

If you think about certain trends in the healthcare space, we talk about with Justin the biotechnology companies in China that are well-positioned to benefit there. Currency dynamics. Those could change. The US interest-rate cycle. Just having low expectations, low valuations, and sort of outperforming those low expectations. That could be a source of outperformance. One thing I’d note as well is that from a diversification standpoint, emerging markets are definitely less correlated with US equities, European equities, than developed markets are with each other. So, I think they play a useful portfolio role from that standpoint.

High-Quality Companies

Dziubinski: And diversification, too. Got it. Then lastly, Dan, you point out in your paper that emerging markets are home to, really, some very high-quality companies. Why do you think that quality is perhaps maybe even a little bit more important when it comes to investing in emerging markets specifically?

Lefkovitz: In order to capitalize on the economic growth you have to have well-managed businesses that are well-positioned and are managed for shareholder value. Our Morningstar Equity Research team, which is global in nature, they do consider several emerging-markets companies to have economic moats around their business, so durable competitive advantages that should allow them to sustain profitability. If you think about Ambev ABEV in Brazil or some of the Mexican airports, Yum China YUMC, Shanghai Pharmaceuticals, Tata Consultancy in India is another one.

Dziubinski: That’s great. Well, thank you for your time today, Dan. We appreciate it.

Lefkovitz: Thanks, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch Watch Out for This Hidden Risk in Your Investment Portfolio in 2024 for more from Dan Lefkovitz.