OSAM: How To Win In Emerging Markets

Emerging markets can make for enticing investments, and new research from James O’Shaughnessy’s firm shows how fundamental-focused investors can really take advantage of EM opportunities.

“U.S. investors, and other investors around the world, tend to overweight their home country in their equity portfolio,” write O’Shaughnessy Asset Management’s Patrick O’Shaughnessy and Ashvin Viswanathan in a report available on the firm’s website. “By doing so, they miss out on considerable investment opportunities abroad.” They say that emerging markets are compelling for three key reasons right now:

  • home bias, which has meant that many U.S. investors “have little to no direct allocation to emerging market equities”;
  • valuation (emerging markets trade at a 31% discount to U.S. stocks using the 10-year cyclically-adjusted price/earnings ratio);
  • “huge mispricings” that are the result of less attention among analysts and less scrutiny for EM firms’ financial statements

That last point makes EMs fertile ground for fundamental-focused investors, O’Shaughnessy and Viswanathan say. They looked at stocks in the U.S., other developed markets, and emerging markets from 1995-2012 to see how those that rated highest using OSAM’s fundamental stock-picking factors fared vs. market averages. They found that in the U.S., the top decile of stocks using a Momentum Composite outperformed the broader U.S. market by 3.3% annualized. Those in the top decile based on dividend yield outperformed by 1.3%, while those in the top decile based on OSAM’s Value Composite outperformed by 4.7%. In other developed markets, the outperformance was greater (6.8% for the high-momentum stocks; 8.7% for high-dividend stocks; and 9.2% for best-value stocks).

In EMs, the outperformance was all in all still greater. High-momentum stocks outperformed the broader EM market by 6.6%; high-dividend stocks did so by 10.6%; and best-value stocks did so by 11.9%. They found that within all the individual EM countries they examined, the outperformance also occurred.

“The important point is that while these factors work everywhere, they work best in what we would argue are the least efficient markets,” O’Shaughnessy and Viswanathan¬†write. “We believe these factors are immune to socio-economic and political idiosyncrasies because they are driven by human nature. In every country, unloved stocks have been left priced too cheaply, allowing a valuation-based strategy to thrive.”

While EMs come with their own unique sets of risks and often have higher volatility than developed markets, OSAM concludes that investors would be wise to use a portion of their portfolios for fundamentally sound EM stocks.