As we move into the 2020’s, it’s worth delving once more into the relationship between the performance of Emerging Market (EM) equities and their economies. There persists a view that investors buy or sell EM because of the relative economic growth discount or premium. We’ve always disagreed with that argument. There remains very little, if any, correlation between GDP growth and stock market performance, as proven by numerous academic studies.
Equity markets the world over are driven by the earnings and valuations of the companies listed on them. The performance of EM versus Developed Markets (DM), since the turn of the century, reflects just that (and is shown in the chart below). Earnings matter.
We’ve plotted the relative GDP growth of EM versus DM below, along with relative equity market performance and earnings of the two regions. Over the two decades, EM economic growth has comfortably outpaced that of DM. However, this economic growth has not translated into earnings – per – share (EPS) growth. EM nominal GDP is up a formidable 500% since 1995 whereas, over same period, EM EPS grew 187% and the market rose by 150% (much closer to EPS growth)¹.
Why has such strong economic growth not translated to EPS growth?
Over the past decade, a lot of this can be explained by a collapse in margins as EM corporates continued to prioritise growth over profitability. Prior to the Global Financial Crisis (GFC) the global economy was growing rapidly, nowhere faster than in EM where companies had huge growth opportunities and acted accordingly, focusing on top-line growth. The world changed post the GFC with the ensuing global economic slowdown causing demand to collapse. However, many EM corporates were slow to react and continued to build out capacity, therefore increasing supply into the slowdown. Revenues and margins collapsed.
However, encouragingly, we have heard with increasing frequency from management teams over the past few years that they have been more disciplined with regards to their capital allocation, prioritising profitability over growth; a stance that is even being adopted by some of the state – owned enterprises. This narrative can now be seen quantitatively with margins recovering over the past few years, in no small part due to a reduction in capital expenditure, with capital only being deployed into ventures that will create profitable growth. As a result, free cash flow (FCF) has inflected. This improvement in cash flow generation is good news for EPS for two reasons – firstly, it is a reflection of an improvement in the ‘E’ and, secondly, it will perhaps control the growth in the ‘S’.
This last point on the two component parts of EPS is worthy of exploring further. We are very familiar now with the huge buyback programmes witnessed in the US. In 2019, US corporates spent over a $1 trillion on net buybacks and dividends², more money than they generated in FCF.
Buying back shares on such a scale (termed ‘de-equitisation’) massages ‘per share’ profitability metrics; EPS grows even if the ‘E’ remains constant. This is in stark contrast to the corporate behaviour in EM where the share count has continued to increase, in effect diluting the EPS number. The chart below shows the net share issuance of EM and DM on a calendar year basis.
While this is shown at an aggregate level the picture is more nuanced at a country level. China, for example, increased its share count by just over 10% p.a. from 2008-2018. Earnings broadly have to increase by 10% just for the EPS number to remain flat.
Many EM corporates prefer to raise capital via equity markets rather than bond markets. This makes sense in most cases. Maturities in EM corporate bond markets are much shorter than in DM, and the bonds are usually denominated in USD creating FX risk for companies.
The winds of change?
EM corporates have numerous opportunities to chase growth given the secular growth stories that persist in many of these markets. It can make sense to raise and deploy capital to generate top – line growth when demand is robust. However, the post – GFC slowdown, and subsequent impact on revenues and margins, has prompted a rethink from some management teams, who have begun to focus on the ‘profitability of growth’ rather than simply ‘growth per se’. The more recent improvement in FCF, allied to stronger balance sheets, suggests that the rate of share issuance we’ve witnessed in the past will moderate from here.
The motivations for share issuance and buybacks can be many and varied. Certainly, equity issuance need not be a margin squeezer if capital is well – allocated and strengthens the underlying business. Buybacks can be a successful tool through which to reward shareholders, but they can also skew EPS figures and mask the true health and profitability of a company. The buyback trend, particularly in the US, has been in direct contrast to rampant equity issuance, and the resulting share count dilution, that has been taking place in EM – flattering the relative EPS figures for US companies. With EM companies now shifting to prioritising profitably over growth, they are starting to redress this imbalance. A reduction in capex and greater focus on capital discipline is supporting margin recovery. Prudent capital allocation, improving balance-sheet strength and better FCF should start see EM companies move away from their dependence on equity issuance; offering better risk/ reward for investors and supporting more sustainable future earnings growth.
¹ Source: Refinitiv DataStream, January 2020, MSCI Emerging Markets Index
² Bloomberg, S&P 500 companies as at 31 December 2019
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.