Lazard Insights Re-emerging Markets Thomas C. Boyle, Director, Portfolio Manager/Analyst Summary • Behind the headlines, some of the world’s biggest commodity-driven emerging markets are “getting it.” They’re cleaning up corporate governance, advancing shareholder interests, and inviting private investment. • Even though emerging markets earnings growth is expected to top that of developed markets in 2020, emerging market shares trade at a steep discount to developed market valuations. • Russia, which had the world’s best-performing stock market in 2019, is the first beneficiary of this emerging trend. • We believe Brazil may be next. Lazard Insights is an ongoing series designed to share value- added insights from Lazard’s thought leaders around the world and is not specific to any Lazard product or service. is paper is published in conjunction with a presentation featuring the author. e original recording can be accessed via www.lazardassetmanagement.com/insights. e supply-chain economies of Asia get emerging market investors’ attention, and the commodity economies get the (often negative) headlines. But investors with a narrow focus may be overlooking a very good thing. It pays to look behind the headlines, where compelling value stories have been unfolding. Renaissance in Russia Foremost among those stories is Russia’s turnaround, a tale of great progress with the possibility of a long runway still ahead. Coming out of the oil price collapse in 2014, the MSCI Russia Index has soundly outperformed both the broader MSCI Emerging Markets (EM) Index and the MSCI All Country World Index in four of the last five years (Exhibit 1). Russian returns compounded at better than twice the rate of the rest of the emerging markets as a whole over the period and one-and-a-half times the MSCI USA Index in dollar terms. Last year to top it all, Russia’s stock market returned more than any other. Perhaps the most extraordinary feature of the Russian market’s extraordinary performance is the fact that after all those gains it still trades at a substantial discount to the EM index. Since bouncing off a recent low in 2018, MSCI Russia has outperformed MSCI EM by a good 50%. Yet by almost every conventional valuation measure—price-to-earnings, forward price-to-earnings, and price-to-book value—the former trails the latter by a large margin. In one measure alone does the Russian market command a premium: dividend yield (Exhibit 2). And therein hangs the tale.
Transcript
Lazard Insights
Re-emerging MarketsThomas C. Boyle, Director, Portfolio Manager/Analyst
Summary• Behind the headlines, some of the world’s
biggest commodity-driven emerging markets are “getting it.” They’re cleaning up corporate governance, advancing shareholder interests, and inviting private investment.
• Even though emerging markets earnings growth is expected to top that of developed markets in 2020, emerging market shares trade at a steep discount to developed market valuations.
• Russia, which had the world’s best-performing stock market in 2019, is the first beneficiary of this emerging trend.
• We believe Brazil may be next.
Lazard Insights is an ongoing series designed to share value-added insights from Lazard’s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the author. The original recording can be accessed via www.lazardassetmanagement.com/insights.
The supply-chain economies of Asia get emerging market investors’ attention, and the commodity economies get the (often negative) headlines. But investors with a narrow focus may be overlooking a very good thing. It pays to look behind the headlines, where compelling value stories have been unfolding.
Renaissance in RussiaForemost among those stories is Russia’s turnaround, a tale of great progress with the possibility of a long runway still ahead. Coming out of the oil price collapse in 2014, the MSCI Russia Index has soundly outperformed both the broader MSCI Emerging Markets (EM) Index and the MSCI All Country World Index in four of the last five years (Exhibit 1). Russian returns compounded at better than twice the rate of the rest of the emerging markets as a whole over the period and one-and-a-half times the MSCI USA Index in dollar terms. Last year to top it all, Russia’s stock market returned more than any other.
Perhaps the most extraordinary feature of the Russian market’s extraordinary performance is the fact that after all those gains it still trades at a substantial discount to the EM index. Since bouncing off a recent low in 2018, MSCI Russia has outperformed MSCI EM by a good 50%. Yet by almost every conventional valuation measure—price-to-earnings, forward price-to-earnings, and price-to-book value—the former trails the latter by a large margin. In one measure alone does the Russian market command a premium: dividend yield (Exhibit 2). And therein hangs the tale.
Russian corporate governance since the global financial crisis has undergone a quiet revolution, at least in terms of financial productivity. Coming out of the crisis, the MSCI Russia payout ratio, the portion of net earnings returned to shareholders, usually in the form of dividends, had bottomed at 15%. It subsequently rose above 30% and has recently topped 50%. The enhanced payout ratio translates to a dividend yield (dividends as a percentage of share price) that has topped 8% and still comes close to 7%—about a percentage point higher than the global high yield bond index—despite the ongoing rally in Russian stocks.1 To put this surge in context, the dividend yield has increased five-fold in the past decade, more than in any other emerging market and well above the index’s 47% increase.
Getting the EM Act TogetherIronically, given the common perception of state-owned enterprises (SOEs) as politically driven bureaucratic boondoggles, Russian SOEs, primarily in the energy and financials sectors, have led the way. The government, counting on SOEs as a funding source, has consistently pressured them to raise their dividend payouts. Privately held companies in the hard commodity sectors, energy and materials, have followed suit, forgoing limited capital expenditure prospects in a soft pricing environment to reward their shareholders.
Russia spotlights the value trends we have seen building in the emerging markets over the past several years—trends we believe will soon start to pay off elsewhere in the emerging markets. Despite the fact that companies in the emerging world trade at a substantial valuation discount to those in developed markets, consensus projections call for emerging market corporate earnings to accelerate past developed markets in 2020, thanks in large part to the emerging markets' long-term GDP growth premium widening out this year (Exhibit 3).
Exhibit 3Anatomy of a Bargain
The EM GDP Growth Premium Is Expected to Widen …a
012345
2023E2022E
2021E2020E
2019E2018
20172016
2015
(%)EM Real GDP Growth
DM Real GDP Growth
… Powering EM Earnings …b
-10
0
10
20
30
2020E2019E201820172016
(%)
S&P 500 Index MSCI EM Index
… While Leaving EM Valuations Trailing Behindc
-50
-25
0
25
20192018
20172016
20152014
20132012
20112010
20092008
20072006
20052004
5
10
15
20ROE (%) P/E Premium/Discount
EM Valuation Discount to DM [RHS]MSCI World Index ROE [LHS]MSCI EM Index ROE [LHS]
As of 31 December 2019a Characteristics shown are calculated on a 1-year trailing basis.
Source: Lazard, MSCIb Calendar year EPS estimates for 2019 were calculated on 31 December 2019.
Source: FactSet Market Aggregatesc Characteristics shown are calculated on a trailing 1-year basis.
Source: Lazard, MSCI
Exhibit 2Russia on Sale
P/E (x)Forward P/E (x) P/BV (x)
Dividend Yield (%)
Russia 6.11 6.65 0.96 6.95Emerging Markets 14.64 12.21 1.65 2.72
As of 31 January 2020
Source: Lazard, MSCI
Exhibit 1World Champion
Index Returns 2015 − 2019
-20
0
20
40
60
20192018201720162015
(%)
MSCI USAMSCI EMMSCI Russia
Cumulative Index Returns
50
100
150
200
250
201920182017201620152014
(100 = 2014)
MSCI USAMSCI EMMSCI Russia
As of 31 December 2019
Note: Characteristics shown are calculated on a 1-year trailing basis.
Source: Lazard, MSCI
3
The Federal Reserve added a tailwind to emerging market returns in 2019 by cutting US interest rates, which in turn helped emerging markets currencies strengthen. The Fed tailwind has dissipated in the worldwide flight to the safety of the dollar occasioned by the outbreak of the COVID-19 virus in China. We don’t anticipate the outbreak will disrupt the emerging market resurgence over the long term, however. Indeed, we think it more likely that the Chinese government’s effort to restart its economy could trigger a V-shaped recovery throughout the emerging world in the second and third quarters.
Brazil Prepares for TakeoffOf all the large emerging markets, Brazil looks to us the one best positioned to stage a Russia-style turnaround. Over the last two years, the country has reined in its notoriously rampant inflation and eased rates, slashing interest on its 10-year bond from 14% to 4%, about the same rate as inflation, which has fallen from double digits. GDP growth, which had hovered around 1% since Brazil emerged from a sharp recession in 2016, has risen above 2%. Politics in this instance has abetted economics. The election of a new president in 2018 brought in an administration determined to deploy market-based solutions to tackle an economy top-heavy with government payrolls and transfer payments. In the first nine months of last year, 23% of the federal budget went to cover salaries twice as high in some instances as compensation for equivalent positions in the private sector. Social security benefits ate up another 44% of the budget.2
The results of the administration’s efforts at reform so far have been highly encouraging. In October, the Brazilian senate approved a pension reform, capping decades-long efforts. The reform, which lifted retirement ages by nine years, may save up to $200 billion in the next 10 years. As impressive as that number is, even more impressive is the expression of national will that made the reform happen. The bill made it pretty much intact through a congress of 26 different parties.
In the new year, the congress is applying the pension-generated momentum to an even tougher nut to crack: tax reform. A burdensome and byzantine tax regime has weighed down the private sector. In 2018, according to the most recent data, taxes consumed better than 32% of GDP, compared to 26% in the United States and about 20% in both Russia and China, two developing markets of a scale comparable to Brazil. And not only do Brazilians lose more of their earnings to taxes, they work harder to file them than citizens almost anywhere else. It took on average 11 times longer in 2018 to prepare taxes in, say, São Paolo than in Chicago (Exhibit 4).
Potential PayoffYet Brazil’s potential looms even larger than its problems. It is the world’s tenth-largest economy and home to 200 million consumers. It exports more of five basic commodities than any other country: coffee, soybeans, sugar, oranges, and chicken; it comes in second in another five: beef, corn, cotton, iron, and beverages.3 To capitalize further on these assets, the government has stepped up a privatization drive launched originally in 2016 to address the government’s budget deficits. In a further iteration under the new administration, it wants to induce the private sector to take a lead role in the nation’s development. Over the course of last year, the administration auctioned off some $28 billion of state assets, ranging from the lottery to portions of the crown jewel in the government portfolio, the Petrobras oil company (Exhibit 5). It aims to realize another $35 billion in privatization auctions this year and ultimately to raise $100 billion for infrastructure projects. In an implicit recognition of the role of foreign capital in realizing its goal, it has advanced a bill through the congress designed to strengthen Brazil’s application for membership in the Organisation for Economic Co-operation and Development by formally guaranteeing the central bank’s independence.
Exhibit 4High Tax, Red Tape
0
10
20
30
40
50
FranceArgentinaUnitedStates
SouthAfrica
ChinaIndiaRussiaBrazil
(Taxes as % of GDP)
As of 31 October 2019
Source: Brazilian Federal Tax Bureau “Carga Tributáriano Brasil 2017” (for Brazil, United States, South Africa, Argentina, and France); Heritage Foundation 2015 Macroeconomic data (for Russia, India, and China)
Number of hours per year incurred in the preparation, filing, and payment of taxes (medium-sized businesses)
189 countries surveyed: World average 234 hours
Brazil...
IndiaSouth Africa
United StatesRussiaChina
United Kingdom 114138159175210
262
1,591
Source: PayingTax2018 – World Bank & PwC
4
Perhaps the most significant implication of the revitalized privatization drive for investors—and, for that matter, for the global economy—is the commitment to tap private capital to help upgrade the transportation infrastructure across the world’s fifth-largest nation by land mass—an infrastructure so deficient that Brazil has managed to become a commodities powerhouse almost in spite of itself. It costs roughly four to eight times more per ton/kilometer to ship goods by rail in Brazil than it does in the United States (Exhibit 6). It costs about the same to grow a ton of soybeans in Illinois as it does in Brazil’s Mato Grosso state, and it costs about the same to ship that ton to China from Santos or from New Orleans to a port in China, but it costs $120 to truck that ton from Mato Grosso to Santos and $25 to haul it by barge from Illinois to New Orleans (Exhibit 7).
The Next Emerging SurgeIn Russia’s recent accomplishments and the initiatives that Brazil is undertaking, we can identify in two commodity-based economies much of the reformist, market-based energy that powered the Asian supply-chain economies in the last decade. In objectively assessing the opportunities this energy generates, we think it pays to filter out the headlines and focus on the fundamentals. In many of the commodity economies, they’ve deteriorated to such an extent that even modest steps to improve capital productivity and corporate governance, boosted by accommodative interest rates, can reap exceptional and enduring rewards.
Our view explains our Brazil conviction, in particular. The government’s ambition to bring Brazil’s infrastructure into the 21st century and its drive to attract private capital gives the nation its best opportunity in generations to realize its potential as breadbasket to a growing, healthier, and more prosperous global population. And its determination to realize its ambition with private capital makes Brazil one of the most compelling stories in the emerging markets today.
Exhibit 6High Price to Pay
Railroad Tariffs
0
5
10
15
20
UnionPacific (US)
CanadianPacific
(Canada)
KCSM(Mexico)
NorthfolkSouth (US)
Perurail(Peru)
Ferrovia T.Cristina(Brazil)
(Cents per ton/km, US$)
As of 2015
Source: AAR, GMexico Transportes, International Transport Forum, OCDE
2 As of 30 October 2019. Source: Secretaria do Tesouro Nacional
3 As of 2018. Source: IGBE, IMF, Brazil’s Ministry of Infrastructure
Important InformationPublished on 26 February 2020
Mention of these securities should not be considered a recommendation or solicitation to purchase or sell the securities. It should not be assumed that any investment in these securities was, or will prove to be, profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. There is no assurance that any securities referenced herein are currently held in the portfolio or that securities sold have not been repurchased. The securities mentioned may not represent the entire portfolio.
The MSCI Emerging Markets Index is a free-float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. The MSCI Emerging Markets Index consists of 26 emerging markets country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey, and United Arab Emirates. The index is unmanaged and has no fees. One cannot invest directly in an index.
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