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Finding value in volatile emerging markets

August 05, 2014

Recent events in emerging markets—from the economic challenges confronting fast-growing "BRIC" countries such as Brazil, India, and China to the ongoing tensions between Russia and Ukraine—have captured headlines, along with investors' attention. But even amid this volatility, allocating part of your portfolio to emerging markets can make sense—provided your approach is balanced, well-diversified, and focused on the long term.

Vanguard Emerging Markets Select Stock Fund, launched in June 2011, is managed by four separate firms, who each manage an approximately equal portion of the fund's assets. Its advisors are Pzena Investment Management LLC, Wellington Management Company, LLP, Oaktree Capital Management, LP, and M&G Investment Management Limited. In this interview, Pzena's John Goetz explains how he approaches managing their portion of the fund.

What defines a country as an emerging market?

John GoetzThe classic definition of an emerging market is one that's in a heavy infrastructure industrial-development phase. A developed country has made the shift more toward services and internal economy, while an emerging market country still focuses on exports, which can be driven by an under-global-market wage that contributes to competitiveness.


Vanguard Emerging Markets Select Stock Fund

Assets: $299.0 million*
Number of stocks: 270*
Expense ratio: 0.94%*
Minimum investment: $3,000
Ticker: VMMSX

Learn more about the fund »

*As of June 30, 2014.

What's your high-level view of the emerging market universe?

It's a fascinating situation. You have to consider what's been happening in China over the past few years to understand its effects on emerging markets as a whole. In 2008, China decided it couldn't count on the United States and Europe as drivers of future growth in exports and did their own massive stimulus program. When they did that, they drove demand to a new peak. By 2011, prices of stocks impacted by Chinese demand were significantly higher than they were in 2008.

Then China thought, "Whoa, we might have overdone it." They had to take their foot off the gas. Since April 2011, emerging market stocks have been underperforming the developed world stock markets, not because their economies are actually growing slower, but because the expectations of growth are starting to wane. Once the markets began to deal with that [pullback], there was a similar effect to what happened in the developed economies in the 2008–2009 downturn when they corrected from a period of excess.

What's happened is a flight to safety, resulting in significant valuation differences between sectors. The consumer staples stocks in China are higher than they were in April 2011 on a relative basis to the market. If you think you're finding a safe haven in consumer stocks in China, you're not because those stocks aren't the ones that came down. As you pursue valuation—finding stocks that aren't overpriced—in China, you have to look to the ones that have fallen a lot: basic materials, industrials, local auto stocks, financials.

Yes, emerging markets have underperformed. Yes, in general today they're a much better bargain than they were in 2011. But be careful about where you're looking for these bargains, because some stocks are up. We add value by searching through the stocks that have gone down, not the ones that are up. Fortunately, we're finding these opportunities on a selective basis—and that's fun.

What's the correlation between stock market performance and GDP growth?

Stock market performance and GDP growth aren't correlated statistically the way people think. Intuitively, they seem correlated. There's a true part to that correlation and a false part.

If you make widgets and you're in an economy that's growing at 20% a year, your business will probably also grow at 20%. This is the true part of the correlation. So, in five years, if your business grows 20% a year, your business will have doubled. So it would seem that your stock price should have doubled as well.

But the other part of the correlation—that the stock price should grow at the rate that earnings are growing—is where the problem is. If your stock is selling at 30 times earnings, the valuation is already reflecting the anticipated growth. The stock price can only keep up if the earnings growth exceeds the expected earnings growth.

"Deep value investing gets its opportunities in a fear-based environment and the volatility it causes. That's when we're able to buy stocks at very attractive pricing. I believe that volatility in emerging markets is likely to continue and we'll continue to have fear be our friend as we manage the portfolio."

—John Goetz

It's the same for economic growth. That's the detail that many people are missing. [For example] it's true that China is growing much faster than the rest of the world—but not as quickly as the rest of the world expects it to grow. That's why some stocks there have fallen.

What's Pzena's investment philosophy for managing your portion of Vanguard Emerging Markets Select Stock Fund?

Our investment philosophy is based on discovering underpriced gems. We do that in a very disciplined way, with the right people to do it.

We use our screening tool to decide which stocks might be very inexpensive and then we follow up with team research to identify, understand, and quantify the issues. Then we meet with the management team who lives this business to make sure we're on the right track with our assumptions.

Another point to mention: Just as we'll only buy a stock if it's in the cheapest quintile on our valuation metric of price to normalized earnings, we must sell it when it's at an average valuation.

How does your value-oriented perspective translate into long-term success in emerging markets?

Most people's conception is that the universe of stocks is divided into growth and value. In fact, value means valuation—and you should be able to buy a growing company as easily as you buy a nongrowing company if you can get it at a cheap price.

We're focused on "price-to-normalized-earnings power" or cash flow. If we think we're buying a growing cash stream, that's worth a lot more than buying a nongrowing cash stream. One of the reasons this line gets so confusing is because the indices divide stocks by metrics like price-to-book. If you have a nongrowing business, you might want to only pay one times book value but if you have a growing business, you might want to pay five times book.

We're comparing the stock price with normalized earnings and our estimate of earnings reflects growth. If we said we weren't going to buy businesses that are growing, we wouldn't have any reason to be in emerging markets. We're just going to buy the growing businesses that are undervalued. Because if you're in an emerging market, all the businesses should be growing.

We did the math to prove our process would work in emerging markets and found during our back tests that a valuation approach was actually more efficacious in emerging markets than in developed markets. I have a simple explanation for that now, having run this for a while: The psychology changes more [in the emerging markets]. Fear is bigger and optimism is bigger. So the share prices are covering a wider range, which gives us, as a valuation-focused firm, a better set of opportunities than if the share prices were moving in a narrower range.

We'd love to buy a rapidly growing business at a very low price for that growth—and that's what our model is doing, screening for companies trading at a low price relative to what that business will make in five to ten years.

When do you see China, which in many instances is still defined as an emerging market, making the transition to developed market and what impact will that have on the fund?

I wouldn't put China in the bucket as being the closest to transitioning from an emerging to developed market. Size and scale can be relevant, but they aren't the only—or even key—developments.

The ramifications of China becoming a developed market and being removed from an index would be significant, just because China is such a big weight in all the indices, especially when you include Hong Kong.

However, the removal of China from the emerging market universe would not change our process because we select in our screening tool from the 1,500 largest stocks in emerging markets. If, for any reason, China became developed, other companies, probably mostly in Africa, would come into our screening universe.

What's your perspective on India's economy and investment potential?

We're hopeful that the business-friendly approach the new government has will lead to better economic growth in India, more company profitability, and higher returns in the stocks than in its history. It's been an under invested economy, it's under industrialized, it still has a reasonably underutilized workforce, even though it has all the major call centers and IT outsourcing centers in the world.

Where we'd be finding our opportunities in India might be off the beaten track. We don't bet on a broad, or macro, thesis, although we consider the macro outcomes for each company. We're doing the micro economics of the business in the context of the macro economics.

What opportunity do you see for emerging-market investing in the near future?

Deep value investing gets its opportunities in a fear-based environment and the volatility it causes. That's when we're able to buy stocks at very attractive pricing. I believe that volatility in emerging markets is likely to continue, and we'll continue to have fear be our friend as we manage the portfolio.


  • All investing, including a portfolio's current and future holdings, is subject to risk, including the possible loss of the money you invest.
  • Past performance is not a guarantee of future results. Investment returns and principal value will fluctuate, so investors' shares, when sold, may be worth more or less than their original cost.
  • Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.
  • Opinions expressed by Mr. Goetz are his own and do not necessarily reflect the views of Vanguard or its management.
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