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Profitability in emerging market companies

February 2020

Emerging market stocks: where the profits flow

Why investors could be severely underestimating the profitability of emerging market companies.

Emerging market (EM) equities deserve to feature more prominently in investors’ portfolios while allocations to developed market stocks need to be dialled down.

That is a view we have held for some time, not least because our economists expect EM countries to outgrow their developed peers by more than 3 per cent per year over the next half decade.

But there is another strand to our investment thesis: valuations.

Our analysis shows that investors are paying almost twice as much, on average, for the return on equity (RoE) generated by developed world stocks than for the same level of  RoE from emerging world stocks.1

What is more, every incremental improvement in earnings prospects is more richly rewarded in developed markets than developing ones. 

This can be seen clearly in the figure below, which shows that the trendline for prospective RoE versus price-to-book value is flatter for EM firms than for developed market companies.

We consider this an anomaly that will disappear over time.

EM profitability: underappreciated
Return on Equity (RoE) by valuations (Price to Book ratios)
Return on Equity by valuations

Source: MSCI, Refinitiv, Pictet Asset Management. Largest 25 countries in the MSCI All-Country World Index. Data as of 31.12.2019

Our view is reinforced by the fact that RoE among developed market firms is already close to its long-term average of 11-12 per cent, and unlikely to move higher.2 

RoE in the developed world has in fact remained steady for the past 40 years, in part because of a decline in asset turnover.

Our calculations show that companies based in advanced economies are becoming less efficient in using their asset base to generate sales.

Forty years ago, companies would generate USD1.2 worth of sales for every dollar of assets they owned. That ratio has since fallen to 0.7.3

The rush of companies buying up rivals’ assets in M&A deals is partly to blame.