Contrarian Investors Consider Wading Into Emerging Markets But Risks Remain (2024)

Investors in emerging markets had their heads handed to them in 2018, losing roughly 18% of their value on the year. If that wasn’t bad enough, just days before the World Economic Forum was slated to begin in Davos, Switzerland, the International Monetary Fund released its World Economic Report for 2019 and 2020. And, the forecast wasn’t great.

Emerging Markets To Slow Before Regaining Steam

According to the IMF the bulk of the slowdown is expected in emerging Europe, where they suggest 2019 growth will fall to 0.70%. That compares to 2018 growth of nearly 4.0%. So, it’s a big drop to be sure. Nevertheless, the IMF also says that they expect growth in emerging Europe to rebound in 2020 to 2.4%. Okay, not great, but still in the plus column. Their forecast for emerging Asia, however, is a bit rosier.

The IMF expects growth in emerging Asia to come in at 6.3% this year and 6.4% in 2020. And, while both numbers are lower than last year’s 6.5% advance, they still aren’t terrible. More importantly, investors with a long investment horizon might actually be well rewarded for allocating some portion of their portfolio to emerging markets right now.

Taking A Contrarian View Can Pay Off

Investing in emerging markets in light of the just released IMF forecast might seem ill-timed. But, when considered in the context of investing like a contrarian, the move may make sense. Generally speaking, contrarian-like investing is taking a non-consensus view relating to a region, country, sector, industry or specific stock. Oftentimes it relates to finding opportunities in beaten down areas of the market, but it can also manifest itself in shorting or avoiding the areas that are the most overhyped. At its core, contrarian investing is trying to play off the psychological biases, herd mentality and emotions that investors often exhibit. So, for long-term strategic investors, emerging markets may represent a contrarian play worth considering.

Right now, the S&P 500 trades at slightly above 18 times trailing 12-month earnings. That’s not the highest it has ever been, but it's higher than the mean P/E (of less than 16) over the last 90 years. The MSCI Emerging Market Index trades at a P/E of 12.4. That’s far cheaper than large-cap U.S. Stocks. So, one could make a relative value argument for giving emerging markets investments a serious look right now.

The notion that an investment is attractive solely because it costs less to buy today than it did, say, a year ago is, on its own, folly. But, because emerging markets investments can be bought now for almost 18% less than one would have paid this time last year may warrant a serious look. This is especially the case given the metrics in the IMF forecast. The fundamentals aren’t terrible and prices potentially reflect all the bad news…and then some.

Emerging European economies do have their challenges. But, emerging Asian economies are still growing at a healthy clip (more than 6% annually). If that rate continues into the foreseeable future--not to mention over the course of the next 15 to 20 years--then investments at these lower valuations might provide attractive incremental returns to a well-diversified long-term portfolio.

Codifying a Fundamentally-based Contrarian Approach

Of the strategies we run at Validea, the one focused on the deepest value and most unloved stocks would the model based on David Dreman's approach outlined in the book, Contrarian Investment Strategies. This strategy is rooted in a number of value metrics and it looks for companies who financials are improving.

The Dreman strategy starts by looking at four contrarian indicators: low P/E; low price-to-cash-flow; low price-to-book; and, low price-to-dividend. The strategy targets those in the bottom 20% of the market as acceptable candidates. So, for today that means we’re looking for a P/E under 10.15, P/CF below 5.81, P/B under 0.95, and P/D of less than 18.25. Stocks need to meet at least two of these valuation tests. From there, the model looks at a host of financial improvement and quality measures including: a low payout ratio (indicating the dividend could be increased over time), a high return on equity, pre-tax profit margins of at least 8%, and a higher than average dividend yield.

Here are five stocks that score high on the David Dreman contrarian strategy followed by the Validea algorithm.

British American Tobacco p.l.c. (BTI) is one of the world’s largest tobacco producers and sells cigarettes, fine cut tobacco and Swedish-style snus all over the world. BTI hits on all four of Dreman’s indicators with a P/E of just 2.02, P/CF of just 2.0, P/B of 0.94 and P/D of 10.29.

ING Group N.V. (ING) is a multinational financial institution based in the Netherlands. ING also meets all four of Dreman’s value indicators as follows:P/E 7.8; P/CF 5.24; P/B 0.84; and P/D 15.20.

Shanghai Petrochemical (SHI) is a Chinese company that processes crude oil into various synthetic fibers and resins. SHI passes three of Dreman’s indicators. Its P/E is currently 4.81, its P/CF comes in at 5.64, the P/B misses at 1.20, and its P/D passes at 9.96.

Ferrari fans will recognize Eni SpA (E) the Italy-based diversified oil exploration, production and distribution company. Eni meets three of the Dreman criteria. Its P/E is 9.2 and its P/CF is 4.25. Eni’s P/B is too high at 1.04, so it fails here. But, with a P/D of 17.54, it passes that test.

Banco Bilbao Vizcaya Argentaria, S.A. (BBVA) is a diversified financial services company with operations in Spain, the United States, Turkey, Mexico and all of South America and Eurasia. Here’s how BBVA stacks up: P/E 8.9 passes, P/CF 5.21 passes, P/B 0.80 passes, but P/D at 19.84 fails.

Each of these stocks carries a certain amount of country-specific, sector/industry-specific and (of course) stock-specific risk. And, again, their low valuations in and of themselves aren't a harbinger of future returns. Nevertheless, adding a contrarian-based investment component into a diversified portfolio structured using a disciplined quantitative approach (free of emotion and bias), may well present investors with incremental return that may well add value over the long haul.

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John Reese, founder and CEO of Validea.com & Validea Capital Management, and his private clients are long all stocks mentioned in this article.