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RAE Fundamental: Tap into the Performance Potential of Emerging Markets

Portfolio Managers Rob Arnott and Chris Brightman discuss RAE Fundamental Emerging Markets strategy’s strong performance in 2016, their contrarian investment approach, and why they think EM stocks are likely to remain attractive.

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John R. Cavalieri, Product Manager, Asset Allocation: Hello, my name’s John Cavalieri at PIMCO. Today I'm joined by Rob Arnott, founder, chairman and CEO of Research Affiliates, and to Rob’s right is Chris Brightman, chief investment officer at Research Affiliates. Gentlemen, thank you for joining us here today.

Rob Arnott, Chairman and CEO, Research Affliates: Thank you.

Chris Brightman, Chief Investment Officer, Research Affliates: You’re welcome.

John: The goal of today is to provide an overview of the PIMCO RAE Fundamental Equity Strategies. And it's taking a bit more of a specific focus on the RAE fundamental EM equity strategy, a strategy that had strong performance in 2016. Could you comment on that, please, as well as outlook going forward?

Rob: Sure. It's not often that I'll speak glowingly about an investment that has risen. As a contrarian that just goes against the grain. But a year ago Chris and I were both out there saying this is the trade of a decade. Well, if it's the buy of a century after the next leg down, it's already the buy of a decade, I don't want to miss that. So I want a meaningful allocation and I want a little bit of dry powder so that I can pile on more if there is another leg down. But I'm not sure there will be.

Lo and behold, January 21 was the low. So, where does that leave us now?

Emerging market stocks are priced at a Schiller P/E ratio of 12. That means they're priced at 12 times their ten-year historical smoothed earnings. 12 times the sustainable long-term earnings. Well, that's pretty cool. US is at 28 times.

So you've got it at 40%. That's pretty interesting. Now, you take that deep discount and you recognize that a year ago it was less than ten times. How often does that happen? We've gone back historically, we've found a couple of dozen examples historically where valuations got below ten on a Schiller P/E ratio, and not cherry-picking the bottom tick, just taking the first month after it went below ten and asking what happened over the next five years? On average the return was 120% over the next five years.

So is this run-up that we've seen the end or the beginning? I think it's more likely the beginning. Now, you have a second dynamic at work.

We had a five-year grinding bear market in emerging market stocks from 2011 through 2015. Just brutal and for all of the obvious reasons. Bargains always exist for a reason. They exist because people legitimately have a narrative that frames their fear, and that narrative has big elements of truth to it.

So you don’t find bargains in the absence of legitimate fear. But it's the legitimate fear that creates the bargains. When you have that legitimate fear, the spread between growth and value can also become unusually wide. So while the Schiller P/E ratio for emerging markets went below ten, the Schiller P/E ratio for fundamental index in emerging markets, dipped well below six times earnings.

John: Because of the value tilt.

Rob: Yes. The value tilt and the huge spread between growth and value. If you take the emerging market stock market and just take the 30% that's cheapest and the 30% that's most expensive — let's ignore the middle 40 — these are the value stocks, these are the growth stocks. The valuation spread between those a year ago was ten to one, ten to one spread. Just enormous.

So it represented an extraordinary opportunity. Were people willing to pile in? No, they were fleeing in droves. That's human nature. So where are we now?

Well, at the very bottom tick of the Great Depression, US stocks briefly, for a few days, went below six times. Emerging markets were distinctly cheaper last January, fundamental index in emerging markets were priced cheaper than that a year ago. They're still priced under eight times.

So you have valuation in your favor. You have, you now have momentum in your favor. When the market’s in freefall, you don't know where the turn is. You want to slowly but surely nibble your way in, because you don't know where the bottom’s gonna be. And as a contrarian you have to be willing to look a little stupid, buying a little too early and buying a little more as it goes against you, in order to have maximum exposure at the turn.

Now, in addition to valuation and momentum, you also have macroeconomic conditions which are improving.

The economic conditions in emerging markets are distinctly better than they were a year ago.  And in all likelihood are going to be better 12 months from now than they are today. We wrote a paper called “The Emerging Markets Hat Trick” in which we identified three factors at work here that make emerging markets notably attractive and notably interesting. So I think we're in the early stages of what's likely to be a long run for these asset classes to give us very respectable long-term real returns.

I've been called a perma-bear. I'm not a perma-bear when something gets this cheap, that's for sure.

John: Great. Well, on behalf of Rob Arnott and Chris Brightman, Thank you.

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