How attractive are public units of multinationals that operate in emerging markets?
There’s an interesting paper from Martijn Cremers, a professor of finance at the University of Notre Dame, on the performance of emerging market stocks that are the publicly traded affiliates of multinational companies.
But like so much in the world of investing, Cremers’ findings, while certainly alluring, need to be examined closely before investors jump into this subset of the emerging markets landscape.
Cremers’s study covered the 13-year period June 1998–June 2011. He found that these affiliates showed remarkably good performance. For example, the affiliates outperformed their country benchmarks—27.4 percent versus 21.5 percent. At the same time, they experienced lower volatility—24.6 percent versus 29.7 percent. And they also had less downside volatility, with their peak-to-bottom performance a loss of 50 percent versus a loss of 62 percent for their local counterparts.
Of particular note was that their relative performance during the financial crisis was good.
Cremers suggested two main reasons for this outperformance—that the affiliates benefit from improved corporate governance as well as a stabilizing role of the parent companies, including improved access to capital. That’s a factor that becomes especially important during financial crises. Cremers hypothesized that these factors “may give these affiliates a clear comparative advantage over their local competitors that should endure in the foreseeable future.”
While his findings are certainly of interest, there are some cautions to be noted.
First, the sample size is extremely small, just 92 companies. Second, the time period is very short, just 13 years. Third, the paper doesn’t report any t-stats, and given the short sample, the small number of stocks and the return volatility in emerging markets, it’s likely that most of the t-stats on the return differences are less than 2.
Another important point to note is that it’s likely that these stocks are already included in a globally diversified portfolio. The only question then, is, Should you consider overweighting them? To do that, you’d have to believe both that the advantages Cremers pointed out will persist and that the excess returns will persist. While there doesn’t seem to be any reason to believe that the advantages Cremers noted won’t persist, there’s good reason to question the latter proposition.
The reason is that information is only valuable if the market doesn’t know it. And it appears that Cremers wasn’t the only one who has “discovered” this anomaly.
Marlena Lee, a vice president on Dimensional Fund Advisors’ (DFA) research team, noted that the price-to-book ratio of these affiliates has doubled during the sample period, from about 3 to about 6. (Full disclosure: My firm Buckingham recommends DFA funds in constructing client portfolios.)
At the same time, the price-to-book ratio of the emerging market countries stayed about flat. In other words, investors are now willing to pay a premium price for the benefits of superior corporate governance and access to more stable capital. The higher prices relative to book value predict lower returns.
In other words, it appears that the marketplace of investors has made the same discovery Cremers made, that better access to capital and stability from the parent company along with improved corporate governance are traits of companies that are less risky. The higher price-to-book ratios now reflect that perception of lower risk. They also now reflect lower, not higher, ex-ante returns.
Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management.