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Value to be found in EMs' longest earnings recession

NELSON ALMEIDA | AFP | Getty Images

Companies on the MSCI Emerging Markets (EMs) Index are currently in their longest-ever earnings recession, according to Morgan Stanley, but cheap valuations continue to lure brave investors in.

"Looking at a history of earnings per share (EPS), this month marks the fourth anniversary of the earnings recession that began in August 2011," Jonathan Garner, Morgan Stanley's chief Asia and emerging markets equity strategist, said in a video posted by the bank on Monday.

EPS have dropped 25 percent from their August 2011 peak, Garner said, pointing to MSCI data. The longest prior earnings recession among emerging markets was the 1997 Asian Financial Crisis, which lasted two years, he added.

But, while the ongoing reporting season is only about a third completed, Garner believes another significant miss is on the table. A 7.3 percent miss on net income is expected for the April-June quarter, he said, compared to a 10.2 percent beat for Japanese companies listed on the Topix and a 4.6 percent beat for S&P 500 firms.

A combination of falling commodity prices, fears about China's slowdown and anticipation of higher U.S. rates are amounting to "something of a perfect storm" for emerging markets, the Institute of International Finance (IIF) explained in a note last Thursday, providing similar data to Morgan Stanley.

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Twelve-month forward EMs earnings are seen declining 14 percent on year in 2015, compared to a 1 percent fall in the U.S. and the euro area's 4 percent spike, IIF said. At a forward price-to-earnings of 11 times, EMs are close to a record discount versus mature market equities that are now trading at over 17 times forward EPS, it added.

"Corporate profit and currency trends are working against the asset class," echoed Ewen Cameron Watt, global chief Investment strategist at BlackRock Investment Institute said in a Monday note.

The biggest losers

Looking at the breakdown of EPS decline by country and sector, it's clear that commodity-exporting countries are the biggest losers.

Since peaking in August 2011, Brazil's EPS has experienced the largest correction at 77.5 percent, Morgan Stanley said. Russia came in second, with an EPS decline of 63 percent since topping in February 2012, and Mexico was third with a 48.8 percent correction.

All three countries rank among the world's ten largest energy producers, but with Brent crude prices 16 percent lower year-to-date, corporate earnings are indeed suffering.

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Old-economy sectors like materials and industrials were the weakest on the back of deteriorating underlying fundamentals. Materials have corrected 86 percent since EPS peaked in 2011, while energy and industrials are both down 60 percent since their peaks of 2012 and 2011, respectively.

Noticeably, China, the largest index constituent, has only corrected 4.4 percent since its EPS peaked late last year. However, losses may deepen following a violent sell-off that saw equities lose $3.6 trillion in value between mid-June and early July.

The IIF estimates zero earnings growth for Chinese corporates this year: "The [historically] tight yuan-dollar relationship is weighing particularly on the export sector. Of note, the yuan is up over 20 percent against the euro over the past year and 14.5 percent against the currencies of major Asian trading partners."

Blackrock's Watt notes there are two catalysts that could change the sector's gloomy outlook: A retreat of the U.S. dollar versus EM currencies and improving profits.

However, neither are likely, he explained. The greenback will continue advancing "until the Fed's first interest rate rise is out of the way (we expect the central bank to pull the trigger by year end)" while profits will continue to be hampered by weak commodity prices.

On the bright side

The price-to-earnings discount in emerging market equities do reflect the group's structural problems, but it also suggests that a value opportunity may be at hand, asset management firm Lazard said in its July market outlook.

"At a stock-specific level, we are still finding companies that are not just navigating the environment well, but also profiting from it by taking market share from weakened competitors," the firm said, adding that meaningful reform efforts were also a bright spot.

"Over time, as economies globally and locally recover, there should be more widespread support. Shorter term, tighter emerging markets credit conditions from U.S. rate hikes could force better capital discipline among companies, which should translate into improved profitability and allow for multiple expansion."

Financials and information technology were the biggest weighted sectors in Lazard's emerging markets equity portfolio as of June 30; its top ten holdings included Taiwan Semiconductor, China Construction Bank and Baidu.

"The EM asset class as a whole may not yet have found its floor. Yet there are opportunities within (we like economies with structural reform momentum). Picking exposures and risks selectively will be crucial for future returns," agreed Blackrock's Watt.