Emerging markets will double their share of global capital markets by 2030.

– Credit Suisse

Introduction and key features

The Emerging Markets have traditionally served as a good place to deploy one’s funds; as mentioned in The Lead-Lag Report, over the last 5 years, the EM cohort has outperformed its DM peers quite handsomely. Investors who are looking to get some exposure to this traditionally lucrative landscape may consider the WisdomTree Emerging Markets SmallCap Dividend ETF (DGS); as the name implies, you get access to dividend-paying small-cap stocks from the emerging markets (stocks are weighted based on annual dividends paid).

DGS tracks the bottom 10% stocks – by market cap – of the WisdomTree Emerging Markets Dividend Index. The stocks that constitute this index are selected from 17 emerging markets (Brazil, Chile, China, Czech Republic, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey). What’s also key is that the annual reconstitution of this index takes place every October, so in effect, you’re looking at the most recently reconstituted weights, and don’t have to fret over an outdated index.

Access to this ETF also offers you a healthy dividend yield of 3.7%, and despite a c.6% rise in DGS over the last month, the current dividend yield is still in line with the 4-year average. That said, access to this ETF does not come cheap with an efficiency ratio of 0.68%, but I don’t feel this is unreasonable, as most emerging markets-themed ETFs tend to cough up expense ratios in the range of 0.6-0.8%.

Holdings – key features

An investment in DGS will give you access to more than 770 names and the constituents here are rather well spread out, without any reliance on any strong pockets. No single stock accounts for more than 1.2% and the top-10 in aggregate only account for less than 8.5%. When you consider a high-beta play such as small-cap emerging markets (DGS’s 3-year beta is 1.2x), you want your risk to be well-diversified amongst a large pool.

Source: Seeking Alpha

Sector-wise as well, things are quite diversified, with no major concentration although there are four segments with double-digit weights. Tech (17% weight) in 2020 has been quite the star from a returns perspective, but one does wonder if there will be further juice left at these lofty levels. So far, every time there has been a dip in global tech, investors have bought and propped it back up, so perhaps one is unlikely to see a prolonged underperformance, even if some anti-tech rotation comes through in the future. More encouragingly, the next three largest sectors of DGS are all cyclicals (Financials, Industrials, Basic Materials), accounting for c.38% of the portfolio. Those of you who subscribe to The Lead-Lag Report would note that in my closing thoughts for last week’s edition, I picked out cyclicals, value, and emerging markets as the key investment terrains that could do well in the near future. Financials have not performed a great deal this year, and offer great value at current levels; I expect a normalized lending environment in 2021 and that should help drive pre-provision profitability. Financials based in emerging markets also have a higher ceiling (relative to developed markets) when it comes to loan growth rates. Recent good news from the manufacturing sector bodes well for industrials and the materials sector, and Lumber’s c.4% rise over the past week may act as a precursor of things to come in these two cyclical sectors.

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The case for Emerging markets

Subscribers of The Lead-Lag Report would note that I’ve been beating the drum for emerging markets of late as I believe there are some conditions that could support momentum here. So far this year, these EM regions have handled growth challenges with greater dexterity than the DM segment. EMs are expected to lead the revival next year as well; as per the latest IMF forecasts, the average GDP in 2021 is expected to come in more than 2% higher than developed market forecasts.

november-13-2020-make-emerging-markets-great-again

Source: IMF

The other thing to note is that trade (exports) tends to play a key role in most of these EMs’ prospects. In fact, the top 3 regions of DGS (Taiwan, South Korea, and China, jointly account for c.54% of the total holdings) are all countries that have fared relatively well during the current crisis, and this is largely due to their strength in household goods and tech-related exports. On account of the WFH and remote working culture, demand for these products the world over has not crumbled, as it has in other industries, and these economies have been able to exploit this. For instance, Taiwan – DGS’s leading geographic exposure (c.25% portfolio weight) – has received rave reviews for managing the pandemic, and at a time when many economies have been witnessing steep declines in the GDP, the nation managed to grow by 3.3% in Q3 (in Q2 it only declined by 0.6%), the highest figure in more than three years. In addition to that, exports in October were up 11% and hit record highs of $2.23bn. In China too, exports have been resilient for the last 5 months with exports in October gaining 11.4% (following a 10% gain last month), the fastest increase in more than one and a half years. Meanwhile, Korean chip exports too continue to be resilient. Manufacturing PMIs for these three regions – which serve as leading indicators – suggest that the momentum may well continue. In light of the trade angle, I also believe the Biden election victory will serve as a salutary environment for trade-dominant economies, particularly China. As mentioned in last week’s edition of The Lead-Lag Report, under the Trump regime, because of these tariffs we’ve been losing c.$57bn annually (Source: American Action Forum).

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The dollar has had a good run this year but with further stimulus and with the national debt at elevated levels, I think we could see some mean reversion on the dollar; a potential depreciation of the dollar will also serve as a useful tailwind for EMs.

Source: WisdomTree

Conclusion

Hitherto, given the difficult economic and business conditions for most of 2020, investors could be forgiven for being wary of the EM small-cap space; a lot of these small-cap EMs “tend” to have uni-dimensional end-market exposure with high client concentration; coupled with that, they may also have lacked the balance sheet to sustain the historical high divi payouts pre-COVID. Now with vaccine momentum well into the home stretch, economic recovery in 2021 looks more than likely. This will likely boost the business prospects of these small-cap players and also help them fulfill their high-dividend paying credentials.

Source: YCharts

Look, even if the economic recovery doesn’t quite go to plan, DGS also offers you some protection in the form of c.4% dividend yield (As per YCharts estimates, the forecasted dividend yield of this ETF is at 6.3%). Besides, DGS valuations too are cheap; as per YCharts estimates, the average earnings of the companies that constitute this ETF are forecasted to grow at a little over 10% over the next 5 years, yet you can pick up this ETF at a single-digit weighted average PE of 9.5x (forecasted PE of 8.3x). With a rough PEG (Price to 5-year earnings growth rate) ratio of less than 1x and a dividend yield of almost 4%, I’d say the current valuations are quite enticing.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This writing is for informational purposes only and Lead-Lag Publishing, LLC undertakes no obligation to update this article even if the opinions expressed change. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. It also does not offer to provide advisory or other services in any jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Lead-Lag Publishing, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.



Via SeekingAlpha.com