Think good tech stocks are only U.S. based? Think again

Innovative companies in emerging markets show striking growth as they benefit from the 'new normal'

Think good tech stocks are only U.S. based? Think again

Western investors have been urged to recognise that the opportunities around the digital revolution extend far beyond their own borders, according to a portfolio manager.

Regina Chi, VP at AGF Investments, conceded that everyone loves the big U.S. tech stocks for good reason: they’ve outperformed the broader market for years, with their “exceptionalism” ony boosted by the COVID-19 remote environment.

She said: “While the S&P 500 is just about even for the year – and that’s after a four-month rally – the tech sector has barely broken stride in its ascension. If this group of companies were superstars at this time last year, the pandemic has only solidified their prominence.”

However, Chi added that from a global perspective, the U.S.-based tech names are not the only digital game in town and that, in emerging markets (EM), a similar revolution is under way and reflected in the surging share prices of digital-economy companies. Just like their counterparts in developed countries, these tech firms are creating and benefiting from a generational shift and getting a boost in the everything-from-home COVID environment.

Chi explained that, since the start of the year, the MSCI Emerging Markets Growth Index, which includes the important new economy names, has gained 13.4 %, according to Bloomberg, while the corresponding value index is down 9.68%, translating into a roughly 23% outperformance by growth over value. She said: “As in the U.S., the divergence became more marked in Q2, coinciding with the height of the pandemic.”

Breaking down the Index, which includes subsets Internet & Direct Marketing Retail, and Interactive & Media Services, the differentiation is even clearer. Between October 2018 and June 2020, the benchmark weight of those two subsectors grew from 10.4% to 19.6%, according to Bloomberg, representing a remarkable 88% increase. This year, the overall MSCI Emerging Markets Index returned 1.75% through July in Canadian dollars; remove the digital element from the equation, however, and the return falls to -3.63%%.

Chi said: “Importantly, the digital universe in emerging markets equities has become very wide and deep. It transcends the China-based stocks that made a name for themselves, even among Western investors, pre-2020.

“In Internet & Direct Marketing, publicly traded companies include fast-growing enterprises in e-commerce and food delivery. For instance; in Interactive & Media Services, they include search and message firms and this burgeoning group transcends China’s border. In total, there are 22 companies in the two relevant MSCI EM subsectors, and South Korea and India are well-represented, the latter in particular in telecom.

“This transformation and corresponding equity outperformance look poised to continue. That’s in part owing to the remarkable rate of innovation in some emerging markets, but also because of continuing tensions between China and the United States.”

She explained that the so-called Holding Foreign Companies Accountable Act, passed by the U.S. Senate in May, would require any company listed on a U.S. exchange to submit to audits by the Public Company Accounting Oversight Board (PCAOB). However, China is the only country in the world that bars its companies from participating in PCAOB audits. If ratified, the law could incentivize Chinese executives, who may or not have already listed in the U.S., to turn to the Hong Kong Stock Exchange (HKSE), at the very least to hedge regulatory risk through a co-listing.

“Listing in Hong Kong could significantly boost investment, as it raises the potential for capital flows from mainland China, where investors are hungry to invest in many of these digital titans, but haven’t been able to do so through U.S.-listed ADRs,” Chi added.

With many smaller-cap stocks without significant earnings caught up in the wave of digital enthusiasm, they have outperformed some more familiar names, suggesting there is more upside in the larger-cap equities, which can have strong earnings growth and multiples that seem reasonable when compared to their EM counterparts.

Chi said: “As with their U.S. counterparts, the fortunes of emerging-market digital stocks might depend on the course of the pandemic – how long it lasts, what the world will be like once it’s under control and, perhaps most importantly, whether the elevated valuations they have enjoyed while the world is under lockdown will continue to be justified when the world gets back to ‘normal?'

“Yet for now, and given that no one knows what ‘normal’ will look like in a year or a decade, Western investors would do well to realize that the impact of the digital revolution – and its opportunities – extend far beyond their own borders.”