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- Emerging market equities offer exposure to fast-growing economies and key drivers of global growth. Many companies in developing markets are relatively inexpensive compared to their developed market peers.
- Investing in a wide range of emerging market stocks, both household names and lesser-known small- and mid-cap securities, gives investors broad diversification and the potential to generate alpha.
- Over the past two decades, a portfolio with a blend of the MSCI Emerging Markets Index and the MSCI World Index (developed market equities) would have generated higher risk-adjusted returns than a portfolio comprised of only the MSCI World Index.
- The Dodge & Cox Emerging Markets Stock Fund, with its valuation discipline and focus on individual companies around the globe and across the entire market cap spectrum, is well positioned to capitalize on the investment opportunities emerging markets offer.
Over the past 40 years, investors have followed the rise of emerging market economies like China and the emergence of global leaders like Alibaba, Samsung Electronics, Taiwan Semiconductor Manufacturing, and Tencent1. While these companies have become emerging market success stories, many investors may not fully appreciate the breadth of investment opportunities across the developing world. Emerging market businesses—many of them are smaller companies that are not well known outside their home markets—are exposed to powerful economic tailwinds, creating a plethora of potential investment targets.
Our enthusiasm for these opportunities, combined with our global research and deep knowledge of companies across industries, prompted us to create the Dodge & Cox Emerging Markets Stock Fund, the seventh fund we have launched in our firm’s 91-year history. We believe our time-tested, long-term, bottom-up, value-oriented approach is well suited for the challenges and opportunities presented by the emerging markets. We will talk about the new Fund later in this paper. To start, we will focus on the emerging markets themselves and what makes them so compelling to us as investors.
Compelling Growth Opportunities
Emerging markets comprise over 80 percent of the world’s population and are responsible for nearly 80 percent of global GDP growth. While most people know that China’s economy is expanding rapidly, dozens of other emerging market countries are also showing impressive growth. Many are benefiting from advances in education and technology and the adoption of more market-friendly policies. This growth story translates into opportunities for companies located or doing business in these markets.
Compared to their developed market peers, many emerging market companies have the potential to increase earnings at a faster rate due to increasing living standards in their domestic markets and rising demand from the rest of the world. That is not to say investing in emerging market companies comes without risks. Many emerging market countries face notable challenges, such as underdeveloped and less resilient economies, greater political instability, and less well-established and predictable legal and regulatory regimes. Emerging market investors may also have less access to reliable, publicly available information about companies. Furthermore, over the past 18 months, emerging markets and emerging market companies have suffered disproportionately from the COVID-19 pandemic, and it is difficult to predict how long it may take for different markets to recover.
However, as a group, emerging market companies are trading at considerably lower valuation multiples than their developed market counterparts (see Figure 1).
Source: Source: MSCI, S&P.
Over the past 20 years, the aggregate market value of emerging market companies as a percentage of total global equity market capitalization has more than doubled (see Figure 2). This shows how quickly emerging markets are growing relative to developed markets and how much the emerging market investable universe has expanded. In 2001, the total market value of the stocks in the MSCI Emerging Markets Index was equal to about 5 percent of the market cap of the MSCI All Country World Index. Today, that number is about 12 percent.3
Stock Selection Opportunities
We think of emerging market stocks in two broad categories: very large businesses (many of them household names) and a much longer list of small and mid-sized firms that the typical investor has never heard of (see Figure 3). By our count, there are thousands of investable companies in the emerging market universe.
Figure 3. Including Smaller Companies in the Investable Universe Allows for Greater Diversification
MSCI Emerging Markets Index Constituents4
One way to think about this split is by focusing on some of the key engines of global growth. Consider the global digital supply chain that underpins our lives. At one end of the spectrum is Taiwan Semiconductor Manufacturing, one of the world’s largest companies, with a market cap of more than $540 billion. At the other end are Yageo ($8 billion market cap), Nanya Technology ($7 billion), and Powertech Technology ($3 billion), other Taiwanese businesses that manufacture and distribute electronic components. This is a small sample of emerging market opportunities, but the larger point is that the growth of the global supply chain plays a role in the potential success of these smaller companies. We see the same pattern in other factors driving global economic growth—commodity production, e-commerce, and increased penetration of financial products. Emerging market companies of all sizes are providing goods and services the world demands.
Since large-cap emerging market companies are mostly concentrated in the Information Technology and Financials sectors, investors need to be willing to invest in small- and mid-cap companies to achieve broad diversification in emerging markets. Not every emerging market investment will succeed, and finding the hidden gems in the small- and mid-cap world is not simple or straightforward. It requires extensive research and a global reach. But for those with the capabilities, the potential rewards are large. Put another way, we believe the emerging markets are an ideal place for active managers to perform their craft.
Diversification Benefits to Investors
Emerging market equities offer unique risks and opportunities that may complement a diversified portfolio. Investing in emerging markets is typically considered riskier than investing in developed markets. Indeed, over the past two decades, the MSCI Emerging Markets Index has been more volatile than the MSCI World Index of developed market stocks, using the standard deviation of monthly returns as a proxy for volatility. Over the same period, the MSCI Emerging Markets Index generated higher returns than the MSCI World Index. That is not surprising. However, investors might be surprised to learn that, over the past two decades, a portfolio reflecting a blend of emerging and developed markets indices would have generated higher returns than a developed markets-only portfolio, with only a modest increase in volatility (see Figure 4, tracking the performance of various blends of the MSCI Emerging Markets and MSCI World Indices).
Figure 4: Exposure to Emerging Markets Has Historically Improved Risk Adjusted Returns5
Source: Bloomberg, MSCI. Past performance is no guarantee of future results.
Index returns include dividends, but unlike Fund returns, do not reflect fees or expenses
We launched the Dodge & Cox Emerging Markets Stock Fund in May 2021 to offer investors a portfolio that includes the most compelling emerging market investment ideas identified by our global research team. We study a broad research universe of roughly 4,300 emerging market stocks across 70 countries, including many emerging market companies that are not part of the Fund’s benchmark, the MSCI Emerging Markets Index. We consider companies across the market capitalization spectrum. Fund holdings include companies based in emerging markets and companies based in developed markets with significant economic exposure to emerging markets.
Casting a wide net means we consider more companies, countries, and sectors than a typical emerging markets fund. Our portfolio includes many stocks that are not household names in the United States. While dozens of Wall Street analysts follow every Fortune 500 company, few analysts cover more than the largest of these emerging market companies. As of September 2021, the Fund had 37 percent of its net assets in small- and mid-cap stocks.6 Many of these smaller-cap holdings have exposure to attractive growth drivers, such as increasing consumption patterns, demand for wealth management services, expanding telecommunications and internet coverage, and real estate development, to name a few. In some cases, there are no large-cap investment alternatives providing exposure to particular growth drivers. By expanding the universe of potential emerging market stocks to include smaller companies, the Fund’s shareholders get two benefits: 1) greater diversification through exposure to companies, sectors, and regions, and 2) additional opportunities to generate alpha through investment in companies not included in commonly tracked indices.
Like other Dodge & Cox Funds, this Fund has below-average fees and expenses compared to its peers. This Fund's net expense ratio is currently capped at 70 basis points7 versus an average of just under 100 basis points for actively managed funds within the Morningstar Diversified Emerging Markets category.8 That difference winds up in the pockets of our shareholders and makes a difference to performance over time.
The Fund is constructed based on Dodge & Cox’s strict valuation discipline and fundamental approach to stock selection, with a portfolio built on the expertise of our global industry analysts. In the years we have spent investing in emerging market companies for other Dodge & Cox mutual funds, we have built tools to enhance our analysts’ ability to identify risks and opportunities in emerging markets. In managing the portfolio, the Emerging Markets Equity Investment Committee also relies upon the breadth of our equity and fixed income research teams. This includes our global macroeconomic analysts who identify the geopolitical and institutional risks that disproportionately affect emerging market currencies and capital markets.
As an active manager, the Dodge & Cox Emerging Markets Stock Fund gives us the flexibility to pursue the opportunities we see as most compelling across emerging markets. Investors who share Dodge & Cox’s long-term investment horizon and are seeking active, value-oriented exposure to developing economies and companies in markets that are difficult to access should consider our Emerging Markets Stock Fund. We look forward to discussing this new investment opportunity with you.
Before investing in any Dodge & Cox Fund, you should carefully consider the Fund’s investment objectives, risks, and charges and expenses. To obtain a Fund’s prospectus and summary prospectus, which contain this and other important information, visit dodgeandcox.com or call 800-621-3979. Please read the prospectus and summary prospectus carefully before investing.
The MSCI Emerging Markets Index is a broad broad-based, unmanaged equity market index of large-and mid-cap securities aggregated from 27 emerging market country indices. The MSCI EAFE (Europe, Australasia, Far East) Index is a broad-based, unmanaged equity market index aggregated from 21 developed market country indices, excluding the United States and Canada. The MSCI World Index is a broad-based, unmanaged equity market index aggregated from 23 developed market country indices, including the United States and Canada. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This publication is not approved, reviewed, or produced by MSCI. The S&P 500 Index is a market capitalization-weighted index of 500 large-capitalization stocks commonly used to represent the U.S. equity market. The S&P 500 Index is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Dodge & Cox. Copyright 2021 S&P Dow Jones Indices LLC, a division of S&P Global, Inc. and/or its affiliates.
The Dodge & Cox Emerging Markets Stock Fund is subject to equity risk and market risk, meaning investments in a Fund can be volatile and may decline in value because of changes in the actual or perceived financial condition of their issuers or other events affecting their issuers. Investment prices may increase or decrease, sometimes suddenly and unpredictably, due to general market conditions. Local, regional, or global events such as war, acts of terrorism, the spread of infectious illness or other public health issues, recessions, or other events could also have a significant impact on a Fund and its investments. In addition, investing in non- U.S. securities may entail risk due to foreign economic and political developments; this risk may be higher when investing in emerging markets.
The above information is not a complete analysis of every material fact concerning any market, industry, or investment. Data has been obtained from sources considered reliable, but Dodge & Cox makes no representations as to the completeness or accuracy of such information. Opinions expressed are subject to change without notice. The information provided is historical and does not predict future results or profitability. This is not a recommendation to buy, sell, or hold any security and is not indicative of Dodge & Cox’s current or future trading activity. Any securities identified are subject to change without notice and do not represent a Fund’s entire holdings.
1 The use of specific examples does not imply that they are more or less attractive investments than the portfolio’s other holdings. As of September 30, 2021, Taiwan Semiconductor Manufacturing, Tencent Holdings, Samsung Electronics, and Alibaba Group Holding were the largest companies in the MSCI Emerging Markets Index. The Dodge & Cox Emerging Markets Stock Fund’s top 10 holdings were Samsung Electronics (5.3% of the Fund's market value), Prosus (4.9%), Alibaba Group Holding (4.8%), ICICI Bank (3.9%), Taiwan Semiconductor Manufacturing (3.3%), JD.com (3.2%), Itau Unibanco Holding (3.0%), Glencore (3.0%), Baidu (3.0%), and Magnit (2.6%).
2 MSCI’s official forward price-to-earnings ratio data is available since June 30, 2003.
3 Unless otherwise specified, weightings and characteristics are as of September 30, 2021.
4 The chart shows the top-ten constituents in the MSCI Emerging Markets Index as of September 30, 2021.
5 Performance data for the MSCI Emerging Markets Net Total Return USD Index is first available in Bloomberg starting on December 31, 1998. As a result, the first annual period of performance begins on December 31, 1999.
6 Defined as under $10 billion in market cap.
7 One basis point is equal to 1/100th of 1%. Dodge & Cox has contractually agreed to reimburse the Dodge & Cox Emerging Markets Stock Fund for all ordinary expenses to the extent necessary to maintain total annual fund operating expenses at 0.70% through April 30, 2022. The term of the agreement renews annually thereafter unless terminated with 30 days’ written notice by either party prior to the end of the term. The gross expense ratio for the Fund was 1.92%, annualized from May 11, 2021 through June 30, 2021.
8 Equal weighted average of the lowest cost share class prospectus net expense ratio for U.S. domiciled funds within the Morningstar Diversified Emerging Markets category (excluding index, enhanced index, and fund of funds). Source: Morningstar Direct (data was downloaded on September 21, 2021). © 2021 Morningstar.