Tomorrow’s Innovators Today
Investing is about trying to create or preserve wealth over the long run—and we think that will get harder to do in the decade ahead. For instance, we expect the traditional 60-40 stock-bond portfolio, which typically has substantial exposure to US large cap equities, to generate real returns of just 2-3% over the next 10 years annualized, compared to 8-10% over the last 10.
In other words, investors will likely have to start thinking outside the box to generate growth, value and income. Happily, innovation is not unique to US mega-cap tech companies. It can be found among other companies in variety of sectors, from technology to healthcare to environmental innovation and beyond.
Many EM companies are becoming local tech titans, while others offer exposure to some of today’s biggest secular growth themes, such as environmental protection, the rollout of 5G technology and millennial consumers. We think millennials are the most powerful consumers in the world, and some 86% of them live in EM countries2.
Meanwhile, we believe the role of technology in driving disruption evens the playing field for many US small- and mid-cap companies, some of which may become the mega-cap household names of the future. These companies are driving innovation in cutting-edge genomics and precision medicine, digital transformation, resource sustainability and other areas that are likely to generate notable growth in a low-growth world. Roughly 60% of the Russell 2500 Growth Index lies in the growth-tilted, cash-rich, innovative sectors of Information technology and healthcare, compared to about 40% in the S&P 5003.
And in our view, many of the stocks in these sectors are on sale today. The MSCI EM was trading at 1.99x book value at the end of 2020, a 51% discount to the S&P 500 and close to the widest gap seen since the early 2000s4. We expect emerging market equities to have 12% higher earnings growth than the S&P 500 in 2021.
While Russell 2500 Growth valuations are not cheap given the strong run, we believe they’re justified by strong fundamentals and growth prospects. As of Dec. 31, consensus expectations for 2021 EPS growth is 57% for the Russell 2500 Growth, compared to 22% for the S&P 500.5
Moving Beyond the Benchmark
Finally, we think active strategies make it easier to access innovation in the EM and SMID cap universes. For instance, active managers can invest in the most promising new companies at their initial public offering (IPO), well before they join an index.
Among EM equities, active managers can help to tilt portfolios away from less-profitable, poorly governed state-owned enterprises, and toward environmental, social and governance (ESG) leaders. Strategies that simply track the MSCI EM benchmark lack this flexibility and can miss getting exposure to high-performing stocks outside the index, including many small and mid-cap companies and China A-shares.
And with nearly half of Russell 2500 Growth companies producing losses, a fundamental, selective approach driven by experienced stock-picking may help investors avoid unprofitable companies while gaining access to undiscovered opportunities with enormous growth potential.
In our view, investors who move down in market cap or expand their borders today may be able to widen the opportunity set and boost their return potential tomorrow.
