Independent Thinking^®

Q&A with Caroline Cai of Pzena Investment

Editor’s note: Emerging markets can afford U.S.-domiciled investors a range of diversification opportunities at relatively low valuations. Here we interview Caroline Cai, CEO and Portfolio Manager at Pzena Investment Management, one of the carefully selected outside fund managers that supplement the core capabilities of Evercore Wealth Management. Please note that the views of the external managers interviewed in Independent Thinking are their own and not necessarily those of Evercore Wealth Management.

Q:        Global equity market performance this year has been driven by a relatively few mega-cap U.S. growth companies. This has led to a significant difference in performance between growth and value stocks, particularly in the United States. Has the disparity between growth and value stocks also occurred in emerging markets?

A:         The growth cohort is outpacing value in emerging markets as well, albeit by about six percentage points versus over 19 percentage points in the United States. The bulk of growth’s alpha stems from a single company, TSMC, which is NVIDIA’s AI chip supplier. This Taiwanese foundry giant had an approximately 17% average weighting in the MSCI Emerging Markets Growth index in 2024, returning roughly 70%. TSMC is not included in the MSCI Emerging Markets Value Index, but it is included in our portfolios, as we believe the stock remains cheap relative to its intrinsic value.

Q:        For U.S.-domiciled investors, what is compelling about investing in emerging markets now?

A:         Emerging markets are particularly cheap, in our view, trading at a 48% price-to-forward earnings discount to the top-heavy U.S. equity market. This offers investors diversification at the largest discount in more than two decades.

That said, we believe it’s important for investors to be selective when it comes to emerging markets. They are inherently disparate, with each country possessing its own unique risks and opportunities. Today, we are observing the type of valuation dispersion that is typical of such a diverse asset class, with India and Taiwan, two countries that we’ve reduced exposure to amid surging equity markets, trading at the upper end of the valuation spectrum, while China, Korea, Brazil, and others (all of which we’ve added to) now boast single-digit forward earnings multiples.

Q:        If investors want to invest in emerging market countries due to the higher growth rates of these economies, how can a value approach lead to superior returns?

A:         Perhaps because developing nations often post higher GDP growth rates than their developed peers, many market practitioners view emerging markets investing as a growth story. However, the value approach has proven far superior over time, with cheap emerging markets stocks (those with low price-to-book ratios) outpacing expensive names by 430 basis points per annum since 1989.¹

Higher-beta emerging markets understandably endure more frequent bouts of volatility but can offer amplified return potential for value investors. We believe this is due to four key factors:

Psychology. Investors tend to exaggerate the significance of near-term problems, effectively discounting the potential for business, industry, management, currency or macroeconomic improvements over time. Active value managers can exploit these overly emotional responses, which are more prominent in emerging markets.

Earnings power. Despite the lack of empirical evidence, investors often inextricably link stock markets to economies, associating GDP growth with higher equity returns. When investors pay up for expectations of future growth, their reactions to disappointment can present a fertile hunting ground for disciplined value investors.

Range of outcomes. Different political and legal structures, currencies, and governance practices all add to the complexity of emerging markets investing, offering robust opportunities across a large pool of stocks.

Under-exploitation. Most investment managers tend to favor macroeconomic or quantitative approaches to emerging markets investing, prompting crowded trades and wider market swings that result in exploitable price dislocations.

These factors present opportunities to buy good businesses with low expectations, at attractive valuations. We believe valuation is the single best determinant of long-term returns in any geography.

Q:        The fund is now slightly overweight in China. What do you find compelling about China now that you did not before?

A:         China has become the largest hunting ground for emerging markets value in recent years. A macroeconomic slowdown and heightened geopolitical tensions have prompted selloffs in many outstanding Chinese franchises, despite these companies displaying solid financial performance. This has resulted in a large subset of Chinese companies offering financial metrics comparable to emerging markets peers at far less demanding valuations.

Despite a host of stimulus measures announced by the Chinese government in recent months, equities remain broadly cheap. Importantly, our investment thesis for the individual Chinese stocks that we own are not predicated on significant monetary or fiscal support from the government. These businesses are, in our view, trading at exceptionally low valuations that already discount persistent and severe economic pain. As Chinese valuations collapsed, we have selectively raised our exposure to stocks that we believe unjustifiably sold off due to temporary geopolitical and macroeconomic headwinds.

Q:        How could the election of Donald Trump, who threatens to impose tariffs on Chinese imports, affect the Chinese companies that you own?

A:         Tariffs and trade wars are always a threat, and we assess these risks on a company-by-company basis to determine whether – and to what extent – they might impact our estimate of a business’ normal earnings power. Generally speaking, the businesses we invest in have resilient operating models that we think are able to adjust to changing circumstances, including U.S. import tariffs.

Q:        Can you please describe the Pzena process in analyzing emerging market companies?

A:         Outside of our initial quantitative screen, our investment process exclusively entails deep, fundamental, company-specific research, whereby we seek to invest in good businesses trading at cheap valuations because of temporary pain that the market is interpreting as permanent/structural.

Our preferred valuation metric is price-to-normalized earnings, or P/N, which is a stock’s market value relative to our estimate of what a business should earn, on average, over the course of a full business cycle under normal circumstances. We only invest in companies in the cheapest P/N quintile of their investment universe. The discount rates we use to generate our normal earnings estimates and compare valuations across emerging market countries vary, depending on the country risk premiums. We use the market’s collective judgment, as proxied by a country’s long-term sovereign rate over the U.S. treasury yield, to measure a country’s risk premium. For example, a Chinese-domiciled company would utilize a materially higher discount rate in our valuation model than a South Korean company, and a South Korean company would have a modestly higher discount rate compared to a U.S. company.

Beyond the impact a higher discount rate has on the valuation of an emerging markets stock, which effectively raises the investment threshold, our research process is standardized across our strategies. Our analysts must understand and consider any factor that affects a company’s business, including the industry/country in which it operates and governance or regulatory issues that can widen the range of outcomes for a company.

For further information, please contact Evercore Wealth Management Partner and Portfolio Manager Judy Moses at [email protected].

¹ Kenneth R. French data.