By Sujata Rao
LONDON (Reuters) - An unrelenting squeeze on company profits is turning investors away from emerging equity markets, which look set to underperform their richer peers for a fourth straight year.
The 3 percent loss by emerging equities this year contrasts with 1 to 2 percent gains by developed and U.S. stocks, after a divergence in performance of almost 30 percent in 2013.
Emerging-market stocks are unlikely to recover until company profits pick up, analysts reckon. And if the latest earnings season is any guide, that will not happen any time soon.
Two-thirds of emerging companies have now reported results from the last quarter of 2013, and their net income has missed forecasts by around 6 percent, according to data compiled by Morgan Stanley. That will be the eighth quarter out of 10 that earnings fell below expectations, Morgan Stanley said.
Compare that with Japan, where companies have beaten net income forecasts by 13 percent, or the United States, where the "beat" is around 4 percent, Morgan Stanley says.
Separately, data from Thomson Reuters Starmine shows more than half the companies have missed earnings forecasts.
For investors, that means emerging companies may be doing fine at generating top-line revenues. They are doing less well at generating profits.
Yves Bonzon, CIO at Pictet Wealth Management, says weak return-on-equity (ROE) - the measure of how well a company uses shareholders' cash to generate profits - is a big worry.
Average ROE in emerging markets slipped to 12.6 percent by the end of February from 15 percent in 2011 and 17-18 percent before 2008. It has languished below U.S levels for more than two years now, the following graphic shows:
GRAPHIC: Emerging markets vs U.S. ROE - http://link.reuters.com/wyr57v
In other words, emerging-market companies earn 12.6 cents for every dollar of shareholder money invested - two cents less than U.S. companies. That, Bonzon says, belies the popular belief that emerging-market equity valuations are cheap.
"ROE is the reason we prefer developed markets over emerging markets. It's a position we have had for a while and plan to keep," Bonzon said.
"What you see is a decline in return on capital employed in the emerging world and an increase in the return in developed markets," he said. "The trend still favours developed markets."
CHANGE
The profit dip became noticeable after the 2008 financial crisis, which showed up inefficiencies at many emerging-market companies.
Investing less, deleveraging balance sheets, and laying off workers allowed Western companies to stay profitable through the downturn. Emerging-market companies not only lacked this flexibility, but many were forced by their governments to raise capital expenditure and wages to support growth. That squeezed profits further.
A year ago, cash was still coming into emerging equities. Flows reversed by mid-year as the U.S. Federal Reserve's plans to reduce financial stimulus programme forced investors to pick and choose investments more carefully.
This year almost $30 billion has fled emerging equity funds tracked by EPFR Global. A Bank of America/Merrill Lynch poll showed a record one-third of investors were underweight the sector.
One such investor is Ayesha Akbar, who helps run a $40 billion-plus multi-asset portfolio at Fidelity Solutions. She says slowing growth in China may further hurt earnings at commodity exporters, and a gradually tightening credit cycle is bad for domestic demand and consumer goods.
"It's not yet time to get back in. We think (flatlining profits) has a bit more room to run," she added.
Jonathan Garner, head of emerging equity strategy at Morgan Stanley, agrees. The pace of earnings downgrades is "abnormally high," he said - twice the level of developed market levels.
"We are seeing a majority of companies and a majority of sectors with downward revisions to earnings estimates, particularly in cyclical sectors that face domestic demand in the emerging markets world," Garner told Insider television.
Top-line revenues are coming under pressure, too. Revenues grew 7.7 percent year-on-year in the fourth quarter, but analysts have cut estimates for January-March 2014 by 0.7 of a percentage point.
"It's more of a top-line revenue problem we are seeing now,"
Garner said. "And un that really stabilises and improves it's difficult to see markets catching a bid."
COST OF CAPITAL
There are a few glimmers of light. Several countries have beaten earnings estimates, among them India, Indonesia, Brazil, amid signs that growth may be starting to recover. Second, the slowdown will have lowered some input costs.
And finally, as the Fed reels in its stimulus and capital becomes scarcer, companies will have an incentive to focus on costs, something that was absent during the easy-money years.
"You can safely deduce that there probably was some capital misallocation going on and as a result the bottom line deteriorated," Pictet's Bonzon said.
"If emerging companies face punitive cost of capital, that will change managers' behaviour. They will stop raising equity and put their balance sheets in order. Then results will improve."
(Graphic by Vincent Flasseur; additional reporting by Simon Jessop; Editing by Larry King)
