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Regina Chi is vice-president and portfolio manager at AGF Investments Inc.

The quintet of Facebook Inc., Apple Inc., Inc., Netflix Inc. and Google’s Alphabet Inc. has outperformed the broader market for years now, and the FAANG group’s exceptionalism has only been boosted by the COVID-19 environment, what with just about everybody staying home and putting their digital devices into overdrive. While the S&P 500 is up 4.9 per cent for the year – and that’s after a near-five-month rally – the FAANG group in 2020 has risen more than 40 per cent.

But the FAANG stocks are not the only digital game in town. In emerging markets (EM), a similar revolution is under way, and it’s being reflected in the surging share prices of digital-economy companies.

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The ascension of EM digital companies, of which Baidu Inc. (search), Alibaba Group Holding Ltd. (e-commerce) and Tencent Holdings Ltd. (services) – known as the BAT stocks – are probably the best-known, is clear in the performance split between growth and value stocks. Since the start of the year, the MSCI Emerging Markets Growth Index, which includes the important new economy names, has gained 13.4 per cent, through July 31, according to Bloomberg, while the corresponding value index is down 9.7 per cent.

When we look specifically at the subsectors of the MSCI Emerging Markets Index that include digital economy companies – Internet & Direct Marketing Retail, led by Alibaba, and Interactive Media & Services, led by Tencent – the differentiation is even clearer. Between October, 2018, and June, 2020, the benchmark weight of those two subsectors grew from 10.4 per cent to 19.6 per cent, according to Bloomberg, representing a remarkable 88-per-cent increase. This year, the overall MSCI Emerging Markets Index is up 1.8 per cent through July 31 in Canadian dollars; remove the digital element from the equation, however, and the return falls to minus 3.6 per cent.

Importantly, the digital universe in EM equities has become very wide and deep. It transcends the BAT stocks. In Internet & Direct Marketing Retail, publicly traded companies include not just Alibaba, but also Chinese e-commerce competitors Inc. and Pinduoduo Inc., as well as Meituan Dianping, an online food delivery service. In Interactive Media & Services, Shenzhen-based Tencent is now joined by Naver Corp., operator of South Korea’s most popular search engine platform, and Kakao Corp., which offers one of the country’s most widely used messenger applications. In India, meanwhile, conglomerate Reliance Industries Ltd. is poised to become a digital giant through its Reliance Jio Platform subsidiary. In total, there are 22 companies in the two relevant MSCI EM subsectors, and they are not all based in China.

This transformation and corresponding equity outperformance look poised to continue. That’s not just because of the remarkable rate of innovation in some emerging markets, but also because of continuing tensions between China and the United States. The 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) – and 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 may not have already listed in the United States, to turn to the Hong Kong Stock Exchange (HKSE), at the very least to hedge regulatory risk through a co-listing. Many of the smaller-cap digital companies on the MSCI index are already listed there; listed on the HKSE just this summer, and Alibaba tapped the exchange last November while maintaining its American depositary receipt listing on the New York Stock Exchange.

We are constructive on the entire sector, but given the recent strong performance, it makes sense to look for relative value. That, thankfully, is not too difficult, because many smaller-cap stocks without significant earnings have been caught up in the wave of digital enthusiasm, and they have outperformed some more familiar names. The digital subsectors of the MSCI Emerging Markets Index have gained 34.1 per cent year-to-date, but if you exclude Alibaba and Tencent, the return has been 36.6 per cent, according to Bloomberg. That suggests there is more upside in the two larger-cap equities, which both have strong earnings growth and multiples that seem reasonable when compared with their small-cap EM counterparts. Alibaba’s valuation in particular looks attractive even when compared with its American counterparts: Its price-to-earnings ratio on the Hong Kong exchange is around 30 times earnings, according to Bloomberg, while Amazon was recently trading at 140 times.

Of course, as with their FAANG counterparts, the fortunes of EM 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 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.

AGF owns stock in Facebook Inc., Apple Inc., Inc., Netflix Inc., Alphabet Inc., Alibaba Group Holding Ltd. and Tencent Holdings Ltd.

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The views expressed are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds or investment strategies. References to specific securities should not be considered as investment advice or recommendations.

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