The current valuations and fundamentals in Emerging Markets make for an attractive entry point, if you can stomach the increased volatility and risk associated with the asset class.
For the better part of the past 15 years, emerging market equities have outperformed their developed market counterparts. Factors contributing to this outperformance included attractive valuations and robust economic growth, with the latter a direct result of favorable demographic trends and the liberalization of markets. From the third quarter of 1998 through the second quarter of 2011, the Russell Emerging Markets Index outperformed the Russell Developed Markets Index 81% of the time on a one year rolling basis. The notable exceptions to the outperformance theme were marked by the bursting of the Technology bubble in 2000, and the global financial crisis that began in 2008. But in both cases, emerging market equities snapped back with a vengeance, more than making up for the short term relative underperformance.
However, beginning in 2011, emerging markets began underperforming developed markets on a consistent basis. The nadir may have been reached at the end of July, at which point the Russell Emerging Markets Index had underperformed the Developed Markets Index by about 20% on a trailing twelve-month basis. As the economist Herbert Stein famously said, “If something cannot go on forever, it will stop.” Have we passed the point where emerging markets can outperform?
At present, the consensus viewpoint appears to be that emerging market assets, both equities and bonds, are at risk of continued underperformance, as the Federal Reserve begins to taper its quantitative easing programs. The mechanism by which this would occur goes something like this – the Fed stops buying bonds, real interest rates rise, and the U.S. dollar and U.S. fixed income assets become more attractive. As a result, capital flows reverse, whereby investors who had previously been seeking higher yielding assets abroad, redeploy their capital to U.S. assets. This will (has) reduce liquidity in emerging markets, and put downward pressure on EM currencies, forcing central bankers in those countries to raise interest rates, even in the face of slowing economic growth. Clearly, this would be a negative for EM equities.
That represents a reasonable narrative, and clearly the influence of macro issues and resulting investor sentiment on market movements should not be underestimated. But policy and sentiment are both notoriously difficult to forecast (consider the Fed’s announcement on September 18th and the market’s reaction if you are in doubt). Therefore, investors concerned with properly allocating assets beyond a short term horizon should focus on the fundamental drivers of performance, namely starting valuation and expected growth rates. While growth metrics are also difficult to forecast with precision, current valuation is unequivocally helpful in determining better or worse times to either add to, or initiate, positions in certain assets. And growth rates need not be perfectly forecast, simply getting the rough order of magnitude correct across equity markets will go a long way toward properly assessing the opportunity set.
Valuations for emerging market equities, as measured by the Russell Emerging Markets Index, look compelling. At the end of August, the P/E of the Index, based on trailing twelve month earnings, stood at 12x, comfortably below its long term average of 14.2x. More interesting is the relative P/E comparison with other equity markets. The ratio of the P/E of the Russell Emerging Markets Index to both the Russell Developed ex-U.S. Index and the Russell 1000 Index, is currently 0.7, which is below both long term averages, and the lowest it has been since the credit crisis. Relative to U.S. stocks, as indicated below, emerging market stocks are one standard deviation below their mean, which has historically been a good point to add exposure.
In addition to lower valuations (on P/E, P/B, P/CF, & P/S), emerging market equities have other advantages relative to U.S. stocks (measured by the Russell 3000 Index), including the following as of August 31, 2013:
- A higher dividend yield: 2.7% vs 2.0%
- Higher expected earnings growth: 12.6% vs 11.7% (I/B/E/S mean long term growth)
- Lower variability in earnings per share: 40% vs 50% (based on the last 10 years)
- Better earnings trends: 33% vs 28% (% of companies with rising estimates)
- Slightly higher returns on equity: 17.2% vs 16.9% (trailing two year average)
- Lower debt to equity: 0.4 vs 1.2
Overall, the current characteristics of emerging market equities are quite favorable. Of course, these qualities do come with additional risk. Emerging market equities have experienced meaningfully higher volatility compared to both large and small U.S. stocks over the long term. The standard deviation of the Russell Emerging Markets Index was 24% over the past 15 years, compared with 16% for the Russell 1000 Index, and 21% for the Russell 2000 Index. It is this excess volatility that financial theory cites as the reason for lower valuations, and thus, higher expected returns. But that begs the question, why do small cap growth stocks currently trade at a P/E of 40x, with an equivalent long term volatility profile? An extreme example to be sure (forgive the cherry picking), but if small growth stocks were trading at a P/E of 12x, as EM stocks do currently, asset allocators would be seizing on the opportunity.
Valuation is never a good short term predictor of performance. Individual stocks, sectors, regions, etc. can remain greatly overvalued or undervalued for extended periods. To be clear, we are not suggesting that there will be a near term payoff to the attractive valuations found in emerging markets. What we do believe, is that the starting point matters greatly in investing, and currently the fundamental characteristics that portend higher long term returns are in place.
Most U.S. based investors demonstrate significant home country bias in their portfolio construction, and now may be a good time to reconsider that bias to some degree. Emerging market stocks accounted for 12.1% of the Russell Global Index as of June 30, 2013. Therefore, the typical 60/40 investor should have about 7.2% allocated to emerging market equities in the absence of a strong view, positive or negative. Upon closer inspection, we think it likely that most U.S. investors will find themselves underweight. We believe that investors should take advantage of the underperformance of emerging markets in recent years and build up their exposure to at least a market weight, if not an overweight position. It is our expectation that doing so will have a positive payoff over the next five years (and maybe sooner).
Clifford Stanton, CFA, is the Chief Research Officer and Portfolio Strategist for Envestnet | PMC. In this role, Mr. Stanton directs all investment research and manager due diligence efforts, covering both traditional and alternative strategies. In addition, Mr. Stanton leverages Envestnet | PMC’s research to formulate and implement multi-manager strategies. He earned a BS in business from Miami University in Ohio and an MBA from the University of Colorado at Denver.
Author’s disclaimer: For investment professional use only. Past performance is not indicative of future results. The opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. Information obtained from third party resources are believed to be reliable but not guaranteed. Any mention of a specific security is for illustrative purposes only and is not intended as a recommendation or advice regarding the specific security mentioned.Diversification does not guarantee a profit or guarantee protection against losses.