C&B Notes

Top-Down Trash

This article highlights the significant shortcomings of broad-brush investing in emerging markets.  Using index funds or ETFs to invest top-down in these geographies typically means committing capital largely to commodity producers and financials.  Sorting the treasure from the trash takes fundamental work.

Emerging stocks appear far cheaper than in developed countries, especially compared with the pricey U.S. market.  So is now the time to close your eyes to the headlines, ignore the sick feeling in your gut and just buy?  Frankly, no.  There are times when such a pure contrarian approach makes sense, but today is not such a time.  True, the MSCI Emerging Market index trades at just 11 times estimated earnings for the next 12 months, against almost 17 times in the U.S.  True, the falls of roughly half in the Turkish and Argentine currencies against the dollar this year have helped drag down the currencies of even countries such as India and Indonesia with better-balanced economies.  True, the biggest emerging equity market, China, is back in a bear market, and so are emerging stock indexes with big China exposure.  Yet, neither emerging equities nor the major emerging bond indexes have even given back all last year’s gains and income, let alone dropped to true bargain prices.  Valuations aren’t especially low by historical standards.  Worse, the index only looks inexpensive because it is weighted toward sectors few want to buy, even in developed markets.

The last point is perhaps the least understood. Emerging markets have far more banks and commodity producers, which trade at lower valuations than more fashionable areas.  Adjust sector weights to match those of developed markets and emerging market indexes trade at the same price-to-forward-earnings ratio as the FTSE World index, according to Philip Lawlor, FTSE Russell head of global markets research.  Investors hoping to take advantage of the turmoil to buy into the emerging middle class at a discount through one of the plethora of emerging exchange-traded funds will be disappointed.  Almost half the cheapest 25% of decent-size emerging stocks — those worth more than $1 billion — are in the financial sector, including many Greek, Turkish and Chinese banks. Many of the rest are in low-growth utilities or Russian oil.  Only 8% of these low-valuation stocks, measured by price-to-book ratio, are in consumer sectors, and none at all in health care…

“Looking at the PE [price/earnings ratio] of the emerging markets index will lead you astray,” says Christopher Smart, head of macroeconomic and geopolitical risk at Barings.  “A lot of the index is global tech and global commodity cycle, much more than it is the emerging middle class.”

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