Diverging Markets

Everyone has grown accustomed to thinking about emerging markets as a monolith — a collection of undifferentiated countries aspiring to the big leagues, with all of the heft and stability of more developed economies.

Emerging markets share similar traits, oftentimes the market prices them similarly, and so they all get wrapped into the familiar and popular one-size-fits-all basket called THE EMERGING MARKET FUND.

Today, that’s the wrong way to think about emerging markets.

There’s a rainbow coalition of countries we label that way and they now have economies and markets as varied as their cultures. Just look at valuations.

A popular one-stop way to invest in emerging markets is via an index fund, such as the Vanguard FTSE Emerging Markets ETF. A casual glance at that index reveals a normalized price-to-earnings ratio of 10.8 (calculated using ten-year trailing average earnings, excluding negatives).  That might look like a reasonable multiple given how beaten down emerging markets are, but there are some surprises behind that figure.

Let’s look at the top ten countries in the index, which represent the vast majority (88 percent) of the index’s holdings. In the chart below, I’ve separated the five most expensive markets from the five least expensive (based on their normalized P/Es) and calculated an average P/E for each.  The five most expensive trade at an average P/E of 16.8, whereas the five least expensive trade at an average P/E of 8.5 — half the price.

So what do you notice here?

First, the variability in valuations is extreme. Brazil and Russia are laughably low by any measure, even after accounting for the incremental emerging market risk and whatever idiosyncratic risks you wish to attribute to them (Vladimir Putin, anyone?). At the same time, the valuations in China and India are princely by any measure, particularly after accounting for the incremental emerging market risk, to say nothing of their own unique risks.

Second, this is the furthest thing from a collection of undifferentiated markets that can easily be slotted into ONE BIG INDEX.

Looking for a value investment? You can steal Russia and Brazil in exchange for their (perceived) troubles.  Brazil is on the verge of bankruptcy; Russia suffers from a collapse in energy prices and from Western economic sanctions. I can hear the efficient market theorists now: “Cheap Brazilian and Russian markets do, in fact, reflect real risks and that’s accurately priced in!”  And the behavioral finance types: “The risks are real, but investors have completely overreacted, as usual!”

Want growth? You could pony up for Mexico, Taiwan or India, countries with bright prospects — although you should seriously consider, as I do, whether current valuations overstate their potential.

Want cognitive dissonance? Trade the farm for China – simultaneously the most expensive emerging market country and one widely feared to be headed for a crash landing.

Most emerging market countries today offer either classic growth or value opportunities. You can buy cheaply and give up growth, or pay up for growth — but you can’t do both. There are, in other words, diverging, emerging markets. It’s useful to think of them as such economically, politically and financially.

This is where your views about efficient markets and behavioral biases come into play. If you believe that prices accurately reflect the relative risks of emerging market countries, and you’re bearish on the global economy, you might pay up for a “growth” portfolio of countries on the theory that growth countries will better weather economic turmoil. If, on the other hand, you believe that geopolitical or economic risks are overstated — or that emotional biases are baked into some of these valuations — the “value” countries seem to be on sale.

I tend to take the long view and recognize that cyclical forces are constantly shuffling the global investment deck. Brazil’s fortunes today will visit India tomorrow and vice versa. Each market in a world of diverging, emerging markets, will reflect evolving realities over time. From that perspective, you don’t need higher math to make distinctions now.

Source: Bloomberg Gadfly, https://bloom.bg/2yzwqLj

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