Stockholm (Ekonamik) – After a strong 2017, emerging market equities underperformed global equities both in 2018 and 2019. On the surface, emerging market equities have more attractive valuations relative to global and US equities. However, Warren Buffett once said that price is what you pay and value is what you get. And considering that the United States and emerging markets house different businesses baskets, are emerging market equities more attractively valued or not?
Is the Valuation Gap Warranted?
The iShares MSCI Emerging Markets ETF changes hands at a price-to-earnings ratio of 11.9 and a price-to-book of 1.6, whereas the iShares Core S&P 500 ETF trades at 20.5 times earnings and 3.2 times book value. Yes, US equities appear more expensive, and emerging market equities do look cheap, but the difference is not always a matter of price alone. European banks have been regarded as cheap for a long time now, yet they still managed to underperform severely in the past decade. Why? Because the average US bank, for instance, earns a mid-double-digit return on equity, whereas European banks make about half that.
Growth and return on capital are two fundamental drivers of intrinsic value. If the US market is dominated by fast-growing businesses that earn high returns on capital and emerging markets are populated by sluggish, low-returning businesses, then US equities should comment a higher price. As an asset manager at Orbis Investment Management wrote earlier this month, “if one market is full of great companies and the other is full of junk, the former should command a richer price.” It is not evident, however, that businesses in emerging markets are so much worse than in the US that the above-mentioned valuation gap is warranted.
More interestingly, the MSCI Emerging Markets Quality Index, which includes high-quality businesses with high returns on equity, stable year-over-year earnings growth and low financial leverage, commands a price-to-earnings ratio of 14.3 and a price-to-book of 3.3 as of the end of May. One may have a hard time arguing why the highest-quality businesses in emerging markets should command a significantly lower price than the average business in the S&P 500.
Asset Managers See Opportunities in Emerging Markets
Given the existing valuation gap, investors and asset managers alike may uncover more attractive risk-reward opportunities within emerging market equities. But to what extent are emerging markets a buying opportunity? Saker Nusseibeh, Chief Executive Officer of Hermes, wrote in mid-February that “there are more reasons to be optimistic about emerging economies than developed ones as we start 2019.” He further pointed out that he was “more confident in the possibility of finding long-term value in markets that are still emerging than in the signs that I see in more established ones.”
Despite emerging market equities underperforming in recent years, Eelis Hein, previously CIO of Finnish asset manager FIM Asset Management, told Ekonamik that emerging market countries “are still ‘emerging,’ which means growth and many investment opportunities.” Hein, however, emphasizes that “in the diverse EM universe, one just needs to be selective when choosing in which countries, assets, sectors, and themes to get involved.”
Victoria Mio, CIO of Chinese Equities at Robeco, wrote in late 2018 that the gap between the economic growth rates in emerging and developed countries was likely to widen in 2019, further adding that “historically, the gap between growth rates in emerging and developed markets is one of the strongest drivers of the emerging market equities relative to their developed market counterparts.” Mio also argued that the “prolonged underperformance of emerging market equities has made valuations more attractive compared to other regions, especially the US.”
The asset management arm of Goldman Sachs agrees, having written in January this year that “we are coming off an eight-year run of underperformance, which is attractive from a mean reversion perspective.” In addition, “we think the sell-off created a more attractive entry point with more favorable valuations.” All in all, the solid long-term fundamentals and more attractive valuations make emerging market equity markets a good hunting ground for equity investors.
Picture from Pixabay