Are Emerging Markets Still Attractive?

January 26, 2018

Are Emerging Markets Still Attractive?

  • The MSCI emerging market index is up 53% in the last 12 months.
  • However, nothing has actually changed in the long term fundamentals which makes things much riskier.



Introduction

If you have been following Investiv Daily for the past year and a half, you know that I have been extremely bullish on emerging markets because of their relative cheapness when compared to developed markets, positive demographics, and positive economic growth.

However, since I first mentioned emerging markets here, the emerging market index is up 53% and as investing is all about risk reward—and risk is a function of the price you pay,—it is extremely important to take another look at what is going on.

Figure 1: MSCI Emerging Market ETF since April 2016. Source: iShares.

What has changed in the last year to justify such an increase? There are two important perspectives to discuss, my perspective—the long term fundamental one—and the market’s perspective on what is going on.

From my perspective, absolutely nothing has changed. Demographic growth is equal, long term expected economic growth hasn’t changed, commodity prices have increased but that is normal as commodities are cyclicals, and the rest of the story hasn’t really changed much which makes emerging market stocks simply riskier now.

From the market’s perspective, China has surprised on the upside, global growth is speeding up, and, most importantly for emerging market economies, commodity prices have jumped while the dollar weakened. This allows for higher profits which short term oriented market participants see as a catalyst for even higher stock prices.

The problem is that these optimism cycles constantly repeat themselves in emerging markets. Just take a look at the Emerging Market ETF over the past 10 years.

Figure 2: MSCI Emerging Market ETF since January 2018. Source: iShares.

The chart above shows how emerging markets are extremely volatile and often trade sideways. Any kind of global risks make investors flee emerging markets and thus, the volatility.

At this moment, most expect the current environment to remain as is for an indefinite period and disregard risk. Unfortunately, that is exactly how money is lost in emerging markets. Those who invested when there was blood on the streets just a year and a half ago have done well. Those who will invest now are simply paying 50% more, and thus their returns will be lower and the risk is higher.

But not all is lost!



There Are Still Investing Opportunities In Emerging Markets

The largest holding of the MSCI Emerging Market Index is Tencent which has been delivering almost 50% revenue growth over the past few years and earnings growth of 25%. This has resulted in a stock price explosion for a 5 year return of 776%.

Figure 3: Tencent’s stock price in the last 3 years. Source: CNN Money.

Its current price to earnings ratio is 69 and its price to book value is 17.26. If Tencent continues to grow earnings at a rate of 25% per year, earnings would grow from the current $0.88 to $2.68 which would still give a 5-year forward price to earnings ratio of just 21.3. Just a year ago, that forward PE ratio would have been 8.76 which makes a big difference in investing.

Five years is a very long period and a lot can happen, both on the global economic field and also in China where any kind of slowdown would have an extremely negative repercussion on stock prices.

What could hit emerging markets are interest rate increases, especially the companies and countries exposed to foreign debt. Therefore, I would say that to blindly invest in emerging markets now is extremely risky. There is a high chance that the trend continues for a while, but also that it reverts in the future which would bring you to zero or negative returns.

The two options now are to continue taking advantage of the trend and being ready to lock in the gains at the first signs of potential weakness, and the second is to look for bargains that haven’t yet been recognized by the market. However, as market participants prefer to invest through ETFs, the current largest ETF holdings will see the highest demand as most ETFs are weighted by market.

Figure 4: Top 10 MSCI Emerging Market ETF holdings. Source: iShares.

I still think emerging markets offer good long term investing opportunities but for low risk high return investing, you should invest there where there is blood in the streets. Such a strategy requires an in-depth analysis of country, sector, and company specific risks in addition to buying at low prices.

The two cheapest markets remain Russia and China, but you really have to understand the specific company you are investing in because at this moment in time, you want to invest in companies that will survive and grow in the next cycle.

Another interesting thing is that ETFs usually invest in the biggest countries which means that smaller countries with lower market capitalizations could still hide bargains.

Figure 5: MSCI Emerging Market ETF country weight. Source: iShares.



What To Do

Carefully analyze what you are buying when investing in emerging markets. Chasing stocks that are already up 50% or even 100% in the last year is never a smart thing to do because the risks are simply too high even if there seems to be no shock at the horizon.

At a similar valuation, sometimes it’s better to hold a domestic stock as you avoid currency and global sentiment risks. Further, really look at the various countries as how global investors approach investing through passively managed index funds is totally crazy.

Nevertheless, you can still invest profitably by carefully picking emerging market stocks.