The U.S. Market Is Irrationally Expensive - What Does The Rest Of The World Have To Offer?

March 16, 2017

The U.S. Market Is Irrationally Expensive – What Does The Rest Of The World Have To Offer?

  • Global markets are much cheaper, but there’s an even better option.
  • It’s relatively easy to find stocks that have huge growth potential at cheap valuations. I’ll describe three sectors.
  • In the long term, the current trend of favoring the U.S. dollar and equities is going to shift to where the growth is. There’s no doubt about it, so be prepared.

Introduction

The U.S. equity market is like driving a luxury car. It’s reliable (low volatility or as some say, low risk), costs you a bit more to maintain (low dividends), it makes you look good (investing with the big boys), and it will eventually bring you to where you want to go.

Investing in emerging markets is like driving a cheap car. Nobody considers your investments cool (looking for bargains in unknown areas like Russia, China, or India), the car won’t be as reliable (break down more often – think volatility), but it will be cheap to repair (high dividends), and eventually will also bring you to where you want to go.

Oh, I forgot one small issue with the luxury car, when it breaks down, usually after 8 to 10 years of usage, it becomes unreliable and extremely costly to repair, plus it has lost more than 80% of what you initially paid for it.

Cars are one thing while markets are another, but many treat them in the same way, buying what’s luxurious and trendy at the moment instead of buying the best investment. Markets are here to allow you to invest in the most profitable business, i.e. a cheap car that will bring you from point A to B at the lowest possible cost giving you the highest return on investment.

I’m a strong believer that the best investment returns in the next decade will come from emerging markets. Let’s use Star Capital’s global markets table to see how cheap emerging markets really are.


Figure 1: World markets by CAPE ratio, PE ratio, price to cash flow, price to book value, price to sales. Source: Star Capital.

The Chinese economy grew 6.8% in the last quarter of 2016, while its stock market is valued with a price earnings (PE) ratio of 7.2, a price to book value below 1, and offers a dividend yield of 4.3%. What investment vehicle will bring you further in the next ten years? China or the U.S. with a PE ratio and price to book ratio 3 times the Chinese, and a dividend that is half what China offers.

Until the U.S. market crashes, the Chinese market will be much more volatile, that’s for sure, but the higher dividends will allow you to reinvest more through the volatility.

Emerging Markets Have Been Out Of Favor For The Last 10 Years

The iShares Emerging Market ETF (EEM) has gone nowhere in the last decade while the S&P 500 is up by 64%.


Figure 2: S&P 500 vs. the emerging market ETF in the last 10 years. Source: Nasdaq.

What’s even more interesting is that emerging market economies grew twice as fast as the U.S. in the last decade but didn’t get much love from investors.

After 10 years, emerging markets are undervalued while the S&P 500 is overvalued. A superficial view at what’s going on would suggest that the S&P 500 will continue to grow as the American economy is doing well, but a concept that 99% of market participants have difficulties understanding is that everything changes sooner or later. When that trend changes and people suddenly see that the luxury car isn’t the best option because fuel or maintenance costs are too high, you’ll want to already be positioned in emerging markets so that the only thing left for you is upside risk.

But Don’t Invest In Emerging Market ETFs

Before investing in emerging markets, please read my analysis of an ETF investment approach here. The best approach to emerging markets is to invest in individual stocks that will give you a good diversified base while grasping the secular emerging markets growth trend.

There is no point in chasing expensive growth stocks when the same can be found at extremely cheap valuations. With no intention of recommending stocks here and for the sake of doing an exercise, I’ll create a portfolio of a few stocks from 3 sectors out of the top 100 holdings of the iShares MSCI Emerging Markets ETF (EEM) with the goal of creating a portfolio that will outperform the S&P 500 and the EEM in the next decade.

Chinese Banks

Chinese banks trade at silly valuations while giving you a 5% dividend yield. Their income and dividends are expected to grow alongside the Chinese economy. All of the four major Chinese banks have more than doubled their revenues in the last 10 years.


Figure 3: Chinese banks – fundamentals. Source: Morningstar.

Automotive Manufacturers

Automotive manufacturers are relatively cheap globally, but the negative sentiment surrounding emerging markets in the last decade has also punished emerging market automotive stocks.

Two companies, Tata Motors (NYSE: TTM) and Hyundai Motors, help explain what I mean. Tata motors is the largest Indian automotive manufacturer with 76.1% of revenue coming from domestic sales. Indian car ownership is expected to grow 775%, yes 775%, by 2040. However, TATA’s PE ratio of 17.3 is absurdly cheap for such potential growth especially since TATA has seen revenue grow 742% in the last decade.

Hyundai, the Korean automotive manufacturer, is in a slump as it has seen its margins decline lately but still boasts a PE ratio of only 4.3, a dividend yield of 1%, and a price to book value of 0.4. The company sells worldwide and has a market share of 16.74% in India. Just the Indian operations of Hyundai should be worth more than the current market capitalization due to the growth potential. Any stock with a PE ratio of 4.3 and forward expected PE ratio of 3.7, is a bargain.

The Oil Sector

I’ll conclude with a quick comparison of Gazprom, a Russian oil company, and Exxon Mobile (NYSE: XOM).


Figure 4: Comparison. Source: Morningstar.

I know Gazprom is a Russian company, but it sells oil and gas which are commodities sold at global prices, so it doesn’t really matter much where a company is from. What’s important is that the fundamentals and growth prospects are mind-blowingly cheap.

Conclusion

The above companies come from a quick scan of the MSCI Emerging Markets top 100 list. Thorough due diligence is necessary before investing, but my point is that good businesses can be found around the globe at silly valuations.

The difference in the price you pay and the dividends you receive will make a huge difference when the current trend that favors the S&P 500 and the dollar shifts to emerging markets as that is where global growth comes from.

Don’t forget that India is going to have a population of 1.7 billion by 2050, thus adding 400 million customers to its already huge market. Alongside economic growth at 7% per year, I wonder what investments will do better in the next three decades.

To learn more about specific opportunities I have identified in India and other emerging markets, click here.

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