Stocks and Shares

Are emerging markets too risky? (Part I of II)

Emerging markets are still the engines for global growth in coming years and decades. However, stocks in many emerging markets look cheap at the moment. There’s a lot of nervousness about emerging market debt levels. OfWealth has been looking at the evidence for whether that concern is warranted, and if you should invest in emerging market stocks.

Buy low and wait. Here at OfWealth we think that’s the only investment strategy that will consistently deliver profits for private investors. It’s called value investing.

To do be a value investor you have to go against the tide of mainstream thinking – be “contrarian” – and have large reserves of an increasingly rare virtue – patience.

When you can’t find value then you’re better off doing nothing and holding cash.

When you can’t find value then you’re better off doing nothing and holding cash. In recent years value has been thin on the ground, especially in artificially pumped up developed country stock markets (and many real estate markets too). Especially the kind of value that makes up for the huge risks of these “rich” countries’ massive debts and weak economic and demographic fundamentals.

Investment markets are choppy at the moment and there’s a lot of uncertainty about. After all, we’re still tiptoeing through “crash season”. This is why OfWealth recently recommended that investors have a large amount of their wealth put aside in cash.

But there is value to be found in selected emerging markets, and sometimes deep value (note: definitely not all of them). At the end of August the MSCI Emerging Markets index – which covers 23 emerging markets, as defined by MSCI – had a P/E of 12.6, price-to-book value (P/B) of 1.4 and dividend yield of 2.9%.

Since the end of August the index level hasn’t changed much so it’s fair to assume these valuation ratios are more or less the same today. That makes emerging market stocks relatively cheap compared with developed markets.

The following chart compares the P/E of the MSCI Emerging Markets index with the S&P 500 index of US shares and the MSCI World Index of 23 developed countries (note: 59% of the index, by value, is the USA).


Using this simple measure, the S&P 500 and MSCI World indices are respectively 53% and 45% more expensive than the MSCI Emerging Markets index. It’s clear that there is relative value in emerging market stocks.

What this means is that emerging markets are out of favour with the investment mob, those dedicated followers of fashion.

What this means is that emerging markets are out of favour with the investment mob, those dedicated followers of fashion. In fact prices have been in a downward trend since April 2011, as shown in the following chart (prices in US dollars).

MSCI Emerging Markets Index

(5 October 2010 to 5 October 2015)

Source: MSCI

That’s a fall of 25% in US dollar terms. And the most brutal part of that descent has been since April this year. This is precisely why emerging market stocks are so interesting at the moment. They’re cheap.

When stocks have fallen hard it means better prices for value investors. Big profits should follow as confidence is restored and prices rise again. The big question is whether prices could fall a lot more before that happens.

Whatever the short term concerns, at this point it’s worth reminding ourselves of something important. This is that emerging markets, taken as as a whole, are still likely to have a great future ahead of them. That’s especially true in relation to developed countries. It’s all too easy to lose sight of the big picture.

Here are some of the most important factors driving growth across emerging markets:

  • Relatively young and fast growing populations, especially in countries like India and continents like Africa, which means steadily more people, doing more things and buying more stuff.
  • Ongoing political and economic reform: communists move on (China, Eastern Europe, Russia, Vietnam), military dictatorships are rare (Latin America, Asia), ex-colonies are finally finding their feet (India, Africa). In short, billions of people around the world are finally being allowed to flourish.
  • Massive and ongoing urbanisation: subsistence farmers in the countryside move to cities, take higher paid jobs in factories or service industries, and become consumers. Put another way, productivity is rising fast.

See this infographic for more on the huge projected growth of emerging markets. It does a good job of highlighting the potential.

At the same time developed countries face big headwinds. They mostly have too much debt. Their populations are rapidly ageing or even shrinking. There are few easy wins for additional productivity since most people are already highly specialised and few live off the land. Most people already have too much stuff. And the political scene in many developed countries is steadily descending into populism, nationalism and farce.

In other words emerging markets are still where most of the growth is likely to be. But of course not all of them are the same – some are better and others worse. And there will still be economic and market cycles to contend with.

But the big picture is that any serious investor should be looking to profit from emerging markets.

But the big picture is that any serious investor should be looking to profit from emerging markets. And when stocks are cheap they should be looking seriously at getting on board.

A large part of the recent weakness in emerging market stocks can be put down to the collapse of commodity prices. Big commodity exporters like Brazil, Chile, Colombia and Russia have seen profits of commodity producers fall sharply.

At the same time the currencies of commodity producing countries have fallen hard against the US dollar over the past year or two. So if you’re an international investor that counts your profits in dollars, or other relatively strong currencies, there has been a double hit.

But this all sets things up nicely for the next boom. Eventually commodity prices will recover, especially if supply is cut as projects are postponed. And currencies will stabilise or even strengthen.

In addition, non-commodity exporters, such as manufacturers that are based in commodity countries with weak currencies, should benefit. Their input costs have fallen relative to the prices they can sell their end products for in most foreign markets.

But from talking to people, and reading a lot of recent analysis, it’s clear that there’s another major concern about emerging markets. It’s all about the big increase in debt that has happened in recent years. (Although, oddly, people seem less worried about the equally massive debt increases in developed countries in recent years.)

Specifically there’s a lot of worry about levels of corporate debt in emerging markets, and in particular borrowings in foreign currency, such as US dollars.

The concern is that with slowing economies and low commodity prices there won’t be enough profit left to pay interest on these debts. The theory is that this would result in mass defaults and a gigantic financial crisis across emerging markets – or at least in many of them.

So I’ve been digging into this issue to find out what I can. I’ll let you know the results in part II, later in the week. But for now just let me say that the evidence is mixed. And if there are serious risks then a lot of them are already factored in to the cheap prices of emerging market stocks.

Stay tuned OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.