What’s So Wrong with Emerging Markets?
Posted on: 07 Jun 2012 by James Farmer

Forgive me if I sound more than usually exercised this month, but I’ve been wanting to get this one off my chest for a little while now. And yes, I’ll freely admit that there are all sorts of reasons why the situation is more complicated than I’m going to make it sound. We always forget at our peril that for every willing buyer there has to be a willing seller, and that the leading industrial powers are always going to have their own investing dynamics, and so on. And that the euro crisis has got most of us looking out for potential knock-on fiscal effects that could easily override the simplistic assumptions of mere large-scale economics.

And blah blah blah…..

But it’s a terribly simple point that I want to make this month, and it goes like this. Over the last 28 months, since the halcyon days of January 2008 when all seemed to be (relatively) all right with the world, UK shares have become 11% cheaper if you measure them in terms of their price/earnings ratios. America’s S&P 500 companies have actually become 4% more expensive. But look beyond these markets and a different picture emerges. India’s shares are now 36% cheaper than they were in January 2008, Brazil’s are 31% more affordable, and China’s are a colossal 67% easier to acquire.

Yes indeed, my unashamedly partisan (and unweighted) selection of ten major stock markets has clocked up a collective 33.5% price deterioration in those 28 months, when measured in terms of its p/e ratios. And if we’d tried to apply a weighting factor we’d almost certainly find that Shanghai’s considerable size would have made the number larger still.

In fact the only one of our ten emerging markets to have upped its cost to investors during that period has been Thailand, although South Korea runs it close with a mere 5% cost deterioration during the same period. (Of which more anon.)

So here’s the question. Given that every single one of these emerging markets is set to see its economy outgrowing the developed world by a significant margin this year, should we be taking more notice of this apparent undervaluation?

 

A Mighty Mark-Down
							% change	%
	Jan 2008		April 2010		April 2012		2008-12	GDP growth
	P/E	Yield	P/E	Yield	P/E	Yield	(in p/e terms)	2012 (f’cast)
Argentina	15.8	1.2	14.2	5.9	7.2	8.6	-54.4	3.8
Brazil	17.3	2.1	17.4	3.2	12.0	3.5	-30.6	3.3
China	25.2	1.4	15.1	2.6	8.3	3.5	-67.1	8.3
India	27.6	0.8	20.8	1.0	17.7	1.5	-35.9	6.9
Indonesia	21.2	1.9	18.9	2.0	16.8	2.1	-20.8	5.9
Mexico	13.4	1.8	17.5	1.6	18.3	2.0	36.6	3.4
Russia	23.1	0.5	13.4	1.3	6.0	2.8	-74.0	3.5
South Korea	13.4	1.6	19.9	1.3	12.7	1.3	-5.2	3.2
Thailand	14.8	3.1	13.0	3.8	15.1	3.5	2.0	6.0
Turkey	15.3	1.9	12.7	2.5	10.4	2.4	-32.0	3.5
Unweighted average	18.7	1.6	16.3	2.5	12.5	3.1	-33.5	3.5
UK	11.7	3.7	12.7	3.0	10.4	3.4	-11.1	0.5
US (S&P 500)	16.9	2.3	17.7	2.2	17.6	2.2	4.1	2.1
Source: Thomson/Reuters (ratios only)

 

Let me say right away that there are contenders here which certainly merit extreme caution, mainly for overtly political reasons – Russia, for one, whose business credibility is fast slipping away under the newly-reappointed President Putin. Or Argentina, which seems hell-bent on frightening foreigners with its current attempt to expropriate a Spanish oil company’s assets. Buenos Aires has seen its average p/e ratio almost halving from 14.2 to 7.2 in the last two years alone. Its ability to pay its debt creditors is more than slightly doubtful at present.

Turkey’s fall from grace has coincided with a period of tricky relations with the EU and a correspondingly warm embrace of Iran’s foreign ministry – although that phase now seems to be falling apart over Iran’s support for Syria’s president Assad and his ongoing assaults against his own people. It’s not the kind of situation that a western investor would be leaping into unless he had a pretty good reason. But consider this. Would Instanbul’s p/e of 10.4 tempt you if you had the option of buying UK stocks at the same price? The bad news, for Turkey, is that you do.

Other emerging markets are looking flawed but still worth exploring. In the March issue of IFA Magazine we described how India’s government has fallen back into a pattern of protectionism, while also backtracking on efforts to stop corruption. And its recent decision to introduce retrospective liabilities on foreign –owned joint ventures (such as the so-called Vodafone case) has undoubtedly blunted foreigners’ appetites for Bombay stocks. But even so, a p/e of 17.7 is a lot more attractive than the 27.6 that you’d have been paying two and a half years ago.

The Growth Imperative

It is, of course, always dangerous to make direct comparisons between emerging and developed markets. On the positive side, the historical p/es that we see in the above table are likely to look positively lavish against prospective p/es during a period of what is likely to be rampaging economic growth. Buy a stock today at a p/e of 20 and it’ll seem cheap in five years’ time when (or if) its sales and profits have trebled. That’s one thing that you won’t see happening so much in the UK – or at least, not across an entire market sector.

Conversely, emerging market investors face the potential problems of disruptive political interference, inflationary pressures and currency instability, and in some cases downright market rigging. No sane investor would ever fail to make allowance for these factors.

Nor should we discount the likelihood that local accounting and reporting standards are unlikely to be as squeaky clean as we might expect in a major market. This is why the most successful funds operating in China, for instance, deploy small armies of Hong Kong and Shanghai analysts who will be streetwise enough to know where the bodies are likely to be buried.

The Old Commodities Argument

For some odd reason there seems to be a belief that emerging markets are exciting because of all the lovely raw materials that they produce. Which is rather odd, because by the time you’ve counted South America (metals and foodstuffs), Russia (oil and gas) and Indonesia (mining), you’ll be hard pressed to name more than a handful of large emerging markets that produce more commodities than they consume. China and India are both enormous net buyers of imported raw materials, and getting larger all the time.

With only a few exceptions, these countries are obliged to import most of their oil and gas. China has coal, certainly, but it isn’t the high-grade stuff that you need to make top-strength steel. For that, it has to look to Australia. That’s one reason why Australia’s economic prospects are looking better than most of the developed world these days. (See our feature on Page XX.)

So is that a good thing or a bad thing? I’d say it’s both. At present, of course, the global commodities markets are in the doldrums – unless you count oil, that is. Steel, aluminium, even coal have been plateauing for long enough to have knocked 28% off the MSCI commodities index in the last year. And, unless you’ve got your money invested in soya and wheat – in which case I bow to your intuitive skills – you probably won’t have been making all that much out of your commodities portfolio recently.

I’m still going to stick my neck out, however, and say that I still hold a candle for the supercycle theory. That’s the one that says that there’s a bigger cyclical destiny that shapes not just our ends but all our short-term cycles too – and that, despite the downward rotation of the smaller wheel, the bigger wheel is still quietly cranking up the pressure for the next upward shift.

Let’s return to our argument, though. Is it logical to ask why a country that’s going to be producing 8% more wealth next year than it did this year should find it harder to afford the raw materials that its industrial producers demand? I wouldn’t bet on it.

Even though China’s export markets are losing ground, especially in the US, I’d take a bit of convincing that this is a seriously dangerous trend. And even if the renminbi yuan should rise by 15% against the dollar – something that the US Government is very anxious for it to do – that’ll still mean that a plastic toy made in China is only 70% cheaper than its US equivalent, instead of 85% cheaper. People will still demand it. And that’s another reason why I’ll take some convincing that the present downturn in emerging markets is justified.

Volatility and Risk On/Risk Off

The volatility of emerging markets, of course, is something that we’ve come to expect. From China to Israel, from Pakistan to Colombia, the limited liquidity of the local stock markets tends to send them in great cyclical swings between boom and bust, feast and famine, as limited free floats and shortages of stock condemn investors to a succession of overpricings and underpricings, with long catching-up periods in between. That’s why it takes either immaculate timing to profit from switchbacking emerging markets, or else the patience of a Buffett to sit it out while a great prospect goes temporarily down the Big Dipper.

It’s equally obvious that today’s volatility is being fed, and constantly informed, by the need of foreign investors to repatriate cash at short notice – probably the biggest single reason why even the prosperous parts of Latin America have been struggling. The dominance of risk on/risk off trading in recent months has been the ultimate proof of that.

It won’t change until the day when Europe finally gets the euro sorted out. If there’s one thing that’s denting stock market confidence in China, it’s the prospect that a poorer Europe with a devalued euro will be hard pressed to buy as much. But do I really think it’ll reduce the profitability of Chinese companies even if it happens? In the long term, no, because soaring domestic economies will take the emerging markets to a new and higher plane.

That being the case, I’m going to carry on whistling hopefully. And keeping my eyes firmly on the middle distance.

My Calendar for 2012

I’ll be looking carefully at China’s transition to its new presidency, which is due to start soon. I’ll be watching India’s state elections for more of the same problems that have been surfacing recently. (And I’ll certainly be keeping an eye on the Vodafone case.) I’ll keep an eye on Venezuela’s October election, when the cancer-stricken  President Hugo Chavez is hoping to squeeze one more term of office out of an increasingly unhappy electorate, and on Mexico, where government troops are losing control to drug traffickers in parts of the north where all the border industries are.

I’ll be hoping for a quieter year in central and west Africa, where unrest in Democratic Republic of Congo, Somalia and Nigeria are still worsening; in the Middle East, where Syria’s unfinished business still casts a cloud over everything; and on Russia, whose ability to spike the oil price is bigger than it seems. And in between times, who knows, maybe I’ll find time to stake a few pounds of my own on some of these amazingly exciting prospects.

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