Credit: Shutterstock photoThe concept of value investing is one that has proven its worth over decades of cyclical investment trends. Most often, investors who adhere to this practice are trying to uncover stocks or areas of the globe that are fundamentally mispriced in relation to more expensive alternatives. Buying at a low relative valuation, with a long-term time horizon, can provide fruitful results as mature trends fade and fresh momentum takes shape.
One stunning example of this valuation gap can be seen in the divergence between emerging market stocks and those here in the United States. The iShares MSCI Emerging Market ETF (EEM) has $26 billion dedicated to an index of 842 publicly traded companies in China, South Korea, Taiwan, India, Brazil and many others.
This ETF debuted in 2003 at the start of a tremendous boom in capital growth for these developing nations. From its April 2003 inception to the pre-crisis peak on October 10, 2007, EEM notched a total return of +389.82% versus just +90.24% for the SPDR S&P 500 ETF (SPY). That’s a gain of more than four times the benchmark of large-cap U.S. stocks!
From peak to gutter, both indexes were decimated by the meltdown that wreaked havoc through the global markets. Yet, when we pick up the story in 2009, a much different picture has been evolving. SPY has gained +254.41% from the March 9, 2009 low through today. EEM has gained +91.47% over that same time frame.
Interestingly enough, the majority of those gains in emerging markets came near the beginning of the rally. EEM has only managed to notch a single positive year since 2011. There has been a plethora of short-term rallies that have ultimately fizzled and led to new lows over the last five years.
This widening gap has been blamed on a number of factors from the deflation in commodity prices to the lack of growth in many of these former red-hot countries. Investors who expected the same correlation of outperformance in the aftermath of the global recession have likely felt let down by the comparative results to-date.
At this point in time, it seems like a natural migration to relieve yourself of underperforming emerging market exposure and focus solely on the strength in the United States. However, over the next decade, that may come with its own risks as well.
Value-mavens will point out that the price/earnings ratio of EEM stands at 12.80, while SPY has risen to a lofty 19.37. Furthermore, the price/book ratio stands at 1.47 for EEM versus 2.74 for SPY. This obvious gap is one that will likely experience a contraction over the next cycle as mean reversion forces compress the spread between these metrics.
The more important question for those considering this valuation chasm is whether another global reset will be needed to spur a changing of the guard?
The 2008-2009 financial crisis was the harbinger of momentum transformation in emerging markets driven by a number of important factors such as peak commodity prices and credit risk contraction. Those same factors may ultimately play an important role in the re-ignition of interest in the fundamentals behind emerging market stocks over the next five to ten years.
Furthermore, ETF investors will have to contend with what specific allocation size and vehicles are most appropriate for their goals. ETF.com lists 174 stock-oriented emerging market funds that range from broadly diversified indexes to regions, single countries, and even niche sectors. That list does not include the exposure you can achieve through comprehensive international funds or global benchmarks as well.
One option that has grown increasingly popular in recent years is to consider a group of emerging market stocks with lower volatility than their peers. The iShares MSCI Emerging Market Minimum Volatility ETF (EEMV) has over $3.3 billion dedicated to a mix of 260 stocks culled from the broader EEM basket that have shown a history of reduced price fluctuations. EEMV charges a reasonable expense ratio of 0.25% to operate the fund.
Another candidate for dividend seekers is the WisdomTree Emerging Markets High Dividend ETF (DEM). This fund seeks out over 300 stocks of emerging market nations with above-average dividend yields. The end result is a unique portfolio of companies that combine to generate a current 30-day SEC yield of 5.50%
These are just two examples of investment strategies within the emerging market sphere that cater to a specific objective. There are countless ways you can expand upon these themes to capture specific criteria or dial in your exposure in various regional aspects.
The Bottom Line
The problem with comparing valuation metrics of independent asset classes is that they can be persistently high or persistently low for very long periods of time. Investors can’t always successfully time the market based on perceived characteristics of expensive or cheap. There must be other guiding factors that play a role in supporting their investment thesis.
Accessing emerging markets through the use of exchange-traded funds provides a low-cost way to get instant exposure through a diversified basket of securities. For those who are seeking to re-position their international exposure or reduce their U.S.-focused portfolio, this segment of foreign stocks may offer up intriguing long-term potential.
Note: all performance data includes dividends reinvested. P/E and P/B data listed via fund company websites.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
