Don’t keep emerging markets stocks at arm’s length

Whenever financial markets fall sharply, at some point they will become cheap.

Has that moment come for emerging market equities? As is the nature of markets, opinions differ, but there are some interesting straws in the wind.

Analysis by JPMorgan Asset Management shows that the benchmark MSCI EM index was trading on a price/book ratio of 1.28 as of late August, suggesting that even if a company went bankrupt, investors would get back almost 80 per cent of their money by selling the underlying assets.

This ratio is now below the troughs witnessed during the global financial crisis and has only been lower twice in the past 20 years: fleetingly after September 11, 2001 and more tellingly during the 1997-98 Asian financial crises. If one assumes emerging markets are not in as bad shape as in 1997-98, which still remains the mainstream view despite the gathering gloom, this might suggest EM stocks are now temptingly cheap.

“Emerging markets have only been this cheap 3 per cent of the time since 1989. Now is not the time to become more negative on the asset class,” says Richard Titherington, chief investment officer, emerging markets and Asia Pacific equities, at JPMorgan AM.

“Sentiment is extremely bearish, approaching levels seen in the depths of previous crises. Three decades of investment experience in emerging markets teaches that panic selling always creates opportunities.”

JPMAM went on to analyse the returns investors who bought in at similarly low price/book ratios enjoyed over the subsequent 12 months. In every case during the past 20 years they have made money, often as much as 50-60 per cent.

Indeed, JPMAM calculates the average 12-month return banked by those who bought into the MSCI Emerging Markets at a p/b ratio of 1.3 has been 49 per cent. For the MSCI Asia Pacific ex-Japan index, this figure rises to 64 per cent.

So that’s that then, go out and buy. Or maybe not.

Tom Becket, chief investment officer at PSigma Investment Management, has also noticed the temptingly cheap price/book ratios. Yet, looking specifically at Asia ex-Japan, he notes that on each of the four times the p/b ratio has fallen below 1.3 over the past 20 years it has carried on sliding for a while before perking up.

The trough reached as low as 0.94 in August 1998, although subsequent nadirs were less extreme at 1.19 in September 2001, 1.22 in March 2003 and 1.23 in February 2009.

Number crunching from Credit Suisse based on these episodes shows, once the p/b ratio has fallen to 1.3, it has always been lower still both one month and three months later, although investors have always made money on a two-year view. Despite these wrinkles, it describes Asian equity valuations as “really quite compelling”.

The numbers also excite Becket, although he is honest enough to admit he thought EM equities looked attractive when they fell to a price/book ratio of 1.45. “As an asset class, they have become so cheap relative to developed markets, relative to their history and relative to their future growth potential. But we are of the view that you need to be very selective,” Becket says.

“Buying for 10 years is a good opportunity. If you want to hold for 10 weeks, I’m afraid it’s guesswork.”

There are, of course, other ways of valuing equities. Perhaps the most commonly used would be the cyclically-adjusted price/earnings ratio. Unfortunately, for emerging markets this measure only goes back to 2005, so it does not cover the 1997-98 crises.

The measure, usually referred to as Cape, was at its lowest during the depths of the global financial crisis, but current valuations are now approaching this nadir.

Given the popularity of price/earnings multiples, how much validity does the price/book measure have as a valuation tool? A lot, argue both messrs Becket and Titherington

“Price/book is very helpful at the asset class level, although it becomes less helpful as you go down to the company level,” Titherington says. “[Book value] is less volatile than earnings. It’s a good proxy for investor sentiment.”

In contrast, he argues a low p/e ratio can be a value trap, signalling that earnings are at a cyclical high, not that a stock is cheap, although the cyclically adjusted measure avoids this problem.

Becket argues price/book has particularly advantages when, as now, economic growth is slowing. “We put huge store behind [price/book], much more than p/e multiples,” he says. “We are going to have to accept lower growth in future quarters. Using p/e multiples is challenging when you have that sort of environment.”

Partly as a result, Becket does not see emerging markets as a whole as attractive, saying he is “very sceptical” about Brazil, Russia, South Africa, Venezuela and, to some extent, Turkey.

In contrast to many though, (including a “Sinophobic western press” that is “rabidly bearish” on the “much despised” Middle Kingdom) a recent trip to Hong Kong has left him bullish on China at current valuations.

“People are falling over themselves to be bearish on China but regional equities are cheap and do not properly reflect the profit growth potential to come in the rest of the decade,” says Becket, who spies opportunities in the consumer, health care, technology, electrical appliances, water and personal finance sectors, while “state-owned enterprises’ reform programmes could provide winners for patient investors”.

“If you have a three-year view, a rare quality these days, then there is great money to be made in China. For the bravest among us, you can find some frankly ludicrous valuations in small-cap stocks, as long as you have a long view,” he adds.

He is equally upbeat about India, arguing that steps by the government to tackle bureaucracy and corruption mean the country “might be able to fulfil its long-term growth potential for the first time since independence, and at valuations that are cheap”.

Titherington believes we need to see three steps before EM equities at large can start to recover, though. Firstly, plummeting currencies need to stabilise, then the economic picture brighten somewhat and finally corporate earnings start to recover.

Depending on your world view, that could take a while, whatever the charts suggest.

Financial Times