Three Reasons You Could Squeeze A Lot More Value From Emerging Market Stocks Than American Ones

Three Reasons You Could Squeeze A Lot More Value From Emerging Market Stocks Than American Ones
Stéphane Renevier, CFA

about 3 years ago3 mins

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What’s going on here?

US stocks are currently expensive. Very expensive. In fact, the only time they’ve ever been more expensive than right now was right before the dotcom bubble burst in 2000. What’s more, US stocks aren’t just pricey in terms of their own history, but also when compared to other regions. The chart below shows that investors are paying twice as much for public US companies “book value” (the total value of their balance-sheet assets) as they are for those in emerging markets (EMs). And that mismatch might just make for an opportunity…

EM v US stock valuations

What does this mean?

"Price is what you pay; value is what you get." Thus spake legendary economist (and Warren Buffett mentor) Ben Graham. Given how expensive US stocks are at present, investors may find they can get much better value overseas. Here are three reasons why I think EM stocks are a particularly attractive alternative right now:

1. Better valuations

The higher an investment’s valuation compared to its historical average, the lower its likely future returns. And while US stocks are expensive, emerging markets look more reasonable – potentially leaving room for more upside. How much exactly? Figures from investment management firm Schroders suggest that, based on the current valuation gap, EM stocks could outperform US equivalents by around 40% over the next two years. Now that sounds like great value!

EMs typically outperform US stocks when valuations are this far apart
This large an EM/US valuation gap has historically preceded significant EM outperformance

2. Higher earnings growth

According to Goldman Sachs Asset Management, EM company earnings are expected to grow by 19% over the next two years. This compares to a mere 2% in the US and a -9% contraction in Europe. EM businesses tend to be more “cyclical”: their earnings growth is more closely tied to the state of the economies in which they operate. Given that these emerging economies generally experience faster growth than developed ones, it makes sense that a post-virus recovery will lead to higher earnings (and therefore share prices) for their companies.

EM economy growth estimates v US, Europe

3. Commodity kick

EM stocks could also benefit from an additional boon: a rally in commodity prices. After years of headwinds for this type of investment, commodities are poised to do well off the back of increased fiscal stimulus, more inclusive US foreign policy, and a strong global economic recovery. EM companies tend to be more exposed to commodity prices than others – and their share prices should therefore shift accordingly.

Why should I care?

If you’re like most investors, then you probably have a significant exposure to US stocks already. And while that’s been a solid trade for the last decade, my view – as explained above – is that current valuations leave EMs looking likely to lead the way in the coming years. The good news is that you can easily implement this idea using emerging-market exchange-traded funds (ETFs). Be sure to use the techniques outlined in our Investment Screening Pack to find what works for you – but in the meantime, here are a couple of my favorites:

💦 The most “liquid” option out there is the Vanguard FTSE Emerging Markets ETF (ticker: VWO). It’s invested in more than 5,000 EM stocks, and its geographic exposure is pretty diversified (40% China, but including countries such as Brazil, Taiwan, and South Africa). With an annual fee of just 0.1%, it’s also one of the cheapest ETFs.

🤔 If you’re a bit more cautious about the current economic environment, then the iShares MSCI Min Vol Emerging Markets ETF (ticker: EEMV) could be a good bet. It’s invested in stocks with lower volatility, which should lead to outperformance in more difficult circumstances.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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