Want an asset class that is cheap? Take a look at emerging markets. They are dirt cheap. There are reasons, of course, but there are always reasons when something is cheap. The question is whether they are cheap enough.
Emerging markets are so far off the radar that they aren’t even hated. After ten years of severe underperformance while the U.S. market has been going gangbusters they aren’t even worth a thought to all but the most dedicated global investors. They just exist somewhere out there in the Oort Cloud of investing doing the usual ridiculous things such as wild inflation, debt defaults, currency collapses, illiquidity risk, and expropriation of investor assets. They have no respect for property rights. An expression of the current view of emerging markets is presented in this rather tendentious article, passed along in Tadas Viskanta’s Abnormal Returns. Meanwhile, just to compound the problem, China has more or less eaten the category, becoming more than a third of the cap-weighted index.
So who needs emerging markets?
Maybe you do. You may at least wish to hold off on a quick dismissal. To a value investor there’s nothing like an asset which has underperformed for ten years and disappeared from the collective mind of the market. There may also be some value in the extent that they diversify, although their lack of correlation to the U.S. market for the past ten years has been that emerging markets have gone down while the U.S. market has gone up. That could be a good thing, at least from the viewpoint of contrarian value investors.
Some of the best informed value investors have noticed and embraced the opportunity. Robert Arnott, founder and board chairman of Research Affiliates, stepped up in a recent Barron’s interview (August 26, 2019, p. S10) to make the case for emerging. The RAFI indexes created by Arnott’s firm are leaders in “smart beta” indexing, including emerging, of course. I’ll have more to say on Arnott in the conclusion to this piece.
Arnott isn’t quite alone. The large institutional money manager Grantham, Mayo, & Van Otterloo (GMO) has been pounding the table for emerging over the past year. In the cover story for its fund section a week ago (“A World Beyond China,” p. L6), Barron’s surveyed the emerging markets world while examining the possible need to minimize China. It’s a view with which I agree strongly, and which I will discuss in this article. On this site you might have a look at asset allocation articles by Lyn Alden Schwartzer, an SA author with whose views I am often in synch. Schwartzer has made several recent pitches for emerging in the larger context of market overviews, including this very recent article. Schwartzer has also expressed some caution on China having to do with its fiscal deficit. In general, though, when it comes to interest in emerging markets these are voices crying out in the wilderness.
Here are the numbers that state the case for emerging versus other global assets:
Ten Numbers On A Bar Chart
Many readers may be familiar with this bar chart of 7-year real return forecasts which is regularly updated on the Grantham, Mayo & Van Otterloo web site. The chart is a snapshot taken at a single moment which broadly forecasts 7-year returns on a number of asset classes. The primary mover of its forecasts are valuations, the one metric which filters out noise and short term market narratives. Its assumption is that while anything can happen in the short term, in the longer term valuations tend to revert toward the historical mean.
The inverse correlation of present valuation and future returns almost always asserts itself over time. The GMO chart has implied this same kind of thing twice in recent decades, in the years leading up to 2000 and also to 2007. In both cases paying careful attention to the information contained in the chart would have saved a great deal of grief. Here’s what that GMO chart says As of August 31:
The major force driving return forecasts across the board is the power that low interest rates have exerted across the spectrum of asset classes. Fixed income itself is priced for miserable future returns based on simple arithmetic. The decline of bond rates to near zero and below zero in many parts of the world assures a nominal return to maturity that is nil to negative, an unprecedented situation. Low rates across the fixed income spectrum have also lowered the discounting rate for future cash flows, in effect pulling future equity returns into the present and severely reducing prospective equity returns. The stunning result is the forecast of a negative real return of 3.3% annually for U.S. large cap stocks over a period of 7 years. That’s the S&P 500 they’re talking about.
The only exception is emerging markets, which have put up thoroughly negative performance over the past decade. It is this negative decade, however, which positions them for outperformance in the 7 -10 years to come. Emerging markets as a whole are historically cheap, cheap enough to offer 5.3% real returns annually over 7 years, while emerging market value is cheap enough to offer almost twice that, 10.1%.
There are no guarantees to this mean reversion argument, but the case is reinforced by a statistical comparison of several Vanguard funds taken directly from the Vanguard site.
Vanguard Provides A Method For Comparison
The Vanguard approach to investing using mainly low cost index funds generally eschews presenting strong opinions about markets, sectors, or asset classes. For that reason the data presented on its various funds is particularly useful because made up of hard numbers presented in a way that makes different funds comparable. Their earnings growth numbers for 5-year historical earnings growth are provided by Morningstar. The table below presents Vanguard’s All Cap Emerging Market Fund, based on FTSE Emerging Markets All Cap China A Index, compared to three other Vanguard index funds representing the asset class for which they are named.
|Vanguard FTSE Emerging Markets ETF||Vanguard S&P 500 ETF||Vanguard FTSE Europe ETF||Vanguard Small-Cap Value ETF|
|Number of stocks||4729 As of 08/31/2019||508 As of 08/31/2019||1356 As of 08/31/2019||858 As of 08/31/2019|
|Median market cap||$18.7 billion As of 08/31/2019||$114.2 billion As of 08/31/2019||$36.3 billion As of 08/31/2019||$3.8 billion As of 08/31/2019|
|Price/earnings ratio||12.9x As of 08/31/2019||20.1x As of 08/31/2019||15.8x As of 08/31/2019||14.6x As of 08/31/2019|
|Price/book ratio||1.5x As of 08/31/2019||3.1x As of 08/31/2019||1.7x As of 08/31/2019||1.6x As of 08/31/2019|
|Return on equity||16.0% As of 08/31/2019||17.3% As of 08/31/2019||13.0% As of 08/31/2019||9.8% As of 08/31/2019|
|Earnings growth rate||12.0% As of 08/31/2019||10.6% As of 08/31/2019||7.8% As of 08/31/2019||7.5% As of 08/31/2019|
The first and most important comparison is between Vanguard FTSE Emerging Markets and the S&P 500. The S&P 500 PE ratio (20.1) makes it more than 50% more expensive than the emerging markets fund (12.9), while its price to book ratio (3.1) is more than double the 1.5 of the emerging fund. In spite of this, earnings growth in the emerging markets fund is greater, 12.0% to 10.6%. The only metric favorable to the S&P 500 is its higher return on equity. This makes sense because the S&P is heavily weighted toward tech, media, internet, new-model businesses which operate with relatively little capital.
There’s a seeming paradox in that the earnings growth rate of the S&P 500 doesn’t track its return on equity. What this suggests is the possibility that its large and mega cap capital-light companies are unable to deploy surplus cash flow at a rate of return equal to their current rate of return on equity. The important thing to note is the major difference in valuation between the emerging markets fund and the S&P 500 fund while earnings growth is actually better in emerging. This strongly supports the forecasts on the GMO bar chart.
The other two funds, Europe and U.S. Small Cap Value, are both priced to do better than the S&P 500 with PE ratios about halfway between the S&P 500 and emerging markets. Europe is more than 20% cheaper than the U.S., but has a far lower growth rate. The U.S. small cap value index is even cheaper, but has slower growth than Europe. Neither should quite be dismissed out of hand, but a global recession would certainly hit them hard and provide a better buying opportunity. Neither presents the striking buying opportunity available in emerging markets.
The Vanguard FTSE Emerging Markets fund is itself a not-half-bad choice, but while it affirms the category, another set of comparisons demonstrates ways to improve upon it. Again I’ll use those handy Vanguard comparison charts.
Searching For “Value” In The Emerging Markets Space
Let me direct your attention back to the second of those two emerging markets lines in the GMO bar chart. Note again that the emerging value bar forecasts a 7-year return of 10.1% real, almost doubling the 5.3% forecast for the emerging markets space as a whole. Value is where you want to be. The question is how to get at emerging markets value. I have been unable to find a fund or ETF with exactly that specific focus. What I was left with was funds which back into value as a result of other factors. I was then able to use the same Vanguard comparisons to confirm that their value focus was supported by the traditional value factors of low PE and low PB.
It turns out that in the emerging markets a high dividend often coincides with value. A part of this is inherent in the high dividend itself, as it includes the necessity of substantial earnings and cash flow. Another – perhaps more important – is that it excludes firms which pay little no dividend. These companies include the large tech driven growth companies which have grown into a large part of the cap-weighted index. These firms invariably have high PE ratios, so that their exclusion for lack of dividends leaves firms that are statistically cheaper. It’s thinking backward, but in an obvious way: when you exclude growth what you are left with is value. A requirement for significant dividends tend to purge the cap-weighted indexes of companies that are expensively priced.
A secondary effect of this approach is a reduction in the weighting of China. The cap weighted approach to emerging markets is heavily tilted toward such internet behemoths as Ten Cent (700.Hong Kong), Alibaba (BABA) and Naspers (NPN.South Africa), which owns a large stake in Ten Cent. As listed in the Vanguard table of top 10 stocks holdings, these companies rank first, second, and fourth in overall weighting. Tencent and Naspers, like many rapid growth companies, pay minuscule dividends with yields just over .3%. Alibaba pays no dividend at all. A high dividend criterion eliminates these companies.
As the recent Barron’s article notes, these three companies plus Taiwan Semiconductor (TSM), ranked third in market cap, and Samsung Electronics (005930.Korea) – ranked fifth, have a higher concentration in the MSCI Emerging Markets index than Microsoft (MSFT), Apple (AAPL),Google, Amazon (AMZN), and Facebook (FB) have in the S&P 500 index. (A small detail: unlike MSCI emerging markets index, the Vanguard FTSE index doesn’t treat Korea as an emerging market.) The three Chinese companies, including the Naspers stake in Tencent amount to 10% of the total FTSE Emerging Index.
One more reason to prefer avoiding mega-cap Chinese companies like Alibaba is that their size and cash flow makes them candidates for the purposes of a government which sees such companies at times as instruments of public policy rather than independent shareholder-owned enterprises.
So what happens when you engineer an index structured so as to eliminate the large Chinese tech/internet companies? Whether your motive is to avoid such stocks outright or to own emerging as a diversification against the influence of exactly such stocks in the S&P 500, they tend to duplicate things you can own easily in the domestic U.S. market. What they add is all the added uncertainties of emerging markets investing.
But here’s the headline: merely removing these three stocks drops the country weight of China in the index by almost a third.
Doesn’t that hurt the level of earnings growth? As you can see in the table below, in two of the three funds examined, the two Wisdom Tree dividend funds, it does not.
|Vanguard FTSE Emerging Markets ETF||WisdomTree Emerging Markets SmallCap Div||WisdomTree Emerging Markets High Dividend||PIMCO RAFI Dynamic Multi-Factor Emerging|
|Number of stocks||4729 As of 08/31/2019||838 As of 08/29/2019||471 As of 08/29/2019||602 As of 08/31/2019|
|Median market cap||$18.7 billion as of 08/31/2019||$1.4 billions as of 08/29/2019||$13.4 billion as of 08/29/2019||$15.3 billion as of 08/31/2019|
|Price/earnings ratio||12.9x As of 08/31/2019||11.1x As of 08/29/2019||9.0x As of 08/29/2019||11.0x As of 08/31/2019|
|Price/book ratio||1.5x As of 08/31/2019||1.2x As of 08/29/2019||1.2x As of 08/29/2019||1.1x As of 08/31/2019|
|Return on equity||16.0% As of 08/31/2019||–||–||–|
|Earnings growth rate||12.0% As of 08/31/2019||13.1% As of 08/29/2019||12.4% As of 08/29/2019||9.3% As of 08/31/2019|
|Foreign holdings||97.5% As of 08/31/2019||100.0% As of 08/29/2019||99.5% As of 08/29/2019||94.9% As of 08/31/2019|
|Turnover rate||10.8% As of October||40.0% As of March||44.0% As of March||43.0% As of June|
All three of these funds have lower aggregate price/earnings and price/book ratios than the Vanguard FTSE Emerging Markets Fund. Somewhat counterintuitively, both the Wisdom Tree High Dividend Fund (DEM) and the Wisdom Tree Small Cap Dividend Fund (DGS) have higher earnings growth rates than the Vanguard FTSE fund which contains the famous growth stocks which together make up 10% of its holdings. The Vanguard fund wins hands down on expense ratio, of course, with its minuscule .12%. The others are quite competitive for the category, however, with expense ratios ranging from .49% to .63%. The major argument for the PIMCO RAFI Dynamic Multi-Factor Fund is that its very low level of China holdings of 12.46% might appeal to those who really, really want to avoid China.
Here are the country weightings:
|Top five countries|
|Vanguard FTSE Emerging Markets ETF||WisdomTree Emerging Markets SmallCap Div||WisdomTree Emerging Markets High Dividend||PIMCO RAFI Dynamic Multi-Factor Emerging|
|1||China 34.30%||Taiwan 29.16%||Taiwan 25.85%||South Korea 17.45%|
|2||Taiwan 14.00%||China 19.77%||China 23.80%||Taiwan 14.06%|
|3||India 10.80%||Brazil 8.21%||Russia 16.50%||China 12.46%|
|4||Brazil 8.40%||South Africa 7.86%||South Africa 6.88%||Brazil 12.08%|
|5||South Africa 6.20%||South Korea 7.05%||Brazil 4.84%||Russia 8.61%|
Notice that currently popular countries like India tend to fall in the country rankings, while unloved countries like Brazil and Russia tend to rise. It should be noted that Russia has the highest growth rate and lowest PE of all the above countries. All in all Russia is the cheapest market in the world except for Greece, which has negative CAPE earnings.
The low PE of the Russian market stems from the usual suspects – weak governance, relatively high inflation, an unpredictable currency, a low level of respect for property rights, and additionally the fact that it is very heavily weighted toward energy – I could probably come up with a few more if I put my mind to it. Its debt situation, however is surprisingly solid, with both a positive current account and a fiscal surplus. The big surprise was the number for growth. Who knew that Russia was a high growth country?
For those of you who can get past the obvious and well-recognized problems, Russia is amazingly cheap at something under 6 times current earnings – exact numbers hardly matter with Russia. You might have a look at the VanEck Vectors Russia ETF (RSX), with its 4.3% yield. I have looked. I haven’t leapt. Not yet, anyway. Maybe I’ll write a short piece about it.
And The Winner Is…
Wisdom Tree Emerging Markets High Dividend Fund (DEM) was the first that I bought and the most obvious. It has the lowest aggregate price-earnings ratio at 9 times current earnings, and its price to book ratio is 20% lower while its earnings growth rate is higher than the Vanguard FTSE fund. It has a lot more Russia than the Small Cap Dividend Fund (DGS) – Russia being mostly a large cap market – and a little more China. DEM has a higher dividend (at 4.86%) than DGS (at 4.05%), not surprising because large caps might be expected to present more companies with high dividends.
The small cap fund (DGS) is not to be dismissed, however, and I bought it second in part to diversify cap level. The presence of a substantial dividend helps screen small caps for those having operational success and actual cash flow, and at both cap levels screens for overall quality.
Here’s what Morningstar had to say about the methodology used by both funds:
Most dividend funds weight their holdings by stocks’ dividend yield, but DEM’s methodology is different. At the May 31 rebalance, DEM’s benchmark index screens the universe of emerging-markets stocks for firms that have paid out at least $5 million in regular cash dividends over the past 12 months and have met certain market-cap and liquidity requirements. These companies are then ranked by dividend yield, and the top 30% are selected for inclusion in DEM’s index. Constituents are weighted by dividends paid, measured by trailing 12 months dividends per share multiplied by shares outstanding, converted into U.S. dollars. This methodology attempts to create a relatively high-yielding fund with a large-cap tilt (larger companies tend to pay a higher total amount of dividends) and a slight value tilt. (At the rebalance, the index tends to sell lower yielding companies and buy higher-yielding companies).
And Morningstar’s praise of the Small Cap Fund (DGS) is fulsome:
WisdomTree Emerging Markets Small Cap Dividend ETF (NYSEARCA:DGS) has a number of positive attributes. Its small-cap focus provides better diversification benefits relative to large caps, as small companies tend to have more exposure to local economies and customers. Long-term investors may also benefit from the small-cap premium, which has also been observed in emerging markets. This fund employs a dividend-based weighting methodology, which, in the emerging-markets small-cap universe, results in a portfolio with a quality tilt. So even though DGS is a small-cap fund, its volatility has been lower than that of the large-cap benchmark MSCI Emerging Markets Index over the past five years. And since inception, DGS has provided higher absolute and risk-adjusted returns.
In reality both funds provide both a quality and value tilt which in the case of the large cap fund seems to me greater than the quote from Morningstar suggests. The large cap fund starts with a market cap of $200 million and the small cap fund draws from the bottom 10% of the local index by market cap. Anyway, I ended up buying them both.
For those of you interested in learning about the methodology in more detail this link will provide it.
How Large Should An Emerging Value Allocation Be?
There are two major reasons to include emerging markets in your portfolio. One is that they contribute to diversification because of limited correlation to U.S. equities and developed market equities in general. The other is that they may add incremental return because of superior growth or a tendency to be more cheaply priced because of perceived risk. As simple math demonstrates, even cheap assets that remain cheap provide higher returns than more expensive counterparts. They may also smooth overall returns because of fairly long cycles of underperformance and outperformance compared to other global markets. Your personal goals and attitude toward risk will influence the kind of allocation these factors suggest.
Emerging markets amount to 21.8% of the Vanguard Total International Index Fund (VTI), meaning that they are 21.8% of markets outside the U.S. as measured by market cap. The equity side of a standard diversified portfolio is 60% domestic, 40% international. If following the number for emerging markets in the international index, the allocation to emerging would be 8.72% of your total equity allocation.
Famous Yale endowment manager David Swensen suggested in his book Unconventional Success (2005) that individual investors use a portfolio that is 50% equities of which 5% is emerging markets. That’s 10% of whatever your personal equity target is – a slight overweighting compared to the percentage of emerging in the actual global index.
I have owned a major position in emerging markets in the past. During the latter stages of the dot com crackup from 2002 to 2004 I owned closed-end country funds for India and Brazil and had good luck with them as I bought both of them at a large discount to net asset value and sold them when they hit a sizable premium, and after underlying markets had roughly doubled. Since that time I have owned no international assets at all until buying the above two Wisdom Tree funds.
That those Indian and Brazilian country funds did so well while the U.S. large cap market was coming unstuck suggests that emerging markets do not always simply follow and exacerbate declines in developed markets. Under some conditions they may – repeat: may – play a helpful role as a constructive diversifier in case of a major downturn in developed markets. My best guess is that emerging markets would decline sharply at the onset of a global recession but begin to gain ground on other markets as some of their strong fundamentals began to assert themselves.
Unless the situation changes radically, I will continue adding incrementally until my emerging markets position reaches 20% or more of total portfolio, equity and fixed, unless relative valuation of global asset classes changes materially. This may sound risky for a sort-of-retired investor, but I am comfortable with a portfolio that combines pure capital preservation with risky assets at the right risk/reward level. I don’t recommend it for others.
In short, I have begun a major pivot in the direction of emerging market value. Please bear in mind that I will ramp up my emerging markets positions in stages.
Conclusion: A Hint From The Smartest Guy In The Room
Let me tell you a bit more about Rob Arnott. Arnott, is one of the smartest macro analysts in the world. To validate this view of Arnott, and increase your own knowledge of the composition of equity returns, read his paper written with the late Peter Bernstein, “What Risk Premium Is “Normal,” Financial Analysts Journal, Vol. 58, No. 2 March/April 2002, pp. 64-85.
By analyzing the composition of historical 75-year stock returns, Arnott and Bernstein, then the dean of institutional investors, pulled together a compelling quantitative argument that starting from the valuation at that time future returns would be far lower than the generally expected historical average. If you don’t know how precisely their expectation was borne out, you are under thirty years old or haven’t been paying attention to the financial world for long.
Armed with numbers and superb analytical skills, Arnott is prepared to stand alone against an overpowering public narrative. Here’s what he told Barron’s about portfolio allocation a little over a month ago:
Hardly anyone would feel alarmed at having 10% in emerging markets or 20% of their stock holdings in international markets. So maybe that’s your normal allocation to those markets, and you go a little higher when they get cheap like they are now. Don’t invest so much that you couldn’t stand the pain of being wrong for a couple of years. For some people that might mean having no more than 10% in emerging markets. For others, it’s more than 25%.”
Arnott’s own money is where his mouth is. Asked by Barron’s where his own money is, he explained that his liquid net worth – aside from his stake in his own firm, Research Affiliates – is more than 50% in emerging markets deep value stocks, done via funds which he is not allowed to discuss. Why not 100%? Because “having all of your eggs in one basket is a bad idea even if you’re convinced that something is the cheapest market in the world.” He owns a “decent-size” allocation to EAFE stocks like the runner-up Vanguard value funds in the above table along with a modest amount of commodities, credit strategies, and high-yield strategies. He owns no U.S. stocks.
Arnott is about halfway to the Buffett position that diversification serves no purpose if you know what you’re doing. I guess I’m a little bit under 25% of the way. You? Know who you are.
What about retirement investors? Purely personal opinion: at this particular moment the S&P 500 and bonds threaten more capital destruction than emerging markets do. I’m 75 and would hope to live quite a few more years, but my appetite for risk is improved by having a pension and a safe fixed income position. If you are nearing retirement or already retired, be cautious about sequence risk in emerging markets. I think they’re a good deal right now, but they are volatile. As always do your own research and your own thinking.
Thanks for reading this to my many readers who remember me after a five months hiatus, and special thanks to several who sent messages inquiring about my health and well-being. I’m fine. My family is fine. It’s extremely hard for me to write in the summer tennis season during which I teach an average of seven hours a day seven days a week and run three junior teams, which I’m happy to say did very well this year. My wife and I also had a pleasant but demanding duty in giving a wedding for her oldest daughter in England, a task which generated several foreign trips. Headlines in the financial world haven’t changed all that much since May, I must say, so maybe there wasn’t anything urgent that needed to be said. I’ll try to write more often. Again, thanks.
Disclosure: I am/we are long DEM, DGS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.