Following our recent blog note on the level of implied returns in the major developed markets, a look at emerging market equities might be appropriate, especially after a sustained period of underperformance. Could it be time to buy back into the dream? What does valuation imply for long run returns?
- The MSCI Emerging Markets Equity (EME) Index (local currency) has returned 10.8% annualised since March 2009 and 2.7% annualised in the last five years.
- The MSCI EAFE (developed non-US) Equity Index (local currency) has returned 12.9% and 9.5% respectively.
- The MSCI US Equity Market Index (local currency) has returned 18.2% and 14.3%.
The underperformance of emerging markets in the last five years is striking. 7 – 12% annualised underperformance versus developed non-US equities and the US Index.
The underperformance is clear when you look at the relative price/book ratio for the MSCI Emerging Markets Index versus the MSCI World Index. Emerging markets have gone from a 16% premium to a 35% discount since 2010.
Call us old-fashioned, but we still adhere to the view that emerging markets, with their relative institutional, social, political and economic frailties should trade at a discount. So, at least we are back on the right side of the axis and about half way to the relative valuation at the trough after the Asian crisis in the 1990s.
The question then becomes “Is the current discount sufficient to deliver an attractive, relative implied return premium for emerging markets versus developed markets?”
Here is the relative valuation of emerging market equities versus the EAFE Index (developed non-US markets) and the UK Equity Index:
- EME at a 14% discount versus EAFE from a near 40% premium in 2010.
- EME at a 21% discount versus the UK from a near 20% premium in 2010.
As we showed in a previous blog piece on expected market returns, the arithmetic of equity returns is very simple – implied returns are a function of four simple numbers:
- The starting valuation ratio.
- The ending valuation ratio.
- The growth rate in earnings per share over the holding period.
- The dividend yield.
Of course, returns can be made to look as attractive as you want if you make outlandish, non-evidence based and obviously biased forecasts for variables 2, 3 and 4 (assuming that we can agree on an appropriate measure of valuation to start from). All one must do is make up a sales story and fix the numbers to fit.
We prefer to let the data speak and on that basis we make the following assumptions:
- The starting valuation is the current MSCI Index price/book ratio.
- The ending valuation is the long run trailing median price/book ratio i.e. we assume that ten years forward the P/B ratio has reverted back simply to its run trailing median level. What could be more conservative?
- The growth rate of earnings per share (and the per share bit is important, especially in emerging markets where vast amounts of equity dilution takes place from net new issuance necessary to finance the growth in earnings) is assumed to be the long run trailing annualised rate of earnings per share.
- The dividend yield is what it is and easily observable.
Now, we can turn to calculating the implied ten year holding period annualised return for EAFE, EME and UK equity indices on the basis of those parameters (it should be noted that earnings per share growth, for example, is staggeringly stable across markets over long time spans).
- The first chart shows the annualised implied return for emerging equities less the annualised implied return for EAFE (developed non-US equities) at monthly points over the last fifteen years.
A number of thoughts spring to mind: (a) investors in the 2007 – 12 period were actually prepared to accept a meaningfully lower implied annualised return in EME equities than in EAFE equities; they believed in the dream of perpetual motion in emerging markets that is at odds with all of the historical data set with the cross sectional correlation between equity returns and growth being negative; (b) investors today seem willing to accept a 1.5% annualised return premium in emerging markets.
- The second chart shows the annualised implied return for emerging equities less the annualised implied return for UK equities at monthly points over the last fifteen years.
Again, UK investors appeared happy to forgo 3% annualised return in 2008 – 10 to chase the emerging markets growth dream and are happy to accept a 1.8% premium today to move from UK equities to the emerging markets.
Of course, besides valuation and long run expected returns under conservative, empirically-validated assumptions, there are other considerations:
- Emerging markets have a higher downmarket beta than developed markets. That is to say, when the US market falls sharply the emerging markets fall far more substantially. Emerging markets offer no downmarket diversification at all.
- We also need to consider other identifiable known factors in returns since, at the end of October, emerging markets had negative absolute momentum and negative relative momentum (versus the UK, US or EAFE). We would want to see positive absolute and relative momentum before we commit to emerging markets.
So, all things considered, the modest implied return premium in emerging markets, the greater drawdown beta, and the negative absolute and relative momentum versus the developed markets all suggest to us that there will come a better opportunity to move back into emerging markets. As Aristotle said “patience is bitter, but its fruit is sweet”.
MONOGRAM CAPITAL MANAGEMENT