Image Credit: Christophe Vorlet
By Jason Zweig | March 31, 2017 12:00 pm ET
Investors should ponder why that quintessential wise man, Benjamin Franklin, owned an asbestos purse. Perhaps it was to keep his money from burning a hole in his pocket. If we all had fireproof purses, maybe we wouldn’t be so eager to put hot money to work.
So far in 2017, exchange-traded funds investing in stocks from such developing nations as Brazil, China, India, Mexico and Russia have taken in $10.5 billion in new money, estimates TrimTabs Investment Research of Sausalito, Calif. With $127.8 billion in total assets, one-twelfth of all the money in these funds has come in over the past 90 days.
Much of that, presumably, is in hot pursuit of high recent returns. Emerging markets are up 12.4% this year — double the return of the S&P 500 index of U.S. stocks, counting dividends.
Investing in emerging markets isn’t a bad idea, but rushing to do so is. These stocks aren’t so much absolutely cheap as relatively cheap — especially when compared with U.S. companies, which still are hovering near all-time highs.
How cheap are these stocks? Emerging-market companies are trading at an average of 12.2 times their expected net profits over the next 12 months, estimates Arup Datta, a portfolio manager at AJO, a Philadelphia-based investment firm.
That’s a tad higher than their long-term historical average of less than 11 times earnings — but much cheaper than U.S. stocks, at 19 times the coming 12 months’ profits.
On a longer, backward-looking horizon, emerging-markets stocks are priced at approximately 14 times their average earnings over the past decade, adjusted for inflation, estimates Research Affiliates, an asset-management firm in Newport Beach, Calif. That’s barely above the low of 13 times earnings they hit during the global financial crisis in 2008.
Stocks in the U.S. are at 29 times their inflation-adjusted long-term historical earnings, a lofty level rarely exceeded in the past.
Emerging markets are “half the price” of U.S. stocks, says Chris Brightman, chief investment officer at Research Affiliates. “History suggests that you’re going to earn much higher returns on lower-priced assets than higher-priced assets.”
The lower valuations of emerging-market stocks provide at least some cushion against the risk of a trade war or other changes in U.S. policy that could hurt developing countries.
But relative cheapness isn’t the same thing as safety. Emerging markets are in better economic shape than they used to be, but they are still prone to currency crashes, commodity collapse and political turmoil.
And speculators who barge into emerging markets expecting to get rich quick have often gotten burned — all the way back to the British and Dutch who bought into U.S. canals and railroads in the early 19th century.
That’s partly because the prospect of faster economic growth excites investors into paying high current prices — but doesn’t necessarily translate into higher future returns. As demand for investment swells, new companies arise and issue oodles of shares — so total profits can get spread thinner and thinner.
Now though, he says, emerging markets could perform well again relative to the developed world. Unlike at U.S. companies, which are already near record levels of profitability, earnings as a percentage of total revenues at emerging-market firms have been growing but remain well below their averages over the past two decades, says Mr. Knudsen. That should give them ample room to keep improving.
Still, many of the biggest companies in emerging markets are government-affiliated, lumbering leviathans that aren’t always the best way to tap into the potential spending power of consumers in those countries.
Just think of China’s enormous commercial banks, says Sammy Simnegar, portfolio manager of the Fidelity International Capital Appreciation Fund and Fidelity Emerging Markets Fund. They dominate the Chinese stock market, but most aren’t particularly attractive investments.
Other companies are based in emerging markets but do much of their business elsewhere. When it comes to popular indexes that seek to capture the returns of stocks in developing countries, says Mr. Simnegar, “some of those building blocks may be defective.”
One of the largest stocks in India, for instance, is Infosys Ltd., which derives roughly 97% of its revenues from outside its home country.
So study a fund’s holdings, or press your financial adviser, to learn whether it will expose you to emerging markets for real or just for show. Above all, there’s no rush to buy just because recent returns have been hot.
Source: The Wall Street Journal, http://on.wsj.com/2mVVdnO
For further reading:
Definition of EMERGING MARKETS in The Devil’s Financial Dictionary