A conservative assessment of valuations suggests that emerging market equities are still priced to d...
A conservative assessment of valuations suggests that emerging market equities are still priced to deliver attractive returns, especially when compared to the developed markets.
Common sense real return expectations for asset classes are best calculated by considering the components of return. Our favoured methodology is to classify the sources of return into change in valuation, growth in fundamentals and income.
Using conservative assumptions and relying on the principle of mean reversion ' that is, our best guess for the medium term is that valuations and growth will approximate their historic norms ' we believe emerging markets are currently priced to return more than 9% a year over the next seven years, after taking inflation into account.
The main driver of this is that the market value of the emerging markets is low relative to their combined profit. The picture for the developed markets is considerably less rosy ' using a similar methodology for US equities, anticipated returns are less than -0.9% a year over the same period.
Therefore, a significant asset allocation towards emerging markets is likely to bear fruit over the coming years.
Perhaps the best way of understanding the goings on in the emerging markets is to think in terms of crisis investing.
Emerging market crises tend to follow a well-trodden path. Two examples are those of Russia and Thailand, both of which suffered 'classic' crises in the late 1990s. The seeds of a crisis are generally sown during good times. Monetary policy becomes loose, economic growth intensifies, attracting a wall of foreign investment that pushes the currency upwards and creates an illusion that borrowing in foreign currency is a good idea.
Ultimately, the festival atmosphere dissipates as rigidities cause a default in the case of Russia, or a currency collapse in the case of Thailand, and a period of contraction follows.
It is during this period that the investment case grows because the potential for corporate turnaround can be extraordinary. The remarkable improvement for the Russian oil sector is well-documented with Russian oil giant Yukos reinventing itself as an unlikely poster child for good corporate governance.
Elsewhere, the share price performance of Norilsk Nickel has been explosive. Having made overseas acquisitions such as Stillwater Mining of the US, Norilsk Nickel inches towards global giant status. Russia is now up 1,000% since its nadir and has breached all-time highs. It would now be prudent to reduce positions in this market.
In contrast, we believe the case for investing in Thailand remains strong. At its 1990's high, the Thai market traded on a multiple of over 20 times earnings. Now, Thai stocks are at only around a third of peak values and stand at an earnings multiple measured in single figures.
Today, it is sometimes referred to as the 'Detroit of Asia' for the high volume of pick-up trucks it manufactures. The economy has had an impressive turnaround with a 'go-getting' administration and lower borrowing rates than the US.
The prospects for the Thai market and emerging markets in general are exciting.
Priced for positive absolute returns.
Currency crises create opportunities.
Thailand poised for more outperformance.
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