Is it a “new normal” or simply a reflection of better growth and earnings prospects? Regardless, emerging-market stocks are trading at the highest valuations relative to advanced-country shares in more than two years as faster economic growth.
The MSCI Emerging Markets Index is valued at 14.1 times reported profits and 1.9 times net assets, compared with ratios of 14.9 and 1.7 for the MSCI World Index.
This time may be different because developing nations have less debt, more profitable companies and are growing twice as fast as advanced economies. Global money managers are more bullish on emerging markets than any region, while mutual fund investors poured $35 billion into the countries this year, even as they pulled $28 billion from the U.S., Europe and Japan, data from Bank of America Corp. and JPMorgan Chase & Co. show.
“There is a case for a re-rating of emerging markets relative to the developed world,” said Philip Poole, the London-based global head of macro and investment strategy at HSBC Global, which oversees more than $400 billion and holds more developing-nation shares than are represented in benchmark indexes. “The fundamentals have changed.”
Emerging markets’ share of world equity capitalization climbed to a record 25 percent in August, up from 22 percent a year ago, as the stocks outperformed developed markets amid signs that economic recoveries in the U.S. and Japan have slowed.
All 10 of the world’s best-performing major benchmark equity indexes last month were in developing countries,
“There’s a growing feeling that emerging markets are where the future lies and the traditional way of looking at emerging markets as a risky play on the developed markets is no longer valid,” Julian Mayo, who helps oversee about $2.8 billion as an investment director in London at Charlemagne Capital, said in a phone interview. “You’ve got the element of economic independence and you’ve also got better earnings.”
South Korea, Indonesia and Chile reported second-quarter economic growth of more than 6 percent. China expanded at a 10.3 percent rate in the quarter, overtaking Japan to become the world’s second-largest economy. Japan grew at a 0.4 percent pace during the period, while U.S. expansion slowed to 1.6 percent.
Smaller debt burdens will help developing countries grow 6.4 percent as a group next year, topping the 2.4 percent expansion in advanced nations, according to forecasts from the Washington-based International Monetary Fund. Emerging-market debt will amount to about 40 percent of gross domestic product this year, compared with 107 percent in advanced nations, IMF estimates show.
Companies in the MSCI emerging index will boost profits 29 percent in the next year, topping 28 percent growth for MSCI World companies.
Emerging-market companies are also finding better opportunities to reinvest their earnings, producing a return on equity of 14.8 percent, compared with 10.2 percent in the developed world, according to Morgan Stanley.
“The major fundamental reason to expect further outperformance of emerging-market equities versus developed- market equities is the superior return on equity,” Jonathan Garner, the chief Asian and emerging-market strategist at New York-based Morgan Stanley, wrote in an Aug. 25 research note. He estimates the MSCI emerging index will extend its gain over the MSCI World this year to as much as 20 percentage points from about 5 percentage points as of yesterday.
The only time during the past decade that emerging-market shares were valued at premium price-earnings ratios to developed markets was the 10-month period ended May 2008, just before credit markets froze and spurred a collapse in global equity prices. The MSCI emerging index has traded at an average discount of about 30 percent to the MSCI World index during the past 10 years, the data show.
Templeton Asset Management Ltd.’s Mark Mobius said in an interview with Bloomberg Radio on Aug. 20 that he’s “very, very confident” buying emerging-market equities because of faster economic growth and lower debt levels than advanced nations.
Mobius, who oversees about $34 billion in developing countries, said his biggest holdings are Brazilian shares including Sao Paulo-based BRF – Brasil Foods SA, a processor of poultry, pasta and soybeans. The stock trades at 51 times reported earnings, and analysts predict profits will climb 76 percent next year, according to data compiled by Bloomberg. The valuation compares with a price-earnings ratio of 13 for Omaha- based ConAgra Foods Inc., which is forecast to boost profits by about 9 percent, the data show.
“In emerging markets, valuations are getting rich because you know the long-term story is very strong,” Frederick Searby, a New York-based Latin America equity strategist at Deutsche Bank, said in an interview. “The growth prospects are much better.”
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