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Summary

  • Emerging markets are undervalued relative to the U.S. market.
  • Economic fundamentals in emerging markets are compelling.
  • Investors seeking to diversify may wish to add some exposure to emerging markets at current prices.

While the U.S. stock market is up, emerging stock markets are down. This development in global equity markets presents a buying opportunity for long-term investors. At current prices, emerging markets are significantly undervalued compared to the U.S. market.

Emerging markets have grown faster than developed markets for the past 20 years. China has grown so much that it is now the world's second biggest economy, surpassing Japan and Germany, based on data from the International Monetary Fund.

Economic growth in China has slowed down recently. The following graph shows the growth rate of gross domestic product in China:

Data Source: YCharts and National Bureau of Statistics of China

Stock markets in the emerging world have underperformed recently as well. The following graph shows the performance of the iShares MSCI Emerging Markets Index ETF (NYSEARCA:EEM) compared to the U.S. market-tracking SPDR S&P 500 ETF (NYSEARCA:SPY) for the last five years:

Data Source: YCharts

Economic fundamentals in emerging markets remain strong. Growth factors include the following:

  • Young workers;
  • Export-led development;
  • Plentiful natural resources;
  • Low government and consumer debt levels; and
  • Growing middle-class consumerism.

Faced with this favorable environment, corporations have an opportunity to grow revenues quickly. In fact, U.S. corporations in China have experienced good operating results lately. "It is still a little surprising how strong China remains, given what you read," said Greg Hayes, Chief Financial Officer of United Technologies (NYSE:UTX), according to the South China Morning Post.

Valuation analysis

Emerging-market stock prices are cheap compared to the U.S. market. The iShares MSCI Emerging Markets Index ETF has a price-to-earnings ratio of 11, whereas the SPDR S&P 500 ETF's price-to-earnings ratio is 17, according to Yahoo Finance. Based on these numbers, emerging markets are on sale: 35% off relative to the U.S. market.

The price-to-earnings or "P/E" ratio measures an asset's price-per-share divided by its earnings-per-share. For example, if an asset's earnings-per-share is $2, and its price-per-share is $20, then its price-to-earnings ratio is 10 times earnings.

The price-to-earnings ratio can be used as a measure of investor sentiment. The historical average price-to-earnings ratio for the U.S. market is about 15. In general, anything higher than 15 indicates that investors have high expectations for growth, whereas anything lower than 15 means that investors have low growth expectations for the asset at issue.

The Vanguard Emerging Markets Stock Index ETF (NYSEARCA:VWO) is one of the best ways to obtain broad exposure to emerging markets. This index-based ETF holds 961 stocks in various countries, including Brazil, India, and South Africa. Currently, the Vanguard Emerging Markets ETF has a price-to-earnings ratio of 11, according to Yahoo Finance. The fund carries an expense ratio of 0.15%, based on data from Morningstar.

The SPDR S&P China ETF (NYSEARCA:GXC) tracks an index of China stocks. China can be bewildering to foreign investors. The rules for foreign investment are so complex that it is a good idea to rely upon professional fund management.

The SPDR S&P China ETF seeks to track a broad array of public companies with operations in China. This ETF holds 268 stocks, and it has a price-to-earnings ratio of nine, according to Yahoo Finance. The SPDR S&P China ETF carries an expense ratio of 0.59%, based on data from Morningstar.

Discussion

Buying as asset simply because it's on sale is not sufficient justification to invest. While emerging markets are attractively priced, these markets are not appropriate for all investors.

Investing in emerging markets entails additional risk, including political and currency risk. These markets are more volatile than the U.S. market. Investors should have sufficient risk tolerance to endure the ups and downs of emerging stock markets.

One of the best reasons to invest in emerging markets is diversification. By investing in different markets with different currencies, investors can broaden their exposure and reduce overall portfolio risk. The risk of an individual asset, including emerging-market stocks, should be considered within the context of your portfolio. Allocating a small portion of your portfolio to emerging-market stocks could actually lower your overall risk profile, since emerging markets tend to move differently than the U.S. market.

Source: Why You Should Invest In These 2 International ETFs