Emerging Markets Now Trading At Premium To Developed

It’s no surprise to anyone with even a passing interest in international investing that foreign stocks have been doing much better than their U.S. counterparts, and emerging markets in particular have been on fire. The iShares MSCI EAFE index fund (EFA) of developed-market stocks is up about 12% year-to-date, while the iShares MSCI Emerging Markets index fund (EEM) is up around 30%.

What may be news however is that emerging markets are now trading at a valuation premium to stocks in developed markets. Specifically, stocks in EEM are trading at 15.0x 2007E earnings per share compared with 14.3x for stocks in EFA. This violates conventional wisdom that emerging markets should trade at a discount to their developed-market counterparts, and surely must be a sign of irrational exuberance and a bubble on the verge of collapse, right?

Maybe not. Now, it is not lightly that we tread in “this time it’s different” territory, but some things have changed that warrant consideration. Globalization has made access to capital easier for firms in emerging markets while at the same time expanding markets for the goods and services these firms produce.

Evidence of emerging market firms’ easier access to capital these days is apparent in the composition of EEM itself: over half the value of the fund is in fact comprised of American Depository Receipts—i.e., U.S. listings of foreign stocks (Figure 2). This is not to say that non-U.S. listings are somehow cut-off from capital; they are not. But a U.S. listing not only facilitates access to large pools of capital but also entails conforming to U.S. standards of accounting and disclosure. As a result, the argument that the opacity of emerging markets is deserving of a valuation discount becomes less pertinent.

So if the majority of stocks in EEM are actually U.S. listings of multinationals that happen to be headquartered in emerging market countries, shouldn’t they be valued just like any other U.S. stock—on the basis of profit expectations?

We think so, and it is here that we find some evidence to support the notion that globalization and the expanded opportunities it entails is translating into faster earnings growth for firms in emerging markets. Annual earnings growth for firms in EEM is expected to surpass that of firms in EFA both this year and next, with next year’s expected earnings growth in emerging markets roughly double that of developed-economy stocks (Figure 3).

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Further, although analysts’ estimates of long-term earnings growth must be taken with a grain of salt, there is probably some information content in the difference between the two funds. Aggregate consensus expectations for long-term earnings growth for firms in EEM is 14.9% compared with 10.2% for firms in EFA. In reality we’d guess that both figures are too optimistic, but nonetheless the bottom-up conclusion that long-term earnings growth going forward is likely to be better for emerging markets firms.

We’re quite sure that emerging market stocks will remain volatile and aren’t suitable for everyone. But don’t let the pundits scare you out of emerging markets entirely just because they now garner a small premium—for there’s a decent case to be made that it’s deserved.

Comments

[Susan:]

How good is EEM as a proxy for emerging markets?
How is the average representative of all the countries?

Two extreme points to consider:
One Brazil proxy (EWZ) trades at about PE=13
One China proxy (FXI) tardes above PE=21

So the disparities seem very large. China with its large average market-cap pulls the averages way up.
It seems like some emerging countries are reasonably values while others are in bubble territory.

By the way, some countries classified as Emerging, like Korea and Taiwan are very close to being considered "developed" at this point.

2007 Sep 27 05:33 PM