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Margin of Safety is an old-fashioned value investor. He is living in freezing Finland, which helps him to cool down and focus on his three investment principles: Don’t lose money Don't lose money Don't lose money Margin of Safety leaves cool growth companies to the boyz from Wall Street and... More
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  • MSCI Emerging Market Index is 50% overvalued 4 comments
    Jan 6, 2011 3:49 PM | about stocks: EEM, VWO

    David Hunkar wrote about the disadvantageous weighting of the MSCI Emerging Market Index. I would like to continue the blues by telling you that the index is seriously overvalued.

    The likely return of MSCI Emerging Market Index during the next five years is 2.17% per year. The index offers a risk premium of 0.10% over 5 year T-Bond, which is ridiculous considering the risks involved in investing in the emerging markets.

    The chart below shows the MCap/GDP multiple of each index component versus the average multiple of the last 10 years.


    Source: The World Bank: Market capitalization of listed companies (% of GDP)

    The weighted average MCap/GDP of the index is 50% above the long-term multiple. Indexes tend to revert to the mean, which is not good news for the returns of this one.

    The investment return of an index is determined by dividends, business growth and valuation change:

    Investment return = Dividend + Growth + Valuation Change

    Factoring in the dividend of 1.7% and the 5 year weighted average GDP growth  of 8.3% results into 2.17% investment return.

    The investment return depends heavily on how long it takes to revert to the mean. The table below shows some examples:

    Dividend

    Growth

    Time

    Return/Year

    1,70 %

    8,3 %

    1

    -23,60 %

    1,70 %

    8,3 %

    3

    -2,73 %

    1,70 %

    8,3 %

    5

    2,17 %

    1,70 %

    8,3 %

    8

    5,05 %

    1,70 %

    8,3 %

    10

    6,03 %

    You might be earning a 6% return, if the mean reversion is slow. The bottom line is however: do you want to invest in an overvalued index?



    Disclosure: I am long VWO.

    Additional disclosure: I am planning to reduce my position based on the analysis.
    Stocks: EEM, VWO
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Comments (4)
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  • ZimboZimbo
    , contributor
    Comments (25) | Send Message
     
    Looks like VWO is no longer the right way to invest in emerging markets. It did great in 2009 (+70%) and was a decent investment in 2010 (+14%), but the party maybe over.

     

    At this price level picking individual stocks can probably work in emerging markets, but a general ETF certainly appears pricy.
    7 Jan 2011, 07:54 AM Reply Like
  • index
    , contributor
    Comments (2) | Send Message
     
    Nice post! I guess from your blog's name that you're from Finland. Have you thought or made any calculations of Seligson's funds? It would be interesting to see if they are over- or undervalued at this time.Personally I've invested for example in Seligson's Emerging Markets fund, which invests in value stocks.
    I hope to see more your blogs and thoughts in the future.
    15 Feb 2011, 02:27 AM Reply Like
  • Margin of Safety
    , contributor
    Comments (11) | Send Message
     
    Author’s reply » Hi!

     

    Yes, I am indeed from Finland:) It's pretty cold here right now...

     

    The MCap/GDP method gives a rough indication of the overall market valuation. The beauty of this metric is that it can be calculated with publicly available reliable data from IMF, World Bank and International Stock Exchanges. Using for instance P/E value is already much more difficult, because there are quite a few ways to calculate it and P/E value is not so easily available for emerging market companies.

     

    MCap/GDP is by no means the whole truth and you should also look at other indicators as well. Emerging markets look however grossly overvalued by other metrics too and also they have received huge capital inflows during the last few years - most of the evidence points to overvaluation despite the projected strong growth.

     

    The emerging market value fund from Seligson selects the investments based on Price to Book ratio. As MCap/GDP values whole markets, it can't tell much about a fund, which focuses on a part of the market.

     

    I am mostly using MCap/GDP for asset allocation purposes. Part of my portfolio is in ETFs and basically I would like to avoid investing new money into a significantly overvalued market. Currently, it looks like European and Japanese markets are undervalued, while US is overvalued and emerging markets are grossly overvalued.

     

    I hope this helps!
    16 Feb 2011, 08:01 AM Reply Like
  • index
    , contributor
    Comments (2) | Send Message
     
    Thanks for a great answer. While studying economics it's great to see professionally written blogs!
    16 Feb 2011, 12:55 PM Reply Like
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