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lskwarek
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Wall Street emerging markets specialist since 1984. Managed proprietary and hedge fund portfolios of emerging market fixed income and equity investments. Currently managing personal investments in emerging markets, distressed equities, and plain vanilla domestic stocks. Focus on long term value... More
  • Why Emerging Markets Are Likely to Underperform This Year 0 comments
    Mar 1, 2011 1:00 PM | about stocks: OIH, ABEV, ITU, BBD, IBDRY, TEF, DANOY

    Why emerging market stocks are likely to underperform the S&P this year:

     

    The Bad News:

     

    1. Valuations: Major emerging market sectors have gotten too expensive

    2. Too crowded:  Even after the selloff: Sell-side waaay too bullish

    3. The easy part is over: Challenges abound

     

    The Good News:  

    1. There will be a good entry point: The party isn't over yet

    2. M&A: Focus on companies with catalysts

    3. Many alternatives: You really can play both developed and emerging markets at the same time

     

    1. Valuations: Duh.  It is always about the fundamentals, even if it feels like it is about funds flow chasing performance (or in this case, exiting emerging markets). 

     

    Just  take a look at EM banks versus developed country banks price to book ( the ratio off which I think banks really trade -- not p/e):

     

    Various Trailing Price to Book Ratios (P/B) for EM Banks

     

    Russia

    2.6

    China

    2.5

    Brazil

    2.4

    India

    2.5

    Hong Kong

    2.8

    US

    1.0

    Spain

    1.1

     

    Greece

    0.4

    Europe combined

    1.0

    As of March 7, 2011

     

    Links: www.stoxx.com/
     bloomberg.com/


    Yes, yes, I know.  Developed market banks are a disaster and who knows what "book value" means, while emerging market banks are growing and there are a billion Chinese all waiting for a credit card.  But look at the price you are paying for that growth, while look at the value you get when you buy recovery (the "disaster").  If Europe or the US doubled, they would still be cheaper than emerging markets (with the US still trading below its long term average of 2.6x, according to JP Morgan).  

     

    2. The market is waaay too crowded, still.  Beware of analysts touting "buy".   The consensus predicts Brasil Foods (BRFS:US) to have an earnings growth of 91% in 2011, Walmex (Walmart of Mexico, WMMVY:US) is estimated to have a 2011 earnings growth of 21%.   From the analysts' lips to God's ears, but generally what happens is that analyst MBA's keep sticking in higher and higher estimates without wondering if it makes logical sense.  Two Brazilian Banks alone, Bradesco (BBD:US) and Itau (ITUB:US), are estimated to have a 2012 earnings growth of over 30% which is highly unlikely in an economy that will be in lock down as the central bank panics on the inflation front.   I think both are wonderful banks   -- just not THAT wonderful.

     

    3.  Those challenges.  The old joke that Brazil is the country of the future and always will be truly applies to all emerging markets.  Bottlenecks of infrastructure, political and judicial structure abound. all of which eat into earnings.  Emerging market majority shareholders with a tiny exception, hate to share with minority shareholders and will find lots of ways to keep the money from you.   Inflation is a bugaboo that they cannot wish away (though I doubt we ever go back to the bad-old days).  Those challenges deserve a healthy respect, and some discount to prices.

     

    The Good News:

     

    Fortunately this time, your decision on investing in emerging markets revolve really around today’s price versus value, and not about some of the issues that plagued emerging markets in the past such as debt defaults, corruption, and mismanagement (we can leave that for our home market).  As the emerging markets sell off continues, valuations will get more reasonable.  On a stock by stocks basis, some already have:  look at Tenaris (TS:US) against Oil Service Holdings (OIH:US).  TS makes pipe that the OIH stick in the ground to get oil out. (TS is an Argentine/Mexican company dressed up as an Italian company in a global business.)  It usually trades in lock step with OIH, or has for the past 5 years or so. http://www.bloomberg.com/apps/quote?ticker=T:US#chart  With the emerging markets sell off, TS now trades at an interesting 20% discount to OIH.  Ambev (ABV:US), the Brazilian/Latin arm of BUD-InBev might get to an interesting discount to its parent (it already is, depending on whose forward estimates you use).  And it just might finally buy it's 50% venture in Mexico, Grupo Modelo  (GMPCY)...someday.

     

    And, finally, you can hedge your bets if you still love emerging markets, but want to play the recovery in Europe and the US as companies pursue M&A in the region.   Danone sells more than 45% of its products in emerging markets (10% of all its dairy sales in Russia alone).  Both Telefonica (TEF) and Ibedrola (IBE:SM) in Spain, gets more than 50% of its profits from emerging markets.  And even a boring US company like Heinz just bought a Brazilian company, raising its estimated sales to emerging markets to as high as 20% of total sales by 2012 fiscal year.

     

    So, as the old adage goes, buy low, sell high.  Emerging markets has had an amazing run, outperforming developed markets by a wide margin in 2009 and 2010.  The sell off that began last fall and continues today will generate some interesting opportunities as traders throw babies out with the bath water.  Pick your spots -- watch for a slew of earnings downgrades by analysts of all their darlings, and you will be well rewarded with good entry points.  Watch for capitulations that begin generating that valuation heartbeat again.

     

    (Disclosure: Of the mentioned stocks, I own OIH, Grupo Modelo, Ibedrola, and VIV (not mentioned, but TEF owns a minority stake)).  Data is sourced from Yahoo Finance, Bloomberg, and company filings.

     






    Disclosure: I am long OTCPK:GPMCF, OIH.

    Additional disclosure: I am also long Ibedrola in Spain
    Themes: Emerging Markets Stocks: OIH, ABEV, ITU, BBD, IBDRY, TEF, DANOY
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