The Case For Emerging Markets And 5 Picks Worth A Look

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Includes: HDB, NTES, SHI, SKM, UMC
by: John P. Reese
Summary

Many emerging market stocks are trading at valuations much lower than their U.S. counterparts.

Top investment firms like GMO and Research Affiliates are favoring EM due to relative valuations and other supporting factors.

We've identified a few names that rank highly using Validea's guru inspired strategies, which based on legendary stock investors like Buffett, Lynch, Zweig, and others.

Emerging market stocks, one of the strongest performing assets classes in 2017, is among the worst performers this year, triggering concern and trepidation in the investment community. But there are redeeming qualities inherent in this group class that could present opportunities for investors.

The recent decline has been triggered by several catalysts:

  • A stronger U.S. dollar creates a challenge for emerging market companies with greenback debt.
  • Trade tensions between the U.S. and major partners (particularly China).
  • Concerns surrounding Turkey, which is under pressure due to high inflation, heavy debt, and disagreement between the country's president and its central bank. The sharp decline of the Turkish lira against the dollar and the dip in the country's stock market have left investors worrying whether the country's woes could leak outside its borders.
  • Rise in U.S. interest rates is drawing capital away from riskier locations.

But there are those who suggest that the concerns are overblown, arguing that EM boasts solid fundamentals including favorable demographics, attractive valuations, and economic growth. One such market expert is GMO founder Jeremy Grantham who, in a June interview with Morningstar, said, "All assets classes are pretty much overpriced badly except emerging, which is priced not-too-badly, particularly at the value end of emerging. It's priced fine, so take as big a position as you dare in emerging." In fact, a Bloomberg article from earlier this year reported that the typically bearish Grantham is "so bullish on emerging-market stocks that he's telling his own kids to invest more than half their retirement money in the asset class," adding that "it's the only investment arena with a realistic shot at delivering 4.5 percent real returns annually over a decade." The same article quotes Voya Investment Management's Barbara Reinhard: "Emerging markets are the place you want to be over the next five years."

In June of this year, Research Affiliates published a paper on the subject titled, "Pundits Predicting Panic in Emerging Markets." While acknowledging the current trepidation surrounding emerging markets, the paper concludes that the fear is not justified for the following reasons:

  • The global economy has become more stable;
  • EM countries have become wealthier and financially healthier;
  • "Countries that are under threat, and thus making headlines, compose only a small fraction of the value of EM equity markets." The most compelling reason for investors to overlook media chatter about the asset class, the firm asserts, is that the largest EM equity markets are not facing a funding crisis.
  • The relative valuation of EM stock markets is "discounting quite a bit of bad news, especially relative to the valuations of U.S. stocks."
  • "The instinctive reaction to a 10% correction in the U.S. market is to 'buy the dip,' while the instinctive reaction to a similar decline in EM is contagious fear."

The paper concludes: "When the risks and the bad news are well known to the market and fear reigns supreme, it's time to buy, not sell."

Using the stock screening models created based on the methodologies of some of the most successful investors of all time, I have identified the following five emerging markets picks:

China

Sinopec Shanghai Petrochemical Company Limited (SHI) is a petrochemical company that earns high marks from our Kenneth Fisher-based screen for its price-sales ratio of 0.59 (our model likes anything under 0.75) as well as its debt-equity ratio of 4.88% and three-year average net profit margin of 7.23% (versus the minimum requirement of 5%). Our David Dreman-based model favors the company's price-earnings, price-cash flow, and price-dividend ratios.

NetEase, Inc. (NTES) is a technology company that operates an interactive online community in China and is a provider of Chinese language content and services. The company earns a perfect score from our Buffett-inspired screen based on its earnings predictability and long-term debt-free balance sheet as well as its higher-than-average return on equity and total capital.

Korea

SK Telecom Co., Ltd. (SKM) provides wireless telecommunications and gets high marks from our Peter Lynch-inspired screen based on its ratio of price-earnings to growth in earnings per share (PEG ratio) of 0.32 - anything under 0.50 is considered best case by this model.

Taiwan

United Microelectronics Corporation (UMC) is a global semiconductor foundry favored by our David Dreman-inspired screen for its positive quarterly earnings trend as well as its liquidity (current ratio of 2.32), price-cash flow and price-book ratios. The current yield of 4.14% adds appeal.

India

HDFC Bank Limited (HDB) offers a range of banking services covering commercial and investment banking on the wholesale side and transactional/branch banking on the retail side. The company's revenue growth (18.88%) relative to growth in earnings per share (20.17%) is favored by our Martin Zweig-based stock screen - this model subscribes to the concept that for earnings to continue to grow over time, they must be supported by a comparable or better sales growth rate and not just by cost cutting or other non-sales measures.

Disclosure: I am/we are long SHI & NTES. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.