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Emerging Markets Represent An Opportunity For The Value Investor

|Includes: EIDO, iShares MSCI Brazil Capped ETF (EWZ), SPY, TUR

Over the past 12 months, the US stock market - as measured by the MSCI US Equity Index - has risen about 16% and is dancing around all-time highs. Overseas the picture is a bit less clear cut. Europe overall has moved up about 16%, Japan 0.13%, China about 1.3% and Emerging markets roughly 2%.

Based on data supplied by FactSet, a financial analytics firm, the US equity market is now among the most expensive in the world when you compare stock prices to company fundamentals such as per-share earnings, dividends and net assets.

Furthermore, emerging economies are expected to grow two to three times faster than developed nations like the US, according to International Monetary Fund estimates.

Is it time to jump into emerging markets? Or is America a safe house against world uncertainty thus wholly deserving of the lofty valuations commanded by its companies?

Well, according to JP Morgan Asset Management now is one of the best times in history for investors to buy into less mature economies. The bank has gone so far as to predict that emerging markets will rise by 10% or more in the coming 12 months. This pop would reverse recent losses and offer a solid gain.

Although we don't feel comfortable making such predictions we do share the Bank's optimism as emerging market shares are very cheap against book value. For example, the MSCI Emerging markets index which is made up of shares of the biggest companies in these regions is currently trading at a price to book ratio of below 1.5 which is the lowest it has been since 2007.

Interestingly, research by JP Morgan has found that since 1995 each time this valuation has dipped below 1.5 the stock market in the next 12 months has tended to deliver returns above 10%.

This occurred in both July 1996 and November 2002, when emerging markets suffered an ugly setback. Shares rose by 27% and 30% respectively in the following 12 months.

In fact these low valuations are totally out of step with fundamentals. In a recent article in Fortune Shawn Tully points out that:

"These countries have younger populations and a greater abundance of natural resources than the developed countries of Europe and North America. The BRICs -- Brazil, Russia, India, and China -- generate 22% of the world's GDP, and owe only 5% of the sovereign debt.

By contrast, the developed countries control 62% of global output, and pay interest on 90% of the government bonds. With fast-growing workforces and ample supplies of crops and minerals, the developing countries are in a stronger position to cover their future interest burdens, and hence channel more of their future growth into private investment, than many western nations are. Few developing nations shoulder total debt exceeding 50% of GDP. For the emerging economies, Brazil is a huge borrower with debt to GDP of around 68%. By contrast, most of the big western economies -- including France, Italy, the U.K., and Germany -- carry burdens of between 80% and well over 100%. Japan's ratio, for that matter, tops 200%."

What about the risks of exposure to emerging markets?

At present there is certainly a fear that emerging markets are not the answer. Aside from the normal risks such as political instability, market volatility, liquidity concerns, poor corporate governance and foreign exchange rates, investors of late have been concerned about China's slowdown and surging inflation in India, Argentina and Turkey. Nevertheless, the main popular concern are the potential effects of the US Federal Reserve's "tapering". Investors fear that "tapering" and rising US interest rates will cause capital to flow out of emerging economies as cheap yield hungry capital will be on the decline.

If money rushes out of emerging economies the value of their currencies could be depressed which can cause damage. Nevertheless, there may be a silver lining as the value of currencies would be determined by market forces which could in turn help export competitiveness.

The bottom line:

With such attractive valuations, it should not come as a surprise that in 2014 the best performing markets are as follows:

Best Performing Markets of 2014 Ticker YTD

Market Vectors Egypt ETF EGPT 26%

iShares MSCI Indonesia ETF IDO 23%

iShares MSCI Philippines ETF EPHE 15%

iShares MSCI Thailand Capped ETF THD 11%

iShares MSCI Turkey ETF TUR 10%

iShares MSCI India Index ETF INP 8%

iShares MSCI Brazil ETF EWZ 6%

*Data as of May 27th

Although, based on the risk factors outlined above, these markets should be considered risky and some would go so far as to say that such picks represent contrarian plays, we contend that the risks are over exaggerated. It should be remembered that one of the reasons why US companies have done so well in the last 12 months is due to the growth in non-US markets and thus if one can stomach some volatility, emerging markets should make up at least a small proportion of any value investor 's portfolio as low valuations today can lead to higher investment returns over time.

-Matthew Castel, Head of Strategy and Investor Relations

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.