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Emerging markets offer favorable conditions for value investing. Here are 3 ways to explore opportunities in emerging markets.
With global bond interest rates near 5,000-year lows and U.S. stocks trading near 100-year highs, the traditional 60/40 balanced investment portfolio’s return outlook is somewhat bleak. Generating an attractive real return is becoming more challenging, requiring that investors look for returns in unconventional places.
The likelihood that we may be in the middle of a paradigm shift concerning inflation only compounds the problem. For the past 40 years, investors have benefited from a generally disinflationary environment, with declining interest rates, rising profit margins, and increasing price-to-earnings (P/E) ratios. If inflation increases in the future, investors can look forward to the opposite: higher interest rates, thinner profit margins, and compressing P/E ratios.
To boost your long-term return, it may make sense to reduce your exposure to expensive U.S. stocks and own some exposure to emerging market stocks. These stocks are generally trading at much more reasonable P/E ratios and tend to outperform those with rising P/E ratios when the dollar depreciates.
According to asset class forecasts from GMO, emerging market value stocks are projected to generate a real return of 5% per annum over the next seven years. This is a reasonable return, but it’s far more significant when viewed through the lens of an anticipated -6.2% real return on large-cap U.S. stocks and -7.9% return on small-cap U.S. stocks. The disparity likely reflects the fact that emerging market stocks generally have price/book values, and price/equity ratios that are well below that of the U.S. and other developed countries.
As a result, investors may benefit from faster GDP growth, higher dividends, and the likelihood that valuation ratios will expand rather than contract. Moreover, periods marked by a depreciating dollar often result in outperformance for emerging market stocks.
Entering the Emerging Markets
Value investing in emerging markets is analogous to how it’s done in the developed world, but there can be unique risks. For instance, currency volatility can pose a threat to investment profits and dollar-denominated share prices. As a result, you need to consider countries in addition to specific companies. You will likely reap better returns if the currency rises against the dollar, but a currency that falls against the dollar will lower your returns.
On the other hand, owning emerging markets can reduce your risk by diversifying your portfolio. Too many investors build a portfolio entirely of companies from their home countries due to familiarity, but they end up missing out on the benefits of global diversification. If the dollar declines in value, for example, foreign stocks are likely to outperform U.S. stocks — owning them can protect your portfolio from a decline in purchasing power.
Value investing is quite common, but many investors are reluctant to invest in emerging markets. When value investing in emerging markets is approached with prudence and discipline, it can generate positive results that will likely strengthen an investment portfolio’s risk-reward profile.
How to Navigate and Find Value in On-the-Rise Markets
As you begin to research promising emerging market investments, follow these three steps:
1. Look for countries with strong fundamentals and fiscal prudence.
There are many ways to analyze emerging markets, but it’s crucial to account for a country’s fiscal discipline. Are market expectations fixed by multiyear fiscal frameworks? Does unreasonable optimism buoy government budget projections? Is the amount of public debt sustainable under various likely scenarios? Generally, it’s advisable to look for companies in countries with a strong rule of law, a current account surplus, and responsibly managed finances.
In the 2000s, Brazil, Russia, India, and China (the BRIC economies) were the most popular emerging markets. But outlooks change regularly, and opportunities may exist for investors that look beyond these four regions. For example, South Korea has become a technology and manufacturing powerhouse.
2. Pay close attention to valuation.
Emerging market valuations must be viewed in the context of the forces that influence them. Exchange rates, inflation forecasts, shareholder friendliness, and local interest rates can all work to boost or negate investment returns. Develop a valuation estimate that accounts for exchange rates and inflation before deciding whether you want to invest.
3. Size your exposure appropriately.
Particularly when you’re new to emerging markets, limiting your investment allocation can be a good idea. As you gain experience (and live through some of the volatility associated with these investments), you can adjust the level of portfolio exposure to fit your appetite for risk.
Like all investments, emerging market stocks present owners with obstacles and opportunities. To be sure, emerging market stocks represent greater volatility. But that volatility is the reason so many investors pass them up, creating a situation today where they’re reasonably valued and may be poised to generate returns that might be difficult to achieve in more developed markets.
By approaching emerging markets carefully and looking for a balance of risk and reward, investors can further diversify their portfolios and tap into attractive investment opportunities. They just have to do their homework first.
Disclosure: This article is for informational purposes only and is not a recommendation of a particular strategy. The views are those of Adam Strauss as of the date of publication and are subject to change and to the disclaimer of Pekin Hardy Strauss Wealth Management.