BRIC shares? At the right price

July 19, 2013

Is the price right? Many reckon that the sell off in emerging markets and growing disenchantment with the developing world’s growth story is lending fresh validity to the value-based investing model.

That’s especially so for the four BRIC economies, where shares have underperformed for years thanks either to an over-reliance on commodities, excessive valuations conferred by a perception of fast growth or simply dodgy corporate governance. Now with MSCI’s emerging equity index down 30 percent from 2007 peaks, prices are looking so beaten down that some players, even highly unlikely ones, are finding value.

Societe Generale’s perma-bear Albert Edwards is one. Okay, he still calls the bloc Bloody Ridiculous Investment Concept but he reckons that share valuations are inching into territory where some buying might just be justified. Edwards notes that it was ultra-cheap share valuations in the early 2000s that set the stage for the sector’s stellar gains over the following decade, rather than any turbo-charged economic growth rates. So if MSCI’s emerging equity index is trading around 10 times forward earnings, that’s a 30 percent discount to the developed index, the biggest in a very long time. And valuations are lower still in Russia and Brazil.

Value investing  involves buying securities at a price that is deemed to be less than their intrinsic value. What Edwards is  saying is that valuations are what matter in emerging markets, not their superior growth of their economies. So:

Despite more ongoing macro problems in EM-land a sub-10x forward PE looks reasonable in historical terms and seems very reasonable compared to QE inflated valuations of developed markets…there is much choppy water ahead for EM as China nears tilting into outright deflation and Bernanke sharpens his fangs and begins to suck the monetary blood out of the global economy and risk bubbles. Nevertheless BRICs might not now be the Bloody Ridiculous Investment Concept they once were.

Gary Greenberg at Hermes Fund Managers noted recently that Russia, valued at around 4.8 times forward earnings, is trading two standard deviations cheaper than its own (cheap) history. And in Brazil shares have fallen far more than can be justified by their earnings or politics, he says:

The baby has been thrown out with the bathwater….a lot of companies are trading as if they are bust. For instance the Petrobras ADR is trading at $13 from $40.

Another gauge of how cheap BRIC shares have become. Bank of America/Merrill Lynch points out that two U.S. banks Wells Fargo and JPMorgan with a combined market cap of $440 billion, now have a higher value than the entire energy and materials sector in the BRICs. Less than three years ago they were worth half the BRIC commodity sectors. BofA/ML think there is more pain ahead for emerging markets but see BRICs as possibly being slightly less vulnerable than the other emerging markets. Their reason? Valuations.

True, things are usually cheap for a reason and in this case it is probably as Edwards puts it, “economic and market chaos”. Another analyst who has long been bearish on emerging markets, John-Paul Smith at Deutsche, also recently turned tactically more positive on the sector. But he is skeptical about the value strategies,  noting that they have not done the trick in emerging markets since 2009 (see graphic below).

His long-held conviction about a looming financial disaster in China also keeps him from advising clients to buy.

Were it not for China factor I would be thinking that for a long-term value investor, emerging equities could be tempting. If your view on China is sanguine it is time to start adding to your position. But if like ourselves you think there is a significant possibility of financial crisis in the not too distant future or at least that medium term growth will be revised down significantly, then there is still a good deal of underperformance to come.

Nor is governance improving in the worst culprits China, Russia and Brazil, Smith says, adding that this effectively prevents minority shareholders from realising any deep value from the companies.

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