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Should emerging market equities trade at a premium?

January 27, 2012

Emerging markets have faster growth, lower debts and better demographics than developed countries, so you would perhaps expect their equity markets to trade on a premium. They don’t.

 

Historically, investors have placed a higher multiple on developed markets – this may have been justified when developing countries seemed more likely to hit a crisis. Now that this has reversed shouldn’t these countries be more highly valued? As the chart below shows, developed markets have consistently traded at a higher multiple than emerging markets apart from a brief period in the mid-nineties. In late 2007 expectations of a decoupling brought the two market valuations closer together – the severity of the subsequent downturn hit emerging markets hard but since then they have traded on a lower P/E ratio. So far this year emerging markets are off to a strong start up over 10% but the valuation discount remains.

Could this just be due to a different sector breakdown? While some emerging countries do have lots of companies in some of the sectors that tend to be cheaper such as energy, financials or materials, at the aggregate level the weightings are fairly similar and a ‘sector adjusted’ P/E ratio shows the same overall pattern.

If we look within developed markets, those companies with emerging market exposure do seem to be rewarded with higher valuations – this would suggest investors believe in the better prospects of emerging markets but aren’t translating this to actual emerging stocks.

Why would this be? There are various explanations –  worries over transparency, rule of law and property rights all play a part. Perhaps the strongest argument why valuations aren’t higher is that despite all the positives, emerging markets have yet to show they have genuinely decoupled from developed markets.

In uncertain times factors like liquidity and stability are perhaps seen as more valuable than exposure to growth. As the chart below shows during recent sell-offs emerging markets have been especially hard hit, despite having little direct link to the troubles of the euro zone.

It may be that when we get to the point where developed markets are off life support and entering the less critical phase of rehabilitation (slower trend growth and deleveraging), emerging markets may secure the premium rating they seem to deserve.

 

 

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