Investing in supposed ‘growth’ stories is often seen as the holy grail, yet often ends up an unholy mess. Growth most spectacularly failed as an investment concept with the implosion of the technology bubble. And in the aftermath of the 2008 Great Recession, emerging markets were seen as the obvious choice for equity investors as they did not have the excess debt problems of the developed world. Once again investing in ‘growth’ has proved a disappointment – most especially for BRIC investors.
No correlation between emerging market returns and economic growth
According to Albert Edwards of Societe Generale, the story of superior growth for the emerging market universe is as entirely plausible as it is misleading. When you look at the evidence, there is absolutely no correlation between emerging market investment returns and economic growth because investors overpay for growth stories and there is no margin for error.
In addition, The Economist magazine reports that Paul Marson of Lombard Odier has extended this research to emerging markets. He found no correlation between GDP growth and stock market returns in developing countries over the period 1976-2005. “A classic example is China; average nominal GDP growth since 1993 has been 15.6%, the compound stock market return over the same period has been minus 3.3%.”
Emerging markets and BRIC investment fantasy end in severe disappointment
The Emerging Market and BRIC investment fantasy has been no different from many of the other investment fantasies – only to see them end in severe disappointment. He thinks it would be fair to say that investors have been pretty shocked by the vulnerability of EM-land over recent months. Over the past month that may be due to the loud sucking noise as investors recoil in horror at the thought of Fed tapering. But it is the chronic under performance of the last two years that has been more notable.
Valuation is what matters for investing
What really matters for investing in EM (or any other investing) is valuation. Investors typically pay too high a price for growth stories. When Societe Generale disparagingly referred to BRICs in November 2011, they thought they were far too expensive relative to developed markets. Societe Generale said at the time that with all the problems of excess debt, and deleveraging stifling growth in developed markets, that emerging markets deserved to be more expensive than developed markets (see for example right-hand chart below showing Price/Book ratio). The dire under-performance of the last 18 months means that EM and BRIC equities are certainly no longer so expensive in absolute or in relative terms.
Although the forward PE of emerging markets never became more expensive than developed equity markets, the PB ratio certainly did (see below). 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 equity valuations of developed markets.
The longer term trailing and forward PE charts below show that the relative overvaluation of developed markets relative to the EM universe has previously been much, much higher than it is now, but a decent valuation gap (opportunity) is opening up once again. And lest we forget, one of the reasons EM equity markets had been such a stellar performer on a decade view, both in absolute and relative terms since the early 2000, is that they were so cheap 10 years ago both in absolute and in relative terms. That was the time to buy—not 2007 onwards.
According to Edwards, Emerging Market and BRICs are beginning to look cheap, most especially on a relative basis. Perhaps they will get cheaper still with the prospect of a China slowdown turning very bumpy indeed and a renminbi devaluation, almost the inevitable consequence of China’s deflationary ills.