Emerging markets have taken a beating the last few months. The valuation discount between emerging markets and developed markets is not only due to higher degree of cyclicality, but also due to various other factors, notes Citi in a recent research report.

Markus Rosgen and Yue Hin Pong of Citi in their recent research report titled ‘GEMS Strategy’ point out EMEA generally has the cheapest valuations, but higher financial vulnerability than Asia as well as a better ROE and higher free cash flow margins.

EM has higher cyclicals weighting

The Citi analysts point out that the argument that an asset class is cheap with lower ROE can’t be used. They point out that such an approach is incorrect as can be deduced from the following graph:

EM PB ROE emerging markets

Collating the MSCI-trailing data and based on a P/BV basis, the analysts point out that the discount of EM to DM now stands at 28%, but the EM ROE stands at 12.7% as against DM ROE at 12.1%.

By focusing attention away from ROE to ROA, the analysts observe that the differential is wider still. This can be seen in the following graph:

EM ROA

The Citi analysts also point out that many conclude EM is cheaper due to sector compositional issues, meaning a higher weight in cyclicals and fewer consumer names, which naturally makes EM cheaper. While conceding that such a conclusion could be true, it fails to address the higher ROE.

The following table captures the sector weightings in DM and EM.

Sector weightings in DM and EM

The analysts highlight that by splitting the weighting data into broad commodities, DM have weight of 14.9% compared to the EM region, where they enjoy a 20.7% weight. In the case of tech, EM has a weight of 11.8% versus DM at 5.7%. In the case of banks, EM makes up 18.6% of the index weight versus 8.4% weight in EM. Thus the analysts conclude that EM is more cyclical than DM.

Sector adjusted EM to DM sector weights

The Citi analysts next tried to ascertain what the P/E, P/BV, ROE or free cash flow yield for EM would be if rather than being more cyclical, the EM region and markets had the same sector distribution as developed markets. For this purpose, the analysts have changed the earnings, book value or free cash flow generation to the level of DM. They used the same sector weights, but EM earnings power, book value and free cash flow.

The following graph highlights the P/E of the DM region and then EM with the same sector weights. The Citi analysts point out that based on this analysis, the EM region is trading at a discount of 40% against DM and therefore EM is cheaper.

EM DM PE adjusted

The report also observed that the chart is similar in terms of PB/V. Moreover, as can be seen in the following graph, DM is again trading at a premium to EM and this is true even if one looks at it on the basis of the median P/BV.

EM DM median PB

Turning their focus towards ROE, the analysts note that ROEs, even adjusted for sector differences, are higher in EM than they are in DM, implying EM does generate higher ROEs than DM and cheaper valuations.

EM DM ROE

The Citi analysts, however, point out that the area where DM uncontestably outshines EM is in free cash flow generation. However, they point out that this is not due to EM incompetence but rather higher growth. The EM GDP is 50% higher than pre-2007, while DM is barely above it.