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Second Quarter 2015: Should You Consider Emerging Markets?

Charles Sizemore
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They’re cheap, most investors are scared to death of them, and yet they have been slowly grinding higher throughout 2015. Are emerging markets — and the iShares MSCI Emerging Markets ETF (EEM) — worth owning as we jump into the second quarter?

In years past, that would’ve been two very distinct questions. The EEM ETF, despite its name, was not really a play on “emerging markets.” It was primarily a play on developed Asian markets like Taiwan and South Korea — countries that already emerged decades ago with standards of living on par with Western Europe. And ironically, it was an indirect play on growth in the U.S. and Europe, as its allocation was massively skewed toward global exporters that sent their wares primarily to the West. And due to quirks in MSCI’s index construction, you even get oddball countries like Greece included in the index. (Hey, I agree in principle with demoting Greece from big-boy, developed-market status, but can you credibly call that mess an “emerging” market?)

For true exposure to growth in the developing world, you had to look elsewhere, such as to the EG Shares Emerging Market Consumer ETF (ECON). The ECON ETF invests in consumer-focused stocks that catered to domestic emerging-market shoppers.

Today, the EEM ETF is still heavily weighted toward developed Asia; South Korea and Taiwan collectively make up 28% of the portfolio, and the two largest stock holdings are Samsung Electronics (SSNLF) and Taiwan Semiconductor (TSM). But as liquidity has improved in “real” emerging markets, so has EEM’s allocation. Today, China is the largest single-country allocation, at 21% of EEM’s portfolio. South Korea and Taiwan take the two and three slots, with 14.6% and 12.6%, respectively.

Brazil, South Africa and India round out the top five, with 8.8%, 7.8% and 7.1%, respectively.

EEM EEM: Should You Consider Emerging Markets?

Looking at the EEM ETF’s track record in recent years, you might wonder why anyone in their right mind would put a single dollar in emerging markets.

Outside of the modest dividend yield, investors have seen no returns at all since the first quarter of 2007. Emerging markets cratered in 2008 during the global housing crisis, cratered again in 2011 during the eurozone crisis and have traded sideways ever since. Excessive dollar strength — which means excessive emerging-market-currency weakness — certainly hasn’t helped either.

But this is precisely what makes the EEM ETF interesting right now. U.S. stocks have been the only game in town for years. But after six years of uninterrupted bull market, U.S. stocks are also wildly expensive, trading at a cyclically adjusted price/earnings ratio (“CAPE”) of over 27.

This doesn’t mean a crash is guaranteed, of course, but it does make me want to expand my scope a little beyond U.S. borders.

EM EEM: Should You Consider Emerging Markets?

Today, valuations are cheap and expected returns are high in the countries that make up the EEM ETF’s largest allocations. Using data from Research Affiliates, we see reasonable expected annual returns over the coming 10 years ranging from 3.8% in Taiwan to 11.7% in Brazil. To put that in perspective, Research Affiliates estimates returns of only 0.7% annualized in American stocks over the next decade.

Estimates are just that — estimates. There is no divine universal law that says that stock returns “have” to follow what their valuations suggest they will, but they give us a useful rule of thumb.

I don’t expect emerging markets to generate the kind of eye-popping returns we saw in the mid-2000s, but I do think we can credibly say that emerging markets are priced to, if nothing else, perform better than U.S. stocks over the next decade. They’re cheap, their currencies have been battered, and a long string of bad macro data has already been priced in.

And that makes emerging markets worth a look.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

 

This article first appeared on Sizemore Insights as Second Quarter 2015: Should You Consider Emerging Markets?

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