Emerging market stocks may be worth the expense

[sukishan]

Investors are daring to believe emerging markets' new-found equity price premium to developed stocks may be justified longer term, countering some unease over rich relative valuations driven by this year's blistering rally.
On a price-to-book basis -- comparing current stock prices with the value of the company on its balance sheet -- the MSCI emerging index trades at an average of 2 versus 1.8 times for the MSCI World, according to Thomson Reuters data.

A high P/B ratio is a sign a business has rosier future prospects and that investors have bid up the shares relative to book value on hopes of better earnings and cash flow ahead.

That rise in valuations is evident after a near 50-percent price surge since January 2009, fuelled by signs of the global economy stabilising and an impatience to put cash to work.
But with recent polls revealing extreme overweight positions in the sector, fund managers seem reluctant to heed what some believe is a warning signal that has twice in the past -- most recently in 2008 -- heralded big-time crashes.

"People are a little bit wary. You can't expect a big premium to develop suddenly and people not to be concerned," said William Calvert, a fund manager who runs $500 million in emerging equities at Axa Framlington in London. "They remember the last time this happened in 2008, everything fell apart."

Admittedly, the current premium of around 10 percent is less than the average 20 percent premium seen on emerging stocks versus their world peers in the year to August 2008 and the 20-30 percent premium the sector enjoyed between 1994-1995.

But given the price-book ratio in April was on par with core stocks at 1.4, there has been a big re-rating as the MSCIEF rose 33 percent in April-June -- its best ever quarterly performance.

While Calvert thinks valuations now look fair for the sector given the uncertainty still dogging the world economy, he and many others say emerging markets can re-rate upwards in future -- both in absolute terms and in relation to developed markets.

RETURN ON EQUITY

Emerging growth rates have long been higher than the developed world as is return on equity, but stock valuations were typically lower as companies found it more expensive to raise new capital. But this could change, starting with a realisation the crisis has impacted developing nations to a lesser degree.

James Syme, who oversees $1.2 billion in emerging equities at Barings Asset Management notes that emerging stocks' return on equity (ROE) is now in the 10-15 percent range, versus less than 10 percent in the 1990s. ROE is the measure of how efficiently a firm uses its assets to generate earnings.

"There has been a dramatic increase in ROE and I would imagine a significantly higher ROE should raise the price-book one is prepared to pay," Syme said. "On that basis emerging markets may even look cheap."

Many believe ROE can grow further as emerging markets increase leverage from current low levels. And as ROE rises and cost of equity decreases, P/B ratios should rise.

"Cost of equity will fall as investors realise the perceived risks over the asset class are misplaced as has been demonstrated by this crisis. And of course growth will increase with recovery," Axa's Calvert said.