How attractive are Emerging Market Equities? A valuation perspective.

Ever since comparable index data became available in 1988, emerging market stocks have outperformed world stocks by more than 3% per year. Of course, this came at a cost of higher volatility, but even if we consider a closer time period, the payoff of investing in emerging markets has been significant.

Source: MSCI

But how do we know if emerging markets are attractively valued at the moment?

1. Medium-term

One key valuation metric used to predict future gains from these stocks is the Price-to-Book Value (P/B), also known as the “Price-Equity” multiple. As a recent article for the Journal of Investing demonstrated, there is a negative relationship between P/B ratios and the subsequent 4-year total average returns in emerging markets.

Source: Keppler and Encinosa, 2017

More specifically, whenever P/B was below 1.22, the total return of emerging markets in the following 4 years was never below zero. In those cases, returns were 12.9% per year on average. In contrast, whenever P/B was higher than 2.76, total annual returns for the next 4 years were always negative, averaging -5.1% annually. Finally, if P/B was between 1.22 and 2.76, the average total return in the next 4 years was 9.4%.

So, where are we now? As of March 31, P/B for emerging markets was at 1.61, in the lower end of the middle interval. According to this model, we should expect 11.4% average annual returns over the next 4 years. This is 4.3% higher than the 7.1% estimate for world equities, according to a similar model. This is even higher than the historical emerging market outperformance.

However, there is a significant amount of risk, as the potential outcomes range from an approximate 10% loss to a 35% gain. This means that, while emerging markets seem like an attractive investment option for the medium-term, they certainly don’t come for free.

2. Short-term

If we try to predict emerging market performance in the short-term based on valuation, the picture is less clear. Using forward Price-to-Earnings ratios (PE), gaps in value between emerging market stocks and world stocks don’t tend to be very good predictors of outperformance for the following quarter.

In the picture below, the diagonal line represents points where emerging markets and developed markets have the exact same quarterly returns. We see that even in cases when the valuation gap is more than 10 (meaning that emerging markets are more undervalued, represented by blue dots), there is not a significant outperformance of emerging markets in future quarterly returns.

Source: UBS

Currently, the forward PE gap is around 4, which still puts emerging market equities at a significant undervaluation relative to world equities.

Even if short-term returns are difficult to predict, right now, emerging markets seem like an interesting investment opportunity in the medium and long term.

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The information contained in this article is General in nature and has been prepared without taking into account your objectives, financial situation and needs.