Foreign Investment

Bargains abroad

Car being manufactured
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With the Eurozone in crisis, some asset manager's preference is shifting towards developed, rather than emerging markets, even though emerging markets have outperformed developed markets for more than a decade, on the back of superior growth in earnings power and a significant rerating relative to developed markets. 

Wilhelm Hertzog, portfolio manager at RE:CM asset managers believes the time in right to snap up some bargains up North: “Looking at markets from a book value and price-to-book (P/B) perspective, which in our experience gives a better indication of long-term value and price levels for markets as a whole than earnings-based measures.

"It is clear that since the early part of 2009, emerging markets have traded at a P/B ratio premium compared to developed markets. However, we believe these high ratios are not justified, for a number of reasons.”

The first reason, says Hertzog, is that over the long term, risk-adjusted returns on capital between markets should not diverge widely. “Theoretically there is no reason why a dollar invested in a developed market should be worth more or less than a dollar invested in an emerging market. Investors will be indifferent about where to invest if the risk adjusted returns are the same from investments in emerging and developed markets respectively. 

If the risk-adjusted returns are different, capital will tend to flow to the superior destination, which will erode the superior returns over time. A clear discrepancy in prospective risk-adjusted returns should therefore not last for a very long time.”

He says the statistics show that capital has been flowing into emerging markets at a rapid rate. “This should drive down the superior returns on capital (and equity) enjoyed in emerging markets over the past decade. 

“There has been a dramatic increase in foreign direct investment (FDI) in low and middle income countries since 2005, which is more or less when emerging markets’ returns on equity (ROE) started increasing meaningfully above that of developed markets.”

He says if you consider the 1.0% - 1.5% average spread in return on equity that emerging markets have earned above developed market for the past 15 years to be a sustainable level, and assume that emerging markets will continue to grow earnings about 2.5% faster than developed markets as they have done on average over the same period. The question that will determine empirically whether emerging markets should trade at a P/B premium to developed markets is simply whether cost of equity differences between emerging and developed markets offset the better growth and returns achieved in emerging markets.  

A 2% difference in cost of equity between developed and emerging markets will fully offset the benefits of the slightly higher levels of growth and profitability enjoyed in emerging markets.

“There is unfortunately no definitive answer to the question of what the cost of equity differential is between developed and emerging markets. But our assessment is that a 2% equity risk premium for emerging markets above that of developed markets is easily justifiable. 

"While political risk and matters like the security of property rights have certainly vastly improved in most emerging markets over the last decade, expropriation of assets, super taxes and capital controls still occur more often in emerging markets than developed markets – recent events in Europe notwithstanding. These all increase investment risk, and hence warrant an increased required rate of return on equity.”

“For these reasons, we do not believe the P/B premium that emerging markets currently enjoy over developed markets is justifiable. We are finding attractive value in high quality businesses in developed markets, and will not be lured into emerging markets just because (or especially because) they are currently top of mind for most investors and capital allocators globally.” 

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This edition

Issue 72