2023-04-19 08:45:00 ET
Summary
- Strength in emerging markets often alternates decade by decade with the U.S. market providing a place to go while the U.S. performs poorly.
- Emerging markets are dirt cheap and priced to earn 11% nominal over 7 to 10 years while quants have U.S. return as low as 3%.
- The catch with emerging markets is the need to avoid China where property rights and rule of law remain dubious as does acceptance of the capitalist approach.
- The Freedom 100 Emerging Markets ETF is one solution but a more comprehensive solution might be a basket of hand-picked country ETFs.
- A weak dollar is very supportive of a powerful emerging markets rally while a strong dollar is a powerful headwind.
"There's always a bull market somewhere." market adage.
Mark Twain once said that "History never repeats itself, but it does often rhyme." The U.S. market is likely in the process of deflating an "everywhere bubble," something which has often been a good time for owning emerging markets stocks. Twain said nothing about emerging markets because in his day the United States itself was more or less an emerging market. It nevertheless had already experienced rhyming phenomena like bubbles (canals, railroads, various agricultural commodities, and gold) followed by the subsequent crashes. The world changes slowly but it changes just enough that exact replications don't quite tip the market's hand. Keep that in mind while I draw upon past cycles to suggest that emerging markets are dirt cheap and based on past experience ready to outperform in a major way.
Bubbles are about extreme valuation, and investment returns derive to a significant degree from changes in valuation. Earnings growth helps a bit, but it can't grow faster than GDP on a regular basis. If it did, corporate earnings would eventually devour the whole economy. With GDP growth around 3-4% this means earnings growth is generally in the low single digits. Tack on a 1.5% dividend and the long term average of 3% inflation. The 14.5% annualized return of the past decade implies a 7% compounded increase in valuation. If you want to invest with the tailwind of a long term bull market, you had best look outside of the U.S.
In the decade of the 2010s the value of the U.S market increased by 222%. That's five times the 45% increase of emerging markets. That was great news as it unfolded with the help of low interest rates and the emergence of a half dozen or so powerful growth stocks. It's not good news at all, however, for future market returns. Committed quants on this site and elsewhere have estimated real returns for the next 7 to 10 years in the U.S. market as something between zero and 3%. The low estimate is from GMO, whose founder Jeremy Grantham has been forecasting a "wild rumpus" as the "everything bubble" of the past decade continues to unravel.
The 7-year GMO chart below shows what has happened to asset values over the course of a long bull market in both stocks and bonds. Most columns show the result of markets which have pulled future earnings and cash flows into the present prices. The underlying assumption of the future forecasts is that returns will revert to normal over a five to ten year period. U.S. stocks have the lowest expected returns. That's the price of U.S. growth stock leadership over more than a decade. Emerging markets, by similar quantitative analysis, should expect to have the best returns over the intermediate term.
As of March 31, 2023
GMO
Take a second look at the chart and linger with a few details and their implications. Be aware that the numbers aren't quite predictions. If used as predictions they will show GMO to have been very wrong for a while at times. However, it was continued rising valuations which postponed the reckoning. What the numbers above do show is how far returns have departed from the mean valuation of various asset classes. What that tells you is the probable headwind or tailwind for the next 7 years. Emerging markets have had a difficult recent decade despite the fact that their GDP per capita increased by 50% versus 20% in the developed world. Why is it then that emerging markets are so roundly hated and virtually ignored by investors?
Should We Have A Hated Category Index?
Is there a foolproof way to find deep value? It's a concept worth considering. A little over a decade ago I was with my wife in Spain while the beauty contest for Miss Spain was going on. Beauty, of course, is in the eye of the beholder. We were there for my wife to do a photo shoot and interviews to open Unilever's ( UL ) Dove campaign for good looking women in their fifties. She has good skin - the photographer told her it was better than Sharon Stone who had been the centerfield for the previous month - but being five feet tall with black hair she would never be mistaken for Gisele Bundchen. I suppose that was Dove's point. While her activities were going on I enjoyed a side trip to Toledo and spent the rest of my time watching the Miss Spain contest on TV. What particularly caught my attention was that they had a category called Miss Ugly.
I felt compelled to see the Miss Ugly part of it through to the end. The non-ugly girls all looked more or less alike, models of Spanish beauty, but none of them stood out much from the crowd. The one who did stand out had features which were all a little bit off, somehow violating the unspoken rules of beauty. Sure enough, at the end of the day she was chosen as Miss Ugly. She was like the girl in high school that nobody would call pretty but who somehow caught my attention. The Spaniards had hit on something.
The Miss Ugly concept popped into my mind when I checked out the SA quant ratings for Diversified Emerging Markets ETFs. I get the approach of SA Quant ratings and use them frequently in single stock articles. Their rankings change somewhat faster than my opinions on stocks and a bit of reverse engineering suggests that they are designed for a somewhat shorter time frame than my preferred ten years or more. I found that there are 65 diversified emerging market ETFs. What stood out as truly extraordinary was that at the time I started to work on this article none of them - not one - had a quant rating higher than Hold. You saw yellow all the way down. The one I had chosen - iShares MSCI Emerging Markets Ex China ( EMXC ) - was number 31 of 65, squarely in the middle. It doesn't get much more hated or obscure than that. That ranking is Miss Ugly if I have ever seen it.
It was John Maynard Keynes who said that stock picking is like a beauty contest in which picking the winner is not picking the girl who is prettiest but picking the girl you think other judges will think is prettiest. That was very clever of Keynes, but for a value investor I think he got it exactly backward. The Spaniards were obviously onto something. Laugh if you want. My wife's sister had been the pretty one when they were kids and my wife had been the smart one, maybe a little beaky before she got the nose job most Iranian teenagers get. Plus she wore librarian glasses. When her sister noticed her image on a kiosk in Portugal she called to provide a critique and commented that no one was looking at her. A friend got off an airplane in Argentina and saw her image several stories up on a building. Her looks obviously made her the perfect emerging markets beauty.
Just for the fun of it I checked out a sampling of the 65 emerging markets ETFs and saw nothing exceptional except that they all had the same basic price chart. Nothing seems to differentiate them except for the fact that several excluded China. This morning I took another look. Exactly one ETF had graduated to the Buy Ranking, It was the Freedom 100 Emerging Markets ETF ( FRDM ), which had been my second choice behind EMXC. It had apparently been promoted on a modest improvement in Momentum, Expenses, and Dividends. That didn't seem so fundamental, but the closer I looked the better FRDM looked. It was, in effect, the winning Miss Ugly of the ugly category. Its focus on freedom, rule of law, and property rights aligned with my own views. Plus no China, of course. Are you kidding - human rights and rule of law?
Here's to the SA Quant system! It worked in two ways. First it reinforced the view that absolutely nobody appreciated emerging markets ETFs. Second, it showed the one ETF which seemed to be bucking the trend and breaking out of its category. It's exactly the kind of quirky winner which might lead a breakout of the entire group. If the Freedom 100 ETFD was breaking out, all the diversified emerging markets ETFs might soon follow.
Emerging Markets Are As Cheap As They Ever Get
The one global asset class which seems to have good prospects for the intermediate future is emerging markets, and its advantage starts with valuation. Here's a chart from this Morgan Stanley report advancing the case for emerging markets at the end of 2022:
Emerging Markets vs Developed Markets Composite Valuation Indicator
Source: MSIM, Bloomberg, FactSet, Haver. Composite measure of 6 valuation metrics: price/book, 12m-fwd. P/E, P/E, price/sales, price/cash earnings, dividend yield. Data as of December 5, 2022
Over the past 35 years, emerging markets have had a dependable negative correlation with the U.S. market. The chart above is based on a composite of valuation measures and as a result presents an outline of bull and bear markets. There is no definitive number for emerging market P/Es, starting with the fact that indexes do not contain the same countries, and every source I have checked has had a different number. The only sure thing is that EM P/Es are currently low, contained in a range between 9 and 12, and numbers for all other measures are similarly low. They also swing wildly, with the valuations in the chart ranging well above and below one standard deviation.
Overall emerging markets have outperformed developed markets since the late 1980s, but their current supporters are like a small private club drawn from the slightly larger club of value investors. In a recent Twitter post Cliff Asness of AQR Capital cited the key fact that GDP per capita has been more than twice that in the developed world while overall GDP has grown to almost half global GDP while overall market cap remains at less than 30% of global market cap. Asness also pointed out a fact visible on the above chart: emerging markets are the cheapest they have been in 25 years. GMO's expected 7-tear annualized return of 7.4% real and about 10% with inflation tops all other asset classes and is consistent with the chart. Inflation in emerging markets as a whole, by the way, is lower than in either the U.S. or other developed markets.
Here's another GMO chart showing the negatively correlated returns of both U.S. and other developed markets with emerging market in the first two decades of the 21st century:
Comparison of U.S. and EM (GMO)
So what's not to like? There's always something, and with emerging markets it starts with the possibility that the U.S. dollar may persist in being strong. EM economies and markets do poorly when the dollar is strong because a strong dollar damages exports and increases their cost of capital. Strength in the dollar was the major factor in making an article with a similar thesis in late 2020 somewhat premature although my emerging markets ETFs did well enough that I escaped just above breakeven. Keep an eye on the dollar. The current dollar chart is ambiguous
Why The Freedom 100 Emerging Markets ETF?
The choice of The Freedom 100 Emerging Markets ETF starts with the fact that it doesn't own China. On September 1, 2021, I published this article with the title "The China Narrative Is Broken; China is Uninvestable For Now." It was, to my knowledge, the first article expressing that view unequivocally on this site and it was among the first on any site. I had sold my Alibaba ( BABA ) a few months earlier, taking a modest profit. I expected and warned that it would eventually make a round trip and undercut its IPO price. It did.
No less a person than Charlie Munger stayed with BABA a couple of years longer. His persistence accorded with the fact that Alibaba was a seductively successful company encased in a system which couldn't accept capitalist success. It was thus a sophisticated value trap. Within a few months of that September 2021 article I sold my small position in the one China small cap ETF and a couple of diversified value ETFs which included a lot of China.
When I published that China article many prominent advocates for sticking with China were talking their book and observing the new necessity to stay on the good side of the Chinese leadership. They were determined to avert their eyes from the fact that the Chinese leadership was increasingly unfriendly to capitalism, human rights, property rights, and the United States. To be fair, as I wrote in that 2021 article, the United States was far from innocent. It's tempting to forget the century starting in the early 1900s which included the "uneven" Opium Treaties and the Boxer Rebellion. The United States, still an emerging democracy, had played a surprisingly central role in suppressing Chinese efforts to determine its own future. Our subsequent relations with China were up and down. We were allies in WWII but enemies in the Korean War (1950-53) which reportedly cost about 36,000 American and 180,000 Chinese lives.
Keeping China out of my portfolio isn't an act of hostility. It's simple awareness of the deep sense of bitterness a Chinese regime like the present one brings to interaction with the U.S. The only real question is whether avoiding mainland China is enough or if one should dig up an old compass from high school trig and draw a circle around China with a radius of several hundred miles. Inside of that circle all investments would be excluded from consideration. That would put Taiwan and South Korea, both contained in the Freedom ETF, inside the zone in which investments have a heightened China-based geopolitical risk.
The major immediate risk is the possibility that China follows up on its threats to take over Taiwan by military force. If that happens, the risk of investment losses is far from the top of the list of worries. Will we be directly involved in a shooting war? Can we whip the PLA and the Chinese Navy so close to the mainland? What would the costs be? The answers have some resemblance to the situation before World War I in which several participants got themselves locked into positions they couldn't get out of and which led to a devastating global war. The best hope is that the possible outcome of a war with China contains such grim possibilities that war should appear irrational to all, but we should bear in mind that this was exactly the situation in 1914. From China's point of view absorbing Taiwan is a matter of pride and ideological commitment although failure to come to a peaceful resolution would amount to killing the golden goose.
A starting point for emerging market investors is removing China their investment. Bear in mind that China is almost 35% of the Vanguard FTSE Emerging Markets Index Fund ETF ( VWO ) and 31% of the iShares MSCI Emerging Markets Index ETF ( EEM ), the difference in the two being less a matter of China holdings than of the inclusion of South Korea in the latter index. The heavy China weightings worked brilliantly for investors and ETF providers while the Chinese mega-caps rose from almost zero to dominate the indexes, but investors have paid the price as they crumbled under various pressures from the Chinese government. The MSCI Emerging Market Ex China ETF is wholly contained within the larger MSCI ETF. All three indexes are cap weighted, thus "passive" in their construction. One difference is that the Ex-China ETF has 695 holdings while the total MSCI version including China has 1229, almost twice as many. The fact that it contains so many small positions is likely the reason that the EEM ETF has a higher expense ratio than its Ex China version, .69 to .50.
The Freedom 100 ETF has significant differences from the cap weighted indexes because of its particular standards and goals. It is constructed from its own Freedom 100 Index and attempts to replicate the contents of the index, but clearly has some leeway which makes it effectively an actively managed index. It presently contains 101 companies chosen to accord with its qualitative goals. There's an interesting interplay between the top six positions by country rank and the top six holdings by industry:
Country List Holdings List
- Taiwan 21.74% Technology 25.30%
- Chile 18.98% Financials 23.14%
- Korea 18.22% Basic Materials 17.43%
- Poland 13.90% Consumer Discretionary 8.57%
- South Africa 6.19% Communications 7.65%
- Brazil 5.52% Consumer Staples 7.19%
A number of things stand out. Chile is a large overweight and combined with Brazil gives FRDM the large basic materials weight historically common in emerging markets countries. Korea and Poland are part of the MSCI index but not the FTSE Index. Taiwan and Korea together are 40% of the ETF, and the presence of Korea contributes to the larger than usual technology position. That being said, while Samsung is a company that competes with the behemoths of technology it is not exactly a young and rising star.
Going a little deeper, Chile is currently over 18% of the country list but down from 25% at the end of 2022. It's unclear whether this results from a cooling enthusiasm for Chile or because FRDM's assets under management jumped 50% in Q1 2023 from around $300 million to almost $450 million. The numbers themselves are relatively small but not terribly small for an emerging market ETF. The jump in numbers may have made it difficult to maintain the 25% level for Chile positions without moving prices. For FRDM the rate of AUM growth within an out of favor market sector suggests that the relatively new "freedom" concept may be catching on.
The most notable absence is India, one of the top three countries in most EM portfolios. Those who have followed the Adani Group scandal are aware that corruption is a major current issue in India. FRDM does seem to be following its stated mandate.
The aggregate P/E ratio for the ETF is about 9.4 (the average of numbers from several sources) and the price to book is 1.55, lower than most. Distribution yield is 2.84%. Despite being to a degree actively managed, the Freedom 100 ETF has a low .49% expense ratio. FRDM, in short, is everything it claims to be and also seems to be succeeding while remaining very cheap. On this basis it is my top choice. FRDM's brief history (since May 23, 2019) is compared to EMXC in the chart below and has outperformed by 12%:
Note the pandemic crash in March 2020 followed by the huge rally which turned out to be a head fake. In December 21 and 28, 2020, I published two articles arguing that emerging markets might be due for a breakout. It was still fairly early in the Alibaba saga but I discussed it briefly and called for extreme caution. What killed the EM rally, however, was not China but severe weakness as the U.S market irrationally continued to soar. There was an important lesson in that: watch the dollar. Have I mentioned that? A rising dollar is the mortal enemy of emerging market stocks lying in ambush for any breakout.
What Are Emerging Markets?
It should be clear at this point that "emerging markets" is a Wittgensteinian category with members that share some but not all characteristics. That lack of a single perfect definition is in part historical and in part a matter of the particular views of index makers.
Starting in 1952 there was a single catch-all term for undeveloped economies. The Cold War was well underway, dividing the world into First World (capitalist countries with focus on individual freedoms) and Second World (the Marxist/socialist countries like Russia and its allies). French historian/anthropologist Alfred Sauvy invented the term Third World, a not very flattering characterization for countries which did not have enough economic organization to be characterized as either capitalist or socialist. They were in fact often battlegrounds between First and Second World ideologies.
As the capitalist system gradually prevailed, these newer economies tilted more toward capitalism and began to be characterized as developing or emerging markets. By 2000 the four most important such countries were the so-called BRICs (Brazil, Russia, India, China). As the dot.com bubble crashed (2000-2003) I bought CEF country funds for Brazil and India which swung from a large discount to a large premium as their local indices doubled. I don't recall exactly why I didn't buy Russia or China, although at the time neither of them had much of a history. Russia had a bank and a few resource companies and China had not yet broken out. There's now a list of emerging market ETFs as well as a second tier list of countries known as "Frontier Markets" which have less well established property rights, rule of law, and oversight of financial activities.
The definition of emerging markets remains rather loose, ranging from countries which have some issues in common with Frontier Markets to countries which might fit better as part of the universe of developed markets. In fact, as mentioned above, the two indexes for emerging markets do not contain exactly the same countries. South Korea and Poland are treated as part of the MSCI emerging markets index but categorized as Developed Markets in the FTSE indexes. The FTSE emerging index includes Kuwait but the MSCI index does not. The less well known Jim Sloan Off The Top Index (my personal opinion) agrees heartily that Korea and Poland are developed markets and also includes Taiwan, the tech capital of Asia, in that category. China does not quite fit in any category. It lacks reliable property and human rights, but its large size and tremendous growth in per capita GDP make it different from most emerging markets. Simple size causes it to swamp other countries in both current indexes. This is beginning to put those indexes at odds with the needs of many investors.
Getting China out of the picture is a partial solution of the problem which makes the Freedom 100 ETF attractive and its Freedom themed portfolio is a positive, but are these steps enough? With the other indexes, you are basically buying China plus other odds and ends. This is especially a problem if you include Taiwan and South Korea, China neighbors on both sides. Combined with the fact that both Taiwan and Korea both have economies resembling those of developed countries and taken together make up 40% or so of most indexes suggest that some investors might want to find a way to eliminate or reduce the influence of Taiwan and Korea in their emerging markets holdings.
With A Little Work You May Individualize Country Focus
The countries in the table below are the ones considered important by Matthews Asia Investment which just created its own actively managed ETF in the emerging markets space. Matthews has a good track record over all, but it will likely have higher expenses and currently has no record. As you can see, there is great diversity within emerging markets and correlation from country to country is slight over the period of seven years. My inclination if buying EM by country ETFs would be to exclude the two China markets, Taiwan, and Korea. India, though less developed in some respects than China could qualify with a little clean-up of the corruption problem. Vietnam is in some respects similar to Frontier Markets, especially in its recent political tilt against capitalism, although it has a much higher education level than most. The countries pushing upward from the status of Frontier Markets bear resemblance to Emerging Markets as they existed around the year 2000, and as you can see in the GMO chart above they did very well in the first decade of the 21st century. I have spent time in all the countries in the table except China, Taiwan, India, and Saudi Arabia, in some cases several decades ago, and found them all livable and full of pent-up energy.
My intention is to produce another article in the not too distant future looking at all the countries in the table (China, Taiwan, and Korea excluded) perhaps along with a few others. I will also continue to think about efficient ways to organize an emerging markets portfolio with the point of departure of the Freedom 100 model. I would appreciate and take into account comments and questions from readers who have ideas, questions, or candidate countries they wish to propose.
For further details see:
FRDM: Emerging Markets Are Hated So Much It May Be Time To Buy