Last updated: 06:11 / Saturday, 24 August 2019
MFS Investment Management

Gregory Johnsen (MFS IM): “Valuation Looks Attractive for Emerging Markets Equity Relative to US Equity Market and Fundamentals Have Considerably Improved”

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Gregory Johnsen (MFS IM): “Valuation Looks Attractive for Emerging Markets Equity Relative to US Equity Market and Fundamentals Have Considerably Improved”
  • Since the global financial crisis, there has been an increasing gap between the Shiller P/E ratios in the US equity market and the Shiller P/E ratios in the emerging market equity
  • As valuation looks attractive for emerging markets equity relative to US equity market, the free cash flow yield and other indicators of quality in fundamentals have considerably improved in emerging market equity
  • The “fragile five” countries: Brazil, Indonesia, India, Turkey and South Africa, have now lower current account deficits and offer higher real interest rates. They are in better shape in terms of that metric than when the taper tantrum occurred back in 2013”

The allocation to emerging market equity in global portfolios is becoming more strategic than ever. The MSCI All Country World Index has now around 10% to 12% in weight to the emerging markets. Global equity portfolios should consider having an allocation to emerging markets.

Since the global financial crisis, there has been an increasing gap between the Shiller P/E ratios in the US equity market and the Shiller P/E ratios in the emerging market equity. While the US Shiller P/E is currently about 32,5 x, the EM Shiller P/E is around 11 x. This gap in valuation could be explained by a period of over earnings in US companies and a period of under earnings in EM companies.  

While the regular price-earnings (P/E) ratio provides information about the valuation of a company by measuring its current share price relative to its per-share earnings, considering the previous year’s earnings or the forward-looking earnings on next year, the cyclically adjusted P/E or Shiller P/E is defined as current share price divided by the average of ten years of earnings adjusted for inflation.   

On the other hand, the free cash flow yield and other indicators of quality in fundamentals have considerably improved in emerging market equity relative to the same metrics in developed markets. “Looking at different periods of time in the last 20 years, we can see that the fundamentals of the emerging market equity have improved. Returns on assets and returns on invested capital are significantly looking better, especially when they are compared with the data of the year 2000, 2015 and more recently 2018. The asset class is getting more attractive levels in its fundamental metrics at good valuations. At this point in time, investors are getting a good dividend yield and the free cash flow yield is also more attractive from a valuation perspective”, explained Gregory Johnsen, Institutional Portfolio Manager at MFS Investment Management.

In the last two decades, the investment in infrastructure and property, plant and equipment in emerging markets relative to sales, the CAPEX/Sales ex-Financials ratio, has been higher in emerging market equity than the average in developed markets, ranging from 5% to 8%. However, in the last two years, the CAPEX to sales ratio in emerging markets has started to decline, this fact can be explained by an upward trend in net profit margin. “Once the CAPEX has been made, then the cost of goods sold starts to decline, allowing for greater profit margins, all things been equal. That is the sort of trend that is occurring in general in the emerging market index. From that perspective, there are some attractive metrics in the asset class”, he added. 

Long-term capital market expectations

According to MFS IM, the 10-year expected annualized return in emerging market equity is about 9,2%, that compares to roughly a 4,8% in global equity, showing one of the higher perspectives in terms of returns among asset classes. These higher expected returns are backed by a real sales growth estimate of 3,4%, based on the investment theme that consumer spending power is growing in emerging markets and brings the potential for sales growth.

“There is a discussion in the market about whether profit margin is peaking in the US equity market or in the global equity markets. Maybe, there is a chance that there would be a reversion to the mean in these markets. Different consultant groups that do their own capital market assumptions see a similar type of outcome in emerging market equity, where this asset class tends to be higher in return, but obviously higher in risk than the other asset classes”, said Johnsen.

Emerging market fundamentals

Emerging market public finances remain relatively strong despite fiscal weakening in some countries. Historically, public debt as a percentage of GDP has been in most emerging countries lower than in developed markets, operating in the 40% to 50% range versus the range over 100% in which developed markets operate.  

Another way to look at the improvement of fundamentals in emerging markets is to analyze the real interest rate and the current account balances of the “fragile five” countries. The fragile five refers to Brazil, Indonesia, India, Turkey and South Africa, countries which produced weak economic and currency data back in 2013, when there was the “taper tantrum” episode.

“The Federal Reserve started talking about bringing interest rates up in the US on the second quarter of 2013, when the countries with the higher current account deficit conditions were highlighted to be potentially susceptible to higher interest rates in the US. Today, these countries have lower current account deficits and offer higher real interest rates, they are in better shape in terms of that metrics that back in 2013” he added. 

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