The Good, the Bad and the Emerging Markets
Recent years have seen global markets split more or less into a 3-horse race. In first place, you have the US – ‘the good.’ The S&P 500 has returned 38% in the last 3 years. In distant second place, you have the rest of the developed markets – ‘the bad.’ The SPDR Developed World (ex-US) ETF has returned 10.9% in USD in the last 3 years. Finally we have ‘the emerging markets.’ This horse seems to have bolted out the back of the gate, returning negative 17.4% in USD over the last 3 years. The following graph provides a better picture of how this race has developed.
The performance gap between the US and emerging markets is now the largest it has ever been since the MSCI Emerging Markets Index was established in 1988, per the below graph. Note however how this gap has fluctuated over the years. It hasn’t simply been an ever-widening gap, rather a mean-reverting series.
The Big Question…
The big question for investors then is: Will this gap revert again, or will it persist indefinitely? If we consider the prevailing narrative today, the US seems to be the only game in town. But we quickly forget that the reverse was true in 2007 and 2011 when the emerging markets narrative was all the rage. In 2007, emerging markets traded at a PE of 19.7x and Price/Revenue of 2.3x. The S&P 500 then traded at a PE of 16.8x and Price/Revenue of 1.7x. In other words, emerging markets traded at a valuation premium of between 17% and 35% (depending how you measure) relative to the US. That would be unthinkable today. Now, those same figures are 15.1x/1.3x for emerging markets and 24.5x/2.8x for the S&P 500 – a premium of between 60% and 115% in favour of the US. Is that really reasonable/sustainable?
Valuations and narratives go hand-in-hand, therefore the most extreme valuations seldom look that extreme given the prevailing narrative. Your mind can play some strange tricks on you to justify the way things are in the present… What looks obvious in hindsight is seldom that obvious at the time. This was true for the housing bubble and the emerging markets rage in 2007, not to mention the tech bubble in 2000. Even for those who can spot the unsustainable extremes, timing is often a great frustration. The few years that look like a blip on a graph can feel like an eternity in the present. That being said, might we look back at the US market in years to come and say that 2024 was an obvious extreme?
Isn’t there a Third Option?
This article started with a discussion of 3 horses. So far we’ve focused on the winner and the non-starter, but what about the other horse? Developed markets outside of the US have a lot to recommend them – think Canada, Europe, Japan. They don’t have the same political risks associated with most emerging market countries, yet they trade at a very similar valuation – a PE of 15.7x and Price/Revenue of 1.3x. You might stretch to justify the current US/emerging markets premium, but is it really reasonable to have the same extreme premium relative to other developed markets? Japan in particular is offering up some attractive investment opportunities at present, particularly considering the Yen is at its lowest in 40 years.
We’ve generally been overweight emerging markets and underweight the US, which hasn’t helped us recently. (We tend to underperform when things go from extreme to more extreme, but we outperform when extremes begin to normalize.) We’re now also considerably overweight developed markets outside of the US, having used most of our available cash to make new investments in this space – primarily in Japan.
Macro Themes or Micro Fundamentals?
As you reach the end of this article you might begin to think that we’re making our investment decisions based on macro/geographic considerations. But this really isn’t the case. We concentrate on company-specific micro fundamentals which ultimately drive returns over the long term: Profitability, financial strength and valuation. But we’re aware that in the medium term macro trends often dominate the return landscape, as they have in the last few years. These macro trends help us to understand why certain extremes have occurred, presenting opportunities to find businesses with good micro fundamentals in specific geographies/industries where these trends have led them to be undervalued. It remains the combination of favourable micro considerations that ultimately drive our investment decisions and therefore also our geographic/industry exposures.
If we look at our portfolios, our largest regional exposure is currently in developed markets (ex-US) at 40%. The median PE of our holdings in this region is 15.3x (vs 15.7x for the developed markets index). Our US exposure is 37% with a median PE of 16.9x (vs 24.5x for the S&P 500). Our emerging markets exposure is 20% with a median PE of 13.8x (vs 15.1x for the MSCI EM Index). The underlying businesses, regardless of geography/industry have consistent profitability and very little debt. The unpredictable macro trends that produce divergent results in various parts of the world will come and go, but it’s these micro fundamentals that produce winning results in the end.