Friday, July 31, 2009

Emerging markets: the starting valuation issue.

Purple haze all in my brain

Lately things just dont seem the same

Actin funny, but I dont know why

scuse me while I kiss the sky

Jimi Hendrix and Purple Haze might conjure up images of pot smoking beach bums, but it’s emerging markets investors whom I’m thinking of right now (especially India and China). Unless you’ve been living under some rock, you are probably aware that there has been some concern that the emerging markets might be suffering from some speculative froth. BRIC 2050 indeed! I've written about emerging markets valuations before here and here. Interestingly, similar arguments would hold true even today.

Exhibit 1: This excellent presentation on investing in emerging markets which had this interesting slide:

While they make some excellent points on emerging markets, historical returns, diversification and high GDP growth rates, I thought they missed out on one HUGE one. In any market, in any situation, the starting valuation is the most important determinant of your subsequent (ex-ante) returns. (Here are three excellent pieces by Hussman on how valuation is a solid predictor of ex-ante returns in the US markets. )

The data presented in the slide is obviously about a month or two old. Book value for India’s BSE Sensex 30 is currently 3.7 with a dividend yield of 1.2%. Price-earnings ratio for China is 35-40. Buying an index, any index, at 4 times book value or 30-40 times earnings is a recipe for disaster.

Note to Jeremy Grantham: No need to worry about blowing an emerging markets bubble. We’ve already gone ahead and done that. What’s even more astonishing is that this bubble has formed in the middle of the Great Recession. (Interestingly, GMO’s emerging markets fund is underweight India and China).

Valuations. Valuations. Valuations. That’s what investing is all about. It’s not about market timing, but market and stock pricing. Stock markets sell at 40 times earnings or 4 times book towards the END of bull markets. I realize some bubbles have ended in 60-70 P/E multiples, but irrational parabolic blow offs are very hard to time at the top – the markets could go up another 50%, but it’ll still qualify as a bubble. Bubbles tend to last longer than you can stay solvent.

Stocks in India and China are priced to deliver disappointing returns. Even if these countries grow like rock stars, much of that is already priced in. Investors banking on emerging markets for their mojo might get neutered in the process.

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