The danger of lopsidedness in emerging markets

Emerging-market investors chasing consumer-orientated stocks have overlooked other lucrative sectors.

Beware the "thematic bubble" in emerging-market (EM) stocks, says a Bank of America Merrill Lynch report. Investors are chasing EM consumers and their "insatiable appetite for internet services, gaming, calling their families, and eating and drinking".

As fund managers have rushed to scoop up shares of fast-growing firms in such sectors, these growth' stocks have become extremely expensive.

They have a median trailing price/earnings (p/e) ratio of 31. The fastest-growing developed-market stocks, by comparison, are on a p/e of 20.6.

Yet while investors are "egregiously overweight" the EM consumption theme, they are "exceptionally underweight" the cheapest EM stocks: those in the energy, materials and financial sectors, where the state is heavily involved. These firms are usually only as cheap as they are now during recessions or crises.

Also, prospects for privatisation and deregulation in these sectors have improved as many EMs need to raise money. Mexico shows how political change can lead to reform. So there is scope for profits at state-backed firms.

Given these valuation extremes and the likelihood that they will revert to the mean, global investors are taking a big risk with their lopsided EM portfolios.

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