Should we pay more for emerging markets?

Does it make sense for emerging markets to be more expensive in valuation terms than developed markets? Much of the market would have you think so.

“Look at the growth”, they say. “These markets are growing faster than developed markets so you should pay a premium for them.” But this doesn’t really make any sense. There have been endless studies showing that there is no connection between the economic growth of a single country and its stock market performance.

But it is also the case that Asian stock markets are often not expensive at all. The cyclically-adjusted p/e (CAPE) of the Asia ex-Japan index has fallen to below 15 times three times since 1982, so it is hard to argue that it is always expensive. 

At the same time, it is worth noting that the whole point of being an emerging market is to turn into a developed market. As CLSA’s Russell Napier points out “a developed market is simply an emerging market that has gone right”. And as an emerging market turns into a developed market, so the valuations investors pay for it will fall.

Let’s not forget that the US was an emerging market around the turn of the last century. Yet anyone who invested then saw the CAPE ratio gradually fall over the next 20 years as it turned into a developed market: pay too much and you pretty much always lose money.

With that in mind, note that India is on a CAPE of 24.7 times, China is on 20.2 times, South Africa is on 22 times, Thailand is on 24 times and Chile is on 36.4 times. The long-term average for the US (since 1881) is 15 times. Something to point out to anyone trying to persuade you to put too much money directly into these markets. 

At the moment, the only emerging market I am mildly interested in would be China. I’m not planning to invest in it (too opaque, too expensive and too dominated by quasi-state companies) but it will be interesting to see what happens to it as the Chinese property bubble bursts.

The Chinese can’t get a real return on their deposits (thanks to a massive round of ongoing financial repression, savings rates are held well below inflation) so as the once-easy returns from property desert them, they might turn to the stock market instead.

That’s something that would push up prices and allow Fidelity’s Anthony Bolton to retire with his reputation intact and everyone else to take the chance to sell their holdings in his – and other – Chinese funds.