Feb 25, 2016 (LBO) – Christopher Brightman, Research Affiliates’ Chief Investment Officer, says the exodus from emerging markets offers wonderful opportunity for opportunistic investors.
Brightman shares market insights for global investment management firm PIMCO’s All Asset funds. PIMCO has 1.4 trillion dollars in assets under management, and their market insights can be read here.
Q: How do you view the portfolio’s positioning in Emerging Market asset classes, particularly after a challenging 2015?
Brightman: Many investors mistake a bear market for diminished prospective returns. From the rear-view mirror, the bear market in emerging markets has been painful. When we look out of the windshield, however, these very asset classes offer the highest potential returns available to today’s opportunistic investor. So, the exodus from emerging markets is a wonderful opportunity – and quite possibly the trade of a decade – for the long-term investor.
With global stock markets selling off in early 2016 following a challenging 2015, and jittery investors pulling the sell trigger on their risky investments, the fear of emerging markets is pervasive. A number of events – slowing growth in China, an unexpected depreciation of the Renminbi, tumbling commodity prices, Middle East tensions, and recessions in Brazil and Russia – have applied downward pressure on emerging market stock, bond, and currency prices. We are sympathetic to those alarmed by these events and recognize that this understandable fear creates today’s bargain prices. While markets are not efficient, neither are they irrational.
We are increasingly confident of our positioning in emerging market stocks and bonds, which represents an allocation of 35 percent in All Asset and 39 percent in All Asset All Authority, as of December 31, 2015. Offering high yields, favorable demographic trends, strong productivity growth prospects, and a long-term trend of improving credit quality, emerging market asset classes are secularly attractive. Valuations, which are both compelling relative to their individual histories and relative to other market opportunities, makes emerging markets even more attractive today.
Across commonly used valuation metrics, emerging market equities are exceptionally cheap. We tend to look at the Shiller P/E, which divides real prices by the ten-year average of real earnings per share, because it allows the price-to-earnings relationship to be viewed in the context of multiple business cycles.
As of January 31, 2016, emerging market equities are priced at a Shiller P/E multiple of 10x, ranked in the lowest 4th percentile since 1990. We find six times in the last 25 years when the emerging markets’ Shiller P/E multiple dipped below 10x. How did these stocks perform after reaching these bargain-basement multiples? Five years later, emerging market equities delivered an impressive average cumulative return of 188 percent!
These results are not singular to emerging markets. Across all countries, when Shiller P/E multiples get depressed to dirt cheap levels, reversion to normal valuations has followed, leading to strong subsequent returns. We mapped the cumulative five-year return path of 13 developed and emerging countries, returns once each country’s valuation multiple dips below 10x. Once Shiller P/E falls below 10x, the average cumulative five-year return is an impressive 118 percent.
During 2015 we also experienced an extraordinary divergence in performance between growth and value, similar to tech bubble of the late 1990s, as I highlighted in past Insights. EM value stocks underperformed growth stocks by more than 5 percent per annum over the last 3 years ending December 31, 2015, a value premium that sank to the bottom decile of all rolling three-year outcomes since January 1997.
What results transpired after value was thus savaged? EM value stocks outperformed growth stocks by an average of 6.7 percent three years later and 7.3 percent five years later. Of course, this result hardly surprises. It is a manifestation of a core tenet of our investment philosophy: the largest and most persistent active investment opportunity is long-horizon mean reversion.