A P: Emerging markets: The reality

The long-term case for outperformance in emerging markets still remains very much intact

As we enter the new financial year, inevitably many emerging market veterans are quite cautious. For, the asset class has spectacularly outperformed over the past five years, and there is a limit to how long the party can last.

In dollar terms emerging markets outperformed the developed markets in 2004 by 9 per cent, have outperformed by 51 per cent over the past three years, and by 92 per cent since their January 1999 relative low (source: Morgan Stanley).

Given the past volatility in the asset class, such strong performance inevitably raises concerns of trend reversal and a temptation to lock in your profits.

After several years of significant improvements in macro fundamentals and corporate profitability, emerging markets now generate a record return on equity (RoE) of 16 per cent, the highest of any region in the world.

The buzz around the asset class has also intensified with most long-term thinkers convinced of the case for its long-run outperformance. Quite a far cry from 1999, the height of the Asian crisis when the survival of the asset class itself was called into question.

With everything going right obviously, one has to start worrying about what could go wrong. Why should the emerging markets keep outperforming?

While I do agree that probably easy money has been made in these markets, and it makes sense to be cautious from a short-term perspective, the long-term case for outperformance still remains very much intact and valid, to my mind at least.

First of all, while the relative performance record for emerging markets (EM) versus the developed markets (DM) since 1999 looks spectacular, and ripe for mean reversion, it does not reveal the true picture.

Despite the 92 per cent relative outperformance of the EM since 1999, if we look at the relative performance numbers since 1994, or the past decade, the picture is very different.

Since 1994 (measured in US dollars) the emerging markets still trail the developed markets by more than 40 per cent (in total return terms), despite all the great performance of the past five years.

This only serves to highlight the magnitude of wealth destruction in the emerging markets world between 1994 and 1998, when the emerging markets dropped by 45"�50 per cent and the developed markets effectively doubled.

Such was the savageness of the Asian currency crisis that it effectively wiped out an entire decade of financial markets performance.

So the harsh truth is that despite all the recent hype about emerging markets and the tech bubble collapse, over the past decade investors would have done significantly better in the developed markets and done well to avoid the emerging world.

Looked at in this way, it is difficult to argue that the emerging markets are high stretched in terms of relative performance. Again after five good years could we be in for six months of weak relative performance? Of course, but that doesn't change the longer-term trend.

The second aspect of the case is that while the emerging markets now trade at the smallest price/book value discount (to developed markets) for a decade, this has to be seen in conjunction with the asset class generating an all-time high RoE of 16 per cent (300 basis points higher than the developed markets) and by itself does not imply that the asset class is no longer cheap.

On a simple one year forward price/earnings (P/E) basis, the asset class still trades at a 37 per cent discount to the developed markets benchmark. Thus it is tough to argue that all the relative value has been arbitraged away.

One of the key changes in emerging markets over the past five years has been the huge improvement in RoE to 16 per cent from 5 per cent in 1999. Hard though it may be to believe but the emerging markets now generate a higher RoE than any other region in the world, including the US.

Obviously, investors are not giving these markets full credit for the RoE improvement as they still trade at a 23 per cent price/book discount to developed markets.

If investors believed in the sustainability of this improvement, then a case could be made that the EM should trade on a par with the developed markets and not at such a large discount.

Most investors still tend to discount this huge rise in RoE as reflecting strong global growth in 2004 and record commodity prices. They are convinced that as global growth slows in 2005 and commodity prices retreat, emerging markets' RoEs will come crashing down.

To the extent the EM bulls are right in laying out the case that we are experiencing a structural improvement in the RoEs due to improved capital allocation policies of EM corporates, there exists significant scope for the P/B discount to narrow further.

Thus, while the valuation gap between the emerging markets and developed markets has narrowed considerably over the past five years as the emerging markets have outperformed, it still does not fully reflect the extent of improvement in EM micro and macro fundamentals.

If one believes in the structural improvements in the EM world then there is still scope for further harmonisation of multiples between the two asset classes.

Another reason used in the past to justify why emerging markets should trade at a deep discount was the perception of very high volatility for the asset class.

This argument is no longer valid as aggregate EM volatility has now declined to levels comparable to the developed markets, though valuations have not fully corrected to reflect this new reality.

Emerging markets today, at least statistically in terms of volatility of returns, are no riskier than the developed markets.

One more common concern among the sceptics is that emerging markets are too hot, too much in the news, and have attracted too much money, all signs of a top and reversal in market performance. When looked at in terms of hard data, we seem to still have a long way to go.

In September 1994, emerging market assets peaked at approximately 1.05 per cent of total US mutual fund assets (source: Morgan Stanley). Even today despite all the strong flows seen over the past 12"�15 months, the same figure sta nds at .83 per cent.

Even if we were only to return to the prior peak levels, this in itself would trigger additional inflows of $10 billion into the asset class.

Given the fact that a much stronger relative case can be made for emerging markets today than in 1994, the level at which this number peaks could be much higher.

Thus, whichever way you cut it the case for emerging markets' long-term relative outperformance remains intact. It is true that having outperformed now for five years, in the very short term the asset class may experience some hiccups, but for any serious long-term investor it remains the place to be.