Is It Time to Invest in Emerging Markets?

Stock markets across the globe have been on a tear this year.
In the U.S., almost every asset class is up significantly on the year. Even European markets are up 20% on average.
Emerging markets, however, have had a far different fate. As you can see in the chart below, there is a 30% percentage-point difference between the emerging markets and the S&P 500.

The performance over the past year is almost the exact opposite from just a few years ago. Remember from 2009 to 2010 when the emerging markets were leading the charge? Investors were scoffing at the global big boys. All the talk was about the young populations, surging idle class, and low rate of sovereign debt that defined most emerging markets.

So, given the recent underperformance of the emerging markets you have to ask the question, is now the time to start seriously considering investing in the sector? You certainly can’t argue that you would be “buying low.”
But before a plunge into the emerging market waters, we must first ask ourselves this: Why have emerging markets struggled?
There are a few reasons. Several of the BRICS (Brazil, Russia, India, China and South Korea) economies rely heavily on the production of commodities. As we have all seen over the past several years, commodity prices have plunged. And if you take a deeper look into, say, the MSCI Emerging Markets ETF (EEM) you will quickly notice that approximately 20% of the index is tied to commodity industries such as energy and materials.
But there are a few other factors.
“Taper talk” has also affected the performance of the sector. Last spring when Fed Chairman Ben Bernanke mentioned a potential pullback in bond purchases, emerging markets were affected significantly more than other sectors. Remember, emerging markets are considered a speculative investment and as such are susceptible to rising U.S. interest rates.  When the Fed first announced a possible taper, the S&P 500 declined 6% over the next few months while the Emerging Markets Index (EEM) fell 17%.
At the same time, the growth rate of several emerging markets, including China and Brazil, has dramatically slowed and nothing has changed since…which begs the question are emerging markets past their prime?
No one will argue that emerging markets are a bargain at the moment in comparison to developed markets like the U.S. or Europe. A quick glance at the most common measure of a stock’s value, the price/earnings ratio (P/E), gives us some insight into how cheap emerging markets are as a sector right now.
As we move towards the end of the year, EEM is trading at a P/E of 12 times 2013 projected earnings, far cheaper than the 16 of S&P 500 (SPY) and 15 of MSCI EAFE Index (EFA).  And if you look at the consensus projections for 2014, the message remains the same . . . emerging markets are considered cheap.
But we know that cheap doesn’t always equal good. There is no doubt that emerging markets should experience a considerably faster rate of growth for the foreseeable future. In addition, some of the largest emerging markets reside in Europe, which is currently in recovery mode. A continuation of the recovery should help to get the emerging markets back on track.
However, most emerging markets economies have little in common. For instance, Brazil, South Africa and Russia are heavily dependent on the success of commodities. South Korea, Taiwan and India rely on the success of technology. And China and Mexico are a mish-mash of everything.
So as an investor, you must ask yourself where you can find the biggest bang for your buck. The days of blindly investing into an index and watching it skyrocket are over. We must be more selective.
My colleague Tyler Laundon feels strongly about one such emerging market — and a stock called Africa Oil (AOIFF). So far, his pick has been a huge success.  Click here to read the report.
Tyler specializes in emerging markets and can help you navigate this relatively inefficient and highly volatile market.

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