by Ivan Martchev | September 21, 2012 1:15 pm
One of the most annoying things about doing investment homework is calling earnings growth correctly — the real fundamentals, if you will — and seeing your stock go down. It happens a lot with individual stocks in a hostile macro environment, but lately it has been happening a lot with entire stock markets, too.
The most egregious such example in the emerging-market universe is the Russian stock market, where earnings and revenues have long surpassed their high watermarks from 2008, yet at its summer lows on June 1, the Russian stock benchmark index traded at roughly half its 2008 peak (it’s up about 25% since).
While Russia is an extreme example of overly discounted earnings growth, other emerging markets also show record earnings not being accompanied with record share prices. (The same is true for the S&P 500, where record 2012 estimated operating EPS of $103.12 have not yet been met with a record index level.)
True, economic growth has slowed globally, but there is more to it in this case.
The fear of the disintegration of the eurozone (and the EU as a result) has been acting as Democles’ sword on world stock markets, where numerous false downs in Europe over the past two years have been met with rallies, while the realization that the latest eurozone solutions are only a Band-Aid have been met with sharp sell-offs. This dynamic has helped coin the term “risk-on, risk-off” environment.
This is why figuring out whether the latest European solution is “the real thing” is key to answering the question of whether emerging markets are a screaming buy from a shorter-term tactical perspective.
The excitement in global stock markets since September comes from the latest European Central Bank suggestion of potentially unlimited buying of problematic sovereign bonds. The markets, however, have chosen to ignore the fact that no such unlimited buying would occur unless Spain or Italy — the countries where the eurozone financial storm is concentrated — submit to the necessary conditions. This seems like another clever variation of a financial carrot-and-stick, which has yet to be properly tested in reality.
However, I will try to give the ECB the benefit of the doubt — with all necessary caveats — and look at which emerging-market sectors would do best should this prove to be the real thing.
One way investors have been playing it safe in emerging markets is by concentrating on large-cap stocks while shunning small caps. This has created interesting opportunities for long-term investors.
Click to Enlarge This is well demonstrated in the divergence of Indian large- and small-cap stocks, investable via the iShares India Nifty 50 Index Fund (NASDAQ:INDY) and the Market Vectors India Small Cap Index ETF (NYSE:SCIF).
INDY trades at an elevated P/E of 28 and price-to-book of 5.1 due to large stakes in Indian financials that typically trade at a premium to other BRIC financials, simply because they are well-run and the Indian economy has less export leverage to problematic developed economies compared to other BRIC markets.
The small-cap SCIF trades at a remarkably reasonable P/E of 8.5 and a discount to book value of 0.7. With an 18.6% stake in financials, I believe SCIF is better balanced than INDY (27% stake) and geared more toward the Indian consumer, with only one ADR available to U.S. investors among its top 20 holdings — MakeMyTrip Ltd. (NASDAQ:MMYT).
Indian large caps probably will trade at a decent premium for a long time, as they are more “liquid” and accessible for foreign investors. However, I do not believe that if the European situation is close to being half-resolved, this massive divergence between Indian small caps and large caps will remain at such an extreme level.
Click to Enlarge The situation in Russian small- and large-caps is similar to India, although not as extreme, as Russian large caps are perennially the cheapest BRIC equities thanks to the large leverage of the Russian economy to the direction of energy and minerals prices.
The large-cap Market Vectors Russia ETF (NYSE:RSX) now trades at a P/E of 6.5 and a price/book of 0.86 with a dividend yield of 4.1%.
The Market Vectors Russia Small-Cap ETF (NYSE:RSXJ), on the other hand, trades at a cheaper P/E of 5.4 and a price/book of 0.76. Again, among the top 20 holding there is only one ADR available to U.S. investors — CTC Media (NASDAQ:CTCM). Similar to India-focused SCIF, this ETF serves a valuable role for providing diversified access to the Russian small-cap space.
If the Europeans mean business this time, I believe emerging-market small caps should see a meaningful valuation re-rating. If, on the other hand, we are back to the same old kicking of the can down the road, emerging-market investors might have the opportunity to establish positions in sectors with long-term potential at attractive valuations and wait it out.
Ivan Martchev is a research consultant with institutional money manager Navellier & Associates. The opinions expressed are his own. Navellier & Associates does not hold positions in any stocks mentioned in this article for its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the aforementioned securities. Investing in non-U.S. securities including ADRs involves significant risks, such as fluctuation of exchange rates, that may have adverse effects on the value of the security. Securities of some foreign companies may be less liquid and prices more volatile. Information regarding securities of non-U.S. issuers may be limited.
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