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Second Quarter 2015: Should You Consider Emerging Markets?

They’re cheap, most investors are scared to death of them, and yet they have been slowly grinding higher throughout 2015. Are emerging markets — and the iShares MSCI Emerging Markets ETF (EEM) — worth owning as we jump into the second quarter?

In years past, that would’ve been two very distinct questions. The EEM ETF, despite its name, was not really a play on “emerging markets.” It was primarily a play on developed Asian markets like Taiwan and South Korea — countries that already emerged decades ago with standards of living on par with Western Europe. And ironically, it was an indirect play on growth in the U.S. and Europe, as its allocation was massively skewed toward global exporters that sent their wares primarily to the West. And due to quirks in MSCI’s index construction, you even get oddball countries like Greece included in the index. (Hey, I agree in principle with demoting Greece from big-boy, developed-market status, but can you credibly call that mess an “emerging” market?)

For true exposure to growth in the developing world, you had to look elsewhere, such as to the EG Shares Emerging Market Consumer ETF (ECON). The ECON ETF invests in consumer-focused stocks that catered to domestic emerging-market shoppers.

Today, the EEM ETF is still heavily weighted toward developed Asia; South Korea and Taiwan collectively make up 28% of the portfolio, and the two largest stock holdings are Samsung Electronics (SSNLF) and Taiwan Semiconductor (TSM). But as liquidity has improved in “real” emerging markets, so has EEM’s allocation. Today, China is the largest single-country allocation, at 21% of EEM’s portfolio. South Korea and Taiwan take the two and three slots, with 14.6% and 12.6%, respectively.

Brazil, South Africa and India round out the top five, with 8.8%, 7.8% and 7.1%, respectively.

EEM EEM: Should You Consider Emerging Markets?

Looking at the EEM ETF’s track record in recent years, you might wonder why anyone in their right mind would put a single dollar in emerging markets.

Outside of the modest dividend yield, investors have seen no returns at all since the first quarter of 2007. Emerging markets cratered in 2008 during the global housing crisis, cratered again in 2011 during the eurozone crisis and have traded sideways ever since. Excessive dollar strength — which means excessive emerging-market-currency weakness — certainly hasn’t helped either.

But this is precisely what makes the EEM ETF interesting right now. U.S. stocks have been the only game in town for years. But after six years of uninterrupted bull market, U.S. stocks are also wildly expensive, trading at a cyclically adjusted price/earnings ratio (“CAPE”) of over 27.

This doesn’t mean a crash is guaranteed, of course, but it does make me want to expand my scope a little beyond U.S. borders.

EM EEM: Should You Consider Emerging Markets?

Today, valuations are cheap and expected returns are high in the countries that make up the EEM ETF’s largest allocations. Using data from Research Affiliates, we see reasonable expected annual returns over the coming 10 years ranging from 3.8% in Taiwan to 11.7% in Brazil. To put that in perspective, Research Affiliates estimates returns of only 0.7% annualized in American stocks over the next decade.

Estimates are just that — estimates. There is no divine universal law that says that stock returns “have” to follow what their valuations suggest they will, but they give us a useful rule of thumb.

I don’t expect emerging markets to generate the kind of eye-popping returns we saw in the mid-2000s, but I do think we can credibly say that emerging markets are priced to, if nothing else, perform better than U.S. stocks over the next decade. They’re cheap, their currencies have been battered, and a long string of bad macro data has already been priced in.

And that makes emerging markets worth a look.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.


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Chinese Stocks: Short-Term Buy, Long-Term Sell

Chinese stocks are one of my favorite value plays for 2015. Just don’t fall in love with them.

The mantra of the permabull is to buy and hold stocks for the long run. That sounds good, and history has generally been on the side of the optimists. But buying and holding can also be a horrendously bad idea.

Consider the case of Japan. High starting valuations, chronic deflation and lousy demographics have caused Japanese stocks to slump into a multi-decade bear market. Had you bought the Nikkei 225 in 1989, your portfolio would be worth less than half your starting value today.

Let’s jump back into Chinese stocks and why I consider them to be a fantastic buy at current prices. I’ll start with one of my favorite valuation metrics, the cyclically-adjusted price earnings ratio (“CAPE”). The CAPE smooths out the volatile ups and downs of the business cycle by taking an average of the past 10 years’ worth of earnings.

Don’t worry, you don’t have to do the math. Research Affiliates, the research firm led by “smart beta” pioneer Rob Arnott, recently created a great research tool that enables you to choose any eight world markets and compare their valuations. Research Affiliates then takes it a step further by forecasting the expected return over the next 10 years based on those valuations. For those who like to delve into the nitty-gritty details, the forecasting methodology is explained here.

Chinese stocks currently trade at a CAPE of 14.6. That may not sound exceptionally cheap until you see that their median CAPE over time is 18.5 and their pre-crisis high CAPE was nearly 50. Arnott and company estimate that Chinese stocks are priced to deliver inflation adjusted returns of about 7% per year over the next 10 years.

Rival estimates by Wellershoff & Partners put the estimate at nearly double Arnott’s. But however you slice it, Chinese stocks are cheap.

There is one other major reason to expect Chinese stocks to perform well. China’s central bank is expected to step up its stimulus plan following a string of disappointing data. The People’s Bank of China lowered its benchmark rate last month, and China watchers expect a cut to bank reserve requirements.

These expectations are already showing up in Chinese stock prices. The iShares China Large Cap ETF (FXI) has quietly been rallying since October and is within striking distance of a new 52-week high.

Chinese Stocks: Long-Term Sell

Now for the bad news. Looking longer term, China has a bleak future. In fact, I would go so far as to say China has no future.

China has had a major birth dearth over the past 30 years due to the One Child Policy. That actually gave China something of a demographic dividend, as man hours that would normally have been spent raising babies were instead diverted to industrial development. But in the process, China sacrificed its future.

Children are the future.  You need them to pay the taxes and man the factories of tomorrow. More critically, in the age of modern consumer capitalism, you need them swiping the credit cards and buying the homes of tomorrow.  This is particularly relevant for China given its government’s stated goal of reorienting its economy away from exports and towards domestic consumption.

Of course, children require mothers to bring them into the world.  And they are about to be in short supply.


China’s population of women of prime childbearing age (25-29) goes into steep decline starting next year. Average age of marriage and first childbirth are rising worldwide, and as a general rule the more developed a country becomes (and the more educated its women become) the higher the age of marriage and motherhood.

So, let’s assume that China’s women are postponing motherhood under their early 30s. Even then, China has a major problem. Its population of women aged 30-34 goes into steep decline starting in 2020.

Conception is still possible into the late 30s and 40s, of course. But it gets more difficult and, realistically, it limits family size.

What does all of this mean?

Chinese stocks are cheap today and generally hated and underowned by investors. In a world in which American stocks trade at nosebleed valuations, Chinese stocks are a bargain.

Just don’t fall in love with them. Given the deflationary demographic abyss China faces, Chinese stocks are a long-term sell.

Charles Lewis Sizemore, CFA, is the chief investment officer of investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays. As of this writing, he does not hold a position in any of the aforementioned securities. 

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Argentina is a Coiled Spring, Just Waiting for Kirchner to Leave

Grant’s Interest Rate Observer penned a great piece on the CFA Institute’s blog: Exit of Argentina’s President Offers Value Opportunity.

Here is an excerpt:

Like Russia, Argentina is so bad that it almost can’t get worse. Notice: almost. In human affairs, there’s always room for deterioration. The speculator in Argentine debt and equities may possibly suffer a permanent loss of capital. However, we judge that — again, as with Russia — valuations favor the optimist. Grant’s is bullish on the Country that Ruined Itself.

In a sense, Cristina Fernández de Kirchner, the disastrous two-term Argentine president, stands to do the value-seeking investor not one good turn, but two. In misgoverning, she’s wrecked the economy. By stepping down, she’ll improve it. Her policies have destroyed asset values. Her leaving will crystallize the opportunity to participate in the recovery of those values.

When Vladimir Putin may choose to become the ex-czar of Russia is anybody’s guess. When Fernández leaves office is already on the calendar. Her constitutionally mandated departure corresponds to the next presidential election in October 2015. Bloomberg recently quoted an Argentine asset manager, Claudio Porcel, to the effect that her successor, whoever he or she might turn out to be, will be a person to be envied: “The next president will regain market access and be able to raise as much as $60 billion in sovereign, provincial, and corporate debt. I can’t imagine a better job.

It can’t be said that the prospects for post-Fernández relief are entirely undiscounted. Since the run-up to the 2013 election in which the incumbent Peronist party suffered its mid-term shellacking, the 13-company Argentine Merval Index has returned 75% in dollar terms, according to Bloomberg. Nor is there much suspense about who the next president might be. Daniel Scioli, governor of Buenos Aires province; Sergio Massa, the former head of Fernández’s cabinet; and Mauricio Macri, mayor of the city of Buenos Aires, are the three acknowledged front-runners. Whatever else their differences, the contenders seem to agree that capital controls must be lifted, real rates of interest restored, and a Paul Singer settlement effected.

And — and — Argentina watchers concur, it would be nice if the government stepped aside long enough to permit development of the country’s immense Vaca Muerta shale oil and gas formation, one of the world’s richest energy deposits. Discovered by YPF in 2011, Vaca Muerta will cost between $140 billion to $200 billion to develop, according to figures cited by the Economist; just $3.7 billion has been ticketed to date (for comparison, the country is expected to spend up to $13 billion this year on foreign oil). “Argentina’s biggest problem is the lack of dollars,” an Argentine corporate executive — he asks to go nameless, as “it’s not good to be quoted in Argentina” — tells Grant. Foreign exchange reserves of the Argentine central bank stood at $52.6 billion as recently as 2011; they have subsequently dwindled to $28.8 billion.


For a case study in what ails Fernández’s Argentina — and for a hopeful glimpse at what might improve upon the incumbent’s long-awaited departure — we present the country’s No. 1 natural-gas delivery company, Transportadora de Gas del Sur SA (TGS); $440 million is the market cap.

There are three business segments: distribution and production of natural gas liquid; natural gas transport; and midstream services. Relatively thriving is the first-named, natural gas liquids unit. Demand is strong and volumes are growing; in the first half of 2014, they jumped by 10.6%. The business is unregulated and revenues are denominated in dollars.

A very different story is the transportation division. Tariffs are regulated — until recently, there had not been an increase since 1999. What with inflation and devaluation, the transportation unit takes in 75% less in dollar terms than it did in 2001. In that year, the parent earned $108.5 million in net income. In the 12 months ended June 30, it netted just $7.8 million.

As to valuation, TGS is quoted at a ratio of enterprise value to EBITDA of just under five times (enterprise value being defined as equity market cap plus debt minus cash). Observes Thompson, “The valuation may seem somewhat cheap when compared to other natural gas transportation/distribution companies in the region — they’re trading at six times enterprise value to EBITDA. However, when factoring in the potential profitability recovery that TGS could have, the valuation is extremely attractive and the investment proposition is very asymmetric.”


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Don’t Let Macro Worries Scare You Out of MTN Group

As we jump into the final quarter of 2014, emerging markets are looking much the way they did at the beginning of the year.  The popular iShares MSCI Emerging Markets ETF (EEM) started the year with a quick 11% drop on, among other things, fears of slowing growth in emerging markets, rising interest rates in the United States and geopolitical concerns across the globe.  And as I write this, EEM is in the midst of a brutal month-long correction based on—you guessed it—fears of slowing growing in emerging markets, rising interest rates in the United States and geopolitical risks across the globe.

It’s easy to forget that from February low to the first week of September, EEM enjoyed a fantastic 24% rally.

Looking at one of my favorite growth markets—South Africa—we see the same story played out.  The iShares MSCI South Africa ETF (EZA) started the year with a 14% decline only to then rally by a good 31%.  But since topping in early September, EZA has quickly dropped 12%.

Trying to call a bottom in any market, let alone volatile emerging markets is a fool’s errand as it depends on investor emotions.  I cannot say when investor sentiment will turn.  But I can say this.  Emerging markets are broadly underowned and inexpensive both based on their own historical valuations and compared to developed markets.  And many emerging markets—South Africa included—remain below their pre-crisis highs, at least in dollar terms.  EZA, for example, has traded sideways since 2010.

Will emerging markets rally in the fourth quarter?  Maybe, maybe not.  Only time will tell.  But on balance, the right conditions are in place for a rally. The stocks are cheap, sentiment is negative, and the interest rate environment should continue to be benign for at least another six months and probably longer.

MTN Group (MTNOY), my pick in InvestorPlace’s Best Stocks of 2014, has gotten dragged down by rotten sentiment towards emerging markets.  MTNOY stock is down about 14% from its September highs due entirely to perceived macro risks; the company has made no announcements over the past month.  At time of writing, we’re still up about 6% for the year, including MTNOY’s impressive 4.6% dividend.

MTNOY’s latest results, for the six months ended June 30, were positive across the board.  MTNOY’s subscriber base increased 3.5% to 215 million users, and overall group revenues rose 4.1% in constant currency terms.   Data revenues rose by a whopping 33.1% in constant currency terms, and profit margins widened; EBITDA margins rose 3.5% to 46.3%.

Revenue shrank slightly in South Africa due to brutal competition in that market.  But MTNOY enjoyed organic, constant-currency growth of 8% in Nigeria, its most important market, and 13.4% on average across its other major African and Middle Eastern markets.

MTNOY is a stock that I believe is uniquely positioned to benefit from the continued rise of Africa’s emerging consumer class. The most critical possession of the new middle class is not the automobile, as it might have been in previous generations, but the mobile phone.  And as the dominant African mobile provider, MTNOY is in prime position to benefit from a long cycle of service upgrades as African consumers switch from prepaid to post-paid monthly plans and from basic plans to data-intensive plans.

After the correction of the past month, MTNOY is on sale again. If you don’t already own shares, this is a good time to buy.  When sentiment turns on emerging markets in general and South Africa in particular, MTNOY should enjoy a nice “double whammy” of a rising stock in South African rand terms and a rise in the value of the rand itself.  For U.S. dollar investors, a return of 50%-100% over the next 12-18 months would seem very reasonable.

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays. 

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Where To Be Invested in the Fourth Quarter: Emerging Markets

This is not a fun time to be invested outside of U.S. borders.  Concerns over Fed monetary tightening–and thus dollar strengthening–have sapped investor enthusiasm for overseas markets and particularly emerging markets. But it is precisely now, when valuations are cheap and investor sentiment so one-sidedly bearish, that you should be allocating at least a portion of your portfolio internationally.

Let’s start with valuations.  I like to look at metrics like the cyclically adjusted price/earnings ratio (“CAPE”), a concept first popularized by the legendary Benjamin Graham—Warren Buffett’s mentor—and more recently by Yale economist and best-selling author Robert Shiller. The CAPE is a fantastic way to get a broad view of how a market is priced. Like all metrics, it is subject to interpretation, but I can think of no better “quick and dirty” way to judge a market’s relative value.

Meb Faber—the portfolio manager of one of my favorite ETFs, the Cambria Global Value ETF (GVAL)—does a fantastic job of compiling CAPE data from around the world. Well, Faber is at it again. In a recent research note, Faber acknowledged that CAPE has its detractors. As I myself have noted CAPE’s usefulness as an indicator can be affected by macroeconomic factors such as bond yields. And others have noted that using historical earnings is problematic due to changes in accounting standards over the years.

Faber published a rebuttal that compares the CAPE to similar 10-year metrics for book value (CAPB), dividends (CAPD) and cash flows (CAPCF). And guess what? The results don’t look all that different. The countries that look cheap by CAPE standards generally look pretty cheap by the other metrics as well. The following chart ranks the countries of the world by the average of the four metrics.

Czech Republic89387
New Zealand222251416
South Korea2313421724
Hong Kong2619293728
South Africa3538333936

A couple broad points jump off the page pretty quickly.  To start, American stocks are pricey, while most major European and emerging markets are relatively—or at least comparatively—cheap.  Of the world markets tracked, only the Philippines, Indonesia and Denmark are more expensively priced that the U.S. markets. Secondly, single metrics can be deceptive.  For example, if you used the cyclically-adjusted price/dividend ratio for Russia, you would see a market that was not particularly cheap.  But in looking at earnings, cash flows and book values, you see one of the cheapest markets in the world.  So, it pays to look at multiple metrics when assessing a market’s valuation.

Now, let’s turn to the subject of the U.S. dollar.  Part of the skittishness towards non-U.S. assets of late is fear that Fed tightening will mean a much stronger dollar.  But is this a reasonable fear?  U.S. interest rates are still among the lowest in the world, and even by the Fed’s most aggressive estimates, short-term rates will only rise over the course of multiple years.  By the end of 2017, the Fed’s policy-setting committee expects the fed funds rate to be 3.75%.  That’s three years from now, and it assumes that the economy continues to recovery without any major hiccups.  Meanwhile, the dollar is already fairly expensive.  Using the Economist’s Big Mac Index as a back-of-the-envelope gauge, Brazil is the only investable emerging marekt with a currency that can be considered “overvalued” relative to the dollar, and even here it is significantly less overvalued than in recent years.   Among developed markets, the UK and Eurozone are roughly fairly valued relative to the dollar.  Loose monetary policy from the ECB could send the euro lower, of course, but we’re starting at a reasonably-priced base.

How should we use this information to invest in the fourth quarter?  I am by no means bearish on U.S. stocks, and I don’t necessarily expect a major correction in the next few months.  But I do believe that U.S. stocks are priced to deliver disappointing returns going forward.  Meanwhile, there are real values to be had elsewhere in the world, particularly in countries that have recently emerged from financial or political crisis.

If you want a nice “one stop shop” for underpriced foreign markets, I recommend Faber’s GVAL.  It’s largest country weightings are a “who’s who” list of the cheapest markets in the world; Brazil, Spain, Austria, Italy, Ireland, Israel and Russia all have 10%-11% weightings.

If you want to choose individual markets, I am most bullish on Spain, Brazil and Russia.  The easiest ways to get access to these markets are via the iShares MSCI Spain ETF (EWP), the iShares MSCI Brazil ETF (EWZ) and the Market Vectors Russia ETF (RSX).

Brazil is in the midst of a contentious presidential election and Russia…well, Russia is Russia.  I expect to see some fairly wild price swings in these two markets in particular.  But I also consider both priced to deliver fantastic returns going forward for investors with the patience and intestinal fortitude to ride out the volatility.

This article first appeared on InvestorPlace.

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays. 

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