U.S. financial markets, which have risen to records, are closed today in celebration of our uniquely American holiday, so I thought I’d do some work on countries abroad.
In my decades of experience as an investor, I’ve always found a few markets among the past year’s biggest losers poised for a dramatic reversal. The idea is mean reversion, a fancy way of saying: The last shall be first, and the first last.
When I scan global markets in search of the best opportunities, there’s one that stands out. To me, it looks capable of delivering triple-digit returns over the next few years: emerging markets. The S&P 500 Index of the largest U.S. stocks has jumped 26 percent this year, while the MSCI Emerging Markets Index has fallen 3 percent.
|Emerging markets offer the best growth potential in a slow-growth world.|
The investment case for emerging markets boils down to three factors:
1. Growth: Emerging markets offer the best growth potential in a slow-growth world.
2. Value: Many stock markets in the developing world are available at historically attractive valuations (price-to-earnings, price-to-book). They’re exceptionally cheap, but they won’t stay that way.
3. Sentiment: Emerging markets are one of the most hated asset classes in the world, and that’s music to my ears. For contrarians, sour sentiment can be a powerful “buy” signal.
Let’s examine the three factors in detail …
Growth: Emerging markets are poised to deliver the fastest economic growth worldwide, with gross domestic product expanding 5.1 percent in 2014, according to the latest data from the International Monetary Fund. That compares with 2 percent for developed economies, including the U.S., Europe and Japan.
Over the next four years, more than 70 percent of global GDP growth will come from emerging markets. Plus, more favorable fiscal conditions and healthier balance sheets should support faster, higher-quality growth for years to come.
Value: Emerging markets are absolute bargains by just about any yardstick. At the end of the third quarter, the MSCI Emerging Markets Index was trading at just 10 times earnings over the next 12 months (the price-to-earnings ratio). For global stocks, it was 13.4, and for the S&P 500 it was nearly 15.
The average price-to-book ratio for emerging market stocks is under 1.5 today, compared with 2.5 for U.S. stocks.
Historically, when emerging markets were that cheap over 10 years, stocks delivered average total returns of more than 50 percent over the next 12 months.
Sentiment: Emerging markets are so out-of-favor today that nobody seems to be paying attention anymore. A recent global fund manager survey by Merrill Lynch (see chart above) confirms near-record levels of pessimism.
In fact, the last two times emerging market stocks were so unloved was … at the bottom of the market in 2006 and 2009.
* After the 2006 “sentiment” low, emerging market stocks rose 78.5 percent over the next 18 months.
* And following the 2009 low, they soared 135.5 percent in a little over two years.
For true contrarians, buying opportunities just don’t get any better than this.
In out-of-favor markets, the bad news tends to be priced in. Positive surprises can be richly rewarded.
Emerging markets have been cellar-dwellers in performance during 2013. But for next year that could change, as they’re trading at a 30 percent discount to U.S. stocks. Plus, I’m seeing a bright green contrarian “buy” signal because sentiment is simply too bearish.
In the past, this trifecta of favorable indicators has led to triple-digit gains in emerging stock markets, and I, for one, am betting on an upside reversal of fortune.
Happy Thanksgiving, and good investing,