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ETF Specialist

Are Emerging-Markets Stocks Too Cheap to Ignore?

Almost, but not quite.

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A version of this article was published in the September 2015 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor by visiting the site.

Emerging-markets stocks have gone from the penthouse to the outhouse. Over the 10-year period ended Oct. 31, 2010, the MSCI Emerging Markets Index experienced an annualized return of 14.62%. The S&P 500’s annualized return was negative 0.02% over this same span. For the five-year period ended Oct. 31, 2015, the MSCI Emerging Markets benchmark declined by 2.8% on an annualized basis, while the S&P 500 was in full-on bull-market mode, gaining 14.33% annually. Today, emerging-markets stocks are unloved, rife with risk, and (unsurprisingly) were recently trading at their lowest levels since 2009. Have they gotten too cheap to ignore?

Investors’ appetite for emerging-markets stocks has apparently waned. From September 2005 through January 2013, emerging-markets equity exchange-traded funds amassed $102 billion in cumulative inflows. In the intervening two-plus years, over $15 billion has flowed out of these funds. Sentiment has soured on the basis of poor relative performance and fraying fundamentals.

Where to begin with the risks? China, of course. The whipsawing Chinese equity market has put the world on edge. I don’t think investors should be as concerned with the ups and downs of the Shanghai Composite Index so much as they should be worried over the broader implications of slowing growth in the Chinese economy. The Flash China Caixin PMI--a key gauge of manufacturing activity in China--fell to its lowest level in almost seven years in September before rebounding slightly (though still indicating contraction in manufacturing activity) in October. Slowing output from “the world’s factory” forebodes weaker export demand and declining demand for raw materials. For years China has been the dominant marginal consumer of (insert a metal, hydrocarbon, or foodstuff of your choice here), so slowing growth is having and will continue to have ripple effects that will be felt disproportionately by its export-oriented raw-materials providers.

Nowhere are the ripple effects of slowing growth in China more evident than in Brazil. Brazil’s exports of everything from beef to iron ore have declined dramatically as Chinese demand has tapered. This has left the country’s economy in a lurch and weighed on the local stock market, which was not long ago dominated by export-oriented firms like government-controlled energy producer  Petrobras (PBR) and iron-ore producer  Vale (VALE). IShares MSCI Brazil Capped ETF (EWZ) is now trading at a level lower than where it bottomed out at the nadir of the global financial crisis, as local equities have hit the skids and the value of the Brazilian real has fallen.

Investors are growing ever-more fearful of emerging markets, so is now the time to be greedy? Emerging-markets equity valuations are looking increasingly compelling, especially on a relative basis. However, in light of the myriad risks they’re facing today, I’d say: almost, but not quite.

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Per Research Affiliates’ expected return data, emerging-markets stocks (as represented by the MSCI Emerging Markets Index) had the highest expected returns of any major asset class as of the end of September. Research Affiliates’ data also show the current Schiller P/E ratio for emerging-markets stocks, at 11, its lowest level ever, and well below its median value of 19 (this data series dates back to 1995). Emerging-markets stocks also feature at the top (if you exclude timber) of GMO’s most recent seven-year asset-class real-return forecast. Ben Inker, co-head of asset allocation at the firm, recently cited emerging-markets value stocks as a “best idea” in a Forbes profile. [1] While valuations are compressed, it’s impossible to say that the worst is behind this asset class and whether expectations of pain to come have already been priced into these markets.

As it stands today, the Morningstar ETFInvestor portfolios have a fair-sized (underwater) bet in place that emerging-markets stocks will pick themselves up. This takes the form of our allocation to  iShares MSCI Emerging Markets Minimum Volatility (EEMV), which comprised 7.7% and 10.4% of the Asset Allocation and Income portfolios, respectively, as of Nov. 6. EEMV is my preferred option for emerging-markets equity exposure; I think it is the most palatable passive approach to a very volatile asset class.

EEMV is less risky than its broad cap-weighted peers by design. This has panned out in practice recently, as evidenced by its lower drawdowns and lesser volatility relative to its market-cap-weighted peers like  iShares MSCI Emerging Markets (EEM). For the 12-month period ended Oct. 31, 2015, EEMV declined 11.39%, versus a 15.48% decline for EEM. Also, over the trailing three-year period ended Oct. 31, 2015, EEMV’s volatility has been roughly 16% less than that displayed by EEM. EEMV’s standard deviation was 12.52% over this span, versus 14.97% for EEM.

EEMV’s lower risk profile is also apparent at a more fundamental level, as evidenced by the composition of its portfolio, specifically EEMV’s tilt toward defensive stocks and its lesser degree of exposure to state-owned enterprises. EEMV had 25.81% of its portfolio in defensive names and 37.59% in stocks Morningstar characterizes as cyclical as of Nov. 9, 2015. This compares with respective figures of 13.89% and 44.52% for EEM. Large SOEs (most notably, Chinese banks and insurance and energy firms) are also underrepresented in EEMV’s portfolio relative to EEM. This lessens concentration risk as well as the risk associated with forking over capital to a class of entities that might not put maximizing shareholder wealth at the top of their to-do lists.

[1] Schaefer, S. 2015. “The New Money Masters: GMO Asset Allocation Whiz Ben Inker.” Fortune. June 29, 2015.

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Ben Johnson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.