The big picture, macro reasons for putting more emerging market stocks in your portfolio are compelling enough.
But you don’t need to buy into the top down macro argument. The micro, stock-by-stock reasons are just as compelling. Put a developed economy stock up against a developing economy peer and much of the time the developing economy stock is cheaper. Much cheaper. If you think that the way you make money in the stock market is to buy low and sell high, that’s a very convincing argument for emerging market stocks.
Let’s do a quick dash through the macro reasons for anyone who’s coming in late.
The world’s developing economies are growing faster than the world’s developed economies. Much faster in some cases: China is likely to see 10% GDP growth this year; India could come at 8% or above and Brazil seems headed for better than 7% versus a projected 1.2% for the European Union and somewhere between 2.5% and 3.5%for the United States.
Banking systems in most of the emerging economies are in better shape than in the developed world. The sub-prime mortgage disaster and the resulting meltdown of major banks and insurance companies did relatively little damage in China, Brazil, India and the rest of the developing world.
Developing countries largely dodged the huge stimulus burdens and pre-crisis spending policies that have left governments in the developed economies carrying debt levels of 70%, 100%, 120% of GDP or more. (Got to be careful here how you do your accounting though. You can make a case, and I have, that China is broke. See my post https://jubakpicks.com/2010/03/12/despite-those-huge-reserves-china-could-be-gasp-broke/ )
Developing countries are by and large younger than developed countries. That’s a big plus for long-term growth but it also means that the burden of paying for retirement and healthcare for an ever larger population of oldsters is further down the road for countries like India and Brazil. (For more on the long-range effects of these costs see my post https://jubakpicks.com/2010/05/25/get-used-to-it-the-global-debt-crisis-will-play-out-over-and-over-again-in-the-next-decades/ )
Now the micro.
I don’t want to argue the macro micro here. It’s just too hard to figure out what a reasonable market multiple is for emerging economy stocks. The Shanghai Composite index, for example, is trading at about 20 times trailing 12-month earnings. That’s way below the five-year high of almost 50 times trailing earnings, so it’s definitely cheaper than it was. But is it cheap in absolute terms? Got me.
But put a developing economy stock head to head with a developed economy peer and the micro picture is frequently very, very clear.
Let’s compare a U.S. bank, Wells Fargo (WFC) the fourth largest U.S. bank by assets at the end of the first quarter of 2010 and a Brazilian bank, Itau Unibanco (ITUB), the largest bank by assets in Brazil.
A share of Wells Fargo went for $28.13 at the close on June 10, 2010. With 5.2 billion shares outstanding the market cap was $147 billion.
Itau’s New York Stock Exchange-traded ADR sold for $19.05 on June 10. With 4.5 billon shares outstanding the market cap was $86.25 billion.
None of this really tells us anything about how cheap these two stocks are. For that we need to look at their price-to-earnings ratio and the earnings growth rates and particularly at a ratio between the price-to-earnings ratio and the earnings growth rate called the PEG ratio.
Analysts project that Wells Fargo will earn $1.97 a share in 2010. At the June 10 closing price of $28.13 the stock traded at 14.27 times 2010 earnings per share. Analysts also project that earnings will grow by an average rate of 9.4% a year over the next five years. That means the stock traded on June 10 at a PEG ratio of 1.52. (That’s the forward PE divided by the average annual growth rate.) The price multiple is 1.52 times the earnings growth rate.
Do the same analysis for Itau Unibanco. Analysts project that the company will earn $1.60 a share in 2010. At the June 10 closing price of $19.05 the stock traded at 11.91 times 2010 earnings per share. Analysts project that earnings will grow by an average rate of 9.6% a year over the next five years. That means the stock traded on June 10 at a PEG ratio of 1.24. The price multiple is just 1.24 times the earnings growth rate.
An investor is paying about 20% less (18.4% to be exact) for Itau Unibanco’s projected earnings growth over the next five years.
Of course, these calculations are only as good as the projections in them. (I used Wall Street consensus projections from MSN Money, Yahoo Finance, Bloomberg, and Thomson Reuters to come up with the figures I used.) But if anything, in my opinion these projections err in projecting too much growth for Wells Fargo and too little for Itau Unibanco. The Brazilian economy is growing roughly three times faster, Brazil’s credit rating is rising and that of the U.S. is likely falling, the Brazilian real is appreciating and the U.S. dollar is depreciating—all these are reasons to suspect that the annual average 9.6% earnings growth rate for Banco Itau is underestimated.
My point, though, is that even without any adjustment to the Wall Street consensus, Itau Unibanco is projected to deliver more earnings growth for your investing buck.
(As an aside to investors trying to decide when to get into a market such as Brazil. Peter Lynch, the great mutual fund manager, long advocated buying growth stocks when their PEG ratio was one or less. At a price of $15.60 Itau Unibanco shows a PEG ratio of 1. I’m not saying you should wait for that price. I’m just saying….)
Itau Unibanco has been in Jim’s Watch List https://jubakpicks.com/watch-list/ since December 17, 2009. The shares have dropped 11.7% from that date through June 10.
In some comparisons the emerging market stock is so much cheaper, even using growth estimates you think ridiculously low, that you’re buying a whole lot of upside for nothing—if it turns out that your growth estimate and not Wall Street’s is accurate.
Compare two steel companies, for example. Brazil’s Gerdau (GGB) sold for $13.60 a share on June 10. Wall Street projected 2010 earnings per share at $1.66 for a projected price-to-earnings ratio of 8.12. Wall Street projects Gerdau’s average annual earnings growth at just 6% over the next five years. I think that’s ridiculously low for a developing country projected to grow by 7% in 2010, but no matter: Even with the low Wall Street earnings growth estimate the PEG ratio comes to 1.36. (I added Gerdau to my watch list in my post https://jubakpicks.com/2010/06/11/the-next-rally-wont-be-like-the-last-one-heres-how-to-make-sure-you-find-the-next-leaders/ .)
Nucor (NUE), to my mind the best U.S. steel company, sold for $42.43 on June 10. 2010 earnings are projected at $1.62 a share for a forward price-to-earnings ratio of 26.19. Wall Street estimates average annual earnings growth of 15% over the next five years. That works out to a PEG ratio of 1.75.
You’ll notice that I’ve been picking pretty good developed economy companies to use in my comparisons. That’s important. You want to find the developing market stocks that can beat the best that the developing markets have. We’re not trying to find mediocre emerging market stocks that can beat really crummy developed market stocks.
So don’t be afraid. Go for it and put those emerging market stocks up against the best.
How does Petrochina (PTR), for example, measure up against ExxonMobil (XOM)?
According to Wall Street projections Petrochina will produce earnings per share of $12.80 in 2010. With the June 10 closing price at $111.765 that’s a forward price-to-earnings ratio of 8.73. Wall Street says Petrochina will show earnings growth of 5.7% a year on average over the next five years. That’s a PEG ratio of 1.53.
ExxonMobil is projected to grow 2010 earnings to $5.76 a share. On the June 10 price of $61.89 that’s a forward price to earnings ratio of 10.59. Average annual earnings growth over the next five years is projected at 8.63%. That’s a PEG ratio of 1.23.
ExxonMobil comes out on top in this comparison. Buy that developed economy oil company if you want the most earnings growth for your buck.
But the contest was closer than I thought it would be. And it tells you something when the best managed, most profitable oil company in the developed world doesn’t run away without breaking a sweat from one of the developing world’s best.
The message isn’t some depressing decline of the developed world drama, however.
Just a reminder that as an investor today you can’t take anything for granted. At least not if your goal is to make a buck.
Full disclosure: I own shares of Nucor in my personal portfolio.
Hi Jim,
any picks for India?
wsm,
Agreed. Novice investors should understand that PE and PEG ratios are exactly what you describe: comparative tools. When there appears to be similar upside potential in two stocks (in terms of where they’re trading relative to your fair value calculation), you can compare the PE and PEG ratios to help determine which one to invest in.
One should also perform an independent “sanity check” of earnings estimates, and consider uncertainty in the numbers used for calculations.
Good article, Jim – and I do think it is educational for novice investors to look at the PEG comparisons between different securities, which you outline.
But it is important to point out that your analysis takes analyst estimates at face value, unchanged. While this type of analysis can provide insight into overall market expectations for certain stocks or sectors, REAL actionable investment ideas are more often born of independent analysis.
When a potential investor can perform his own valuation of a company, and therefore has an independent idea of intrinsic value, then he can make responsible, informed investment decisions. If he leaves the analysis where you left it, all he can say is that this stock looks a little cheaper than that one, based on some analyst’s guess-timates of earnings and growth rate.
CallOfDutyFan,
You underestimate Europe’s ability to screw up. 😉
greenflash98,
While I agree there is inflation on the horizon, we aren’t there yet. The problem is that most of the money that was handed out was given to people and institutions which are currently sitting on it. Until it hits the economy, we are actually facing deflationary pressure (which the dollar’s strengthening isn’t helping).
southof: Good question. I’m sure Jim has a good idea. Definitely depends on the company. From what I read on suncor’s quarterly report, they were in the 30’s cost per barrel at the end of last year. They had some setbacks with some fires and lost production so that the cost went into the 50’s. I haven’t done any research yet on other companies such as cnq and imo.
Ed and greenflash98:
You guys may find Bill Gross’ Investment Outlook newsletter interesting. A few months ago, he talked about how emerging market debt may be a whole lot better than developed countries’ debt. Jim’s article on emergency market equities reminds me of what Bill Gross has been talking about in his past few newsletters w.r.t debt.
In any case, the long term prospects for the USD don’t seem to be good. The short term strength is purely relative. What will happen in the long term could also be contradictory, if everyone messes up worse than America. 🙂 Which I doubt.
at what price must oil trade for it to be profitable to dig it out of the sands?
I watched from close-up, with awe and disbelief, as GM crumbled under the weight of bad judgement and blind ambition, dragging Ford and Chrysler behind by association. The BP situation feels remarkably parallel, even though they have a lot more cash to burn through and some level of diplomatic immunity. There is still a GM out there, but that doesn’t mean much to the stockholders of record as of 531/09.
Until we know that the bp well is capped and the uncertainty is taken out, i’m thinking of getting into an oil sands stock for some energy exposure. Looking at Suncor(su). Looks like there 5 year peg is 0.5-1, depending if you look at yahoo finance or msn. They selling off natural gas and north sea operations and looking to increase oil sands by 10-12%/year. I think this could be a good risk/reward play on the price of oil
@Ed: I think Jim was referring to the longer term picture for the dollar. Our out of control deficit/debt problem is undoubtedly (at least to my mind) going to be the cement boots on the feet of the dollar for quite some time (decades). The appreciation over the last several months is relative to the weakness and uncertainty in the rest of the world, which is likely a much shorter phenomenon. I’m sure you know this, so I wonder if you see the US shoring up it’s debt issues more quickly than I?
@Astrid: My two cents are that if you want to dollar-cost average into emerging markets over the next 12 months, that seems an eminently reasonable thing to do. The point of DCAing is to take advantage of just this type of uncertainty, after all. Jim IS trying to time things to some extent with his holding off until later in the year, but remember he cannot DCA with the Picks Portfolio, so he is looking for a better comfort level. Ed believes things are going further south from here, and he may be right. But he may also be wrong, as I am sure he will tell you. We will not know where the bottom is until after the fact, making it impossible to time it exactly. Dollar cost averaging is a tool to overcome this limitation. Wish you the best, and I may soon join you…
kricmond:
I will 3rd Bob & Ed. I owned BP pre-spill and sold on a slight bounce after, but held too long. For me, I would not touch the stock again. There are too many unknowns and almost all potential seems down. Below is a link that estimates cleanup at $37B and that bankruptcy (a common theme lately) would not absolve BP of financial responsibility. Plus with hurricane season here, just think if we get a monster that takes all that oil onshore. Ugly.
There are other companies getting punished that do not have the same unknowns and those would be better options IMO. Some that have been mentioned here are NE and DO (I own DO) for offshore instead of RIG. Exxon, PBR (I own PBR) and others for big oil.
http://preview.bloomberg.com/news/2010-06-15/bp-bankruptcy-would-offer-no-protection-from-gulf-damages-cleanup-costs.html
kricmond,
I will second what bob just said, and add that if BP does bounce back from this (big IF), then you should still be able to buy it at a lower price than this much later than now.
BP wouldn’t be my 1st choice in this sector. With pressure to whack the dividend, , legal unknowns (including criminal…If Holder has his way they’ll serve the CEO of BP at the next bar-b-que) ongoing financial obligations to clean up and take care of the financial impact of several states, these guys have a tremendous amount on their platter. My guess is they will survive…the question is to what degree? will they still be a major player in the sector? Exxon and others will have a crocodile tear in the corner of their eye, but they will no doubt exploit this tragedy to their advantage (like sharks and blood in the water).
I would shy away from Halleburton, Transocean and anyone else associated with BP.
Good morning,
Jim or fellow bloggers,
This is off subject but I was wondering if you give some insight on BP. The stock is hovering aroung 30 share. Do you see BP recovering from this oil spill and if so would you recondmentation this stock for a buy?
Astrid,
There is still significant downside risk. Part of the problem we have is that we really don’t know what the market bottom is.
Should we be trying to time our investments into emerging markets or use dollar cost averaging? Jim seems to be a market timer (wait until later in the year to invest). But I’m beginning to wonder whether it might not be better to dollar cost average my planned investments in emerging market ETFs over (say) the next 12 months.
Jim,
Do you still own ITUB personally? I saw when you added to watch list you did, but in this post didn’t…I don’t recall a mention of a sell…perhaps sold w/o a reference in articles….which is acceptable 😉 and a potential savings of that 10% + drop too…
>the Brazilian real is appreciating and the U.S. dollar is depreciating<
Jim,
Actually, the dollar has been appreciating since last November, unless you mean against the real specifically. However, since ITUB and WFC aren't directly competing, that factor is irrelevant to how either company is doing, except that both are dealing in appreciating currencies.
> The message isn’t some depressing decline of the developed world drama, however.
Are the developing MARKETS cheap or the developed MARKETS expensive?
I think this post indirectly makes the claim that the markets in the developed economies are overvalued and they have to come down quite a bit.
http://pragcap.com/felix-zulauf-the-march-2009-low-wont-hold