The Bottom Line
- Investors concerned about the recent run-up in U.S. stocks might consider emerging markets (EM), where valuations are lower.
- Consider the price/earnings (P/E) ratios for each region. The MSCI EM P/E was 15.7 at the end of February—compared with 21.7 for the S&P 500. That 6 point gap is well above the 20-year average of 4.7.1
- While a P/E of 15.7 (which above the 20 year average of 14.8) might not seem overly attractive given the sometimes turbulent history of the sector, current factors and future prospects support a sympathetic view.
- If so, investors waiting for valuations to retreat (to the very low levels of the late ‘90s, early ‘00s and financial crisis of ’08-’09) before stepping in could be disappointed.
- Why is this unlikely? Because fundamentals in these countries are much more robust—and the economic outlook is improving—as noted by EM equity specialist manager Martin Currie.
- Another factor to keep in mind: the MSCI EM Index itself has changed significantly in recent years, making P/E comparisons to the past much less relevant.
- For example, the index weighting to higher debt/lower return on equity (ROE) sectors like materials and energy (which tend to have lower P/Es) is much lower today, while lower debt/ higher ROE sectors like technology have greater prominence.
- In other words, the index P/E may be higher today, but it represents a different mix of companies that may deserve a higher valuation.
- The key for investors, of course, is being able to access the best-run businesses positioned to benefit from the strong secular trends that define EM, such as a growing middle class, the rise of e-commerce and the expansion of financial services—which requires the kind of selectivity available through active equity managers.
1 Source for all data is Bloomberg and Legg Mason, as of 2/28/17.