Earlier this week, we looked at emerging markets and why many investors stick to domestic stocks due to two biases: home country and recency, despite a compelling case for emerging market investing.
To more fully understand the case for global diversification, I’ll resume the discussion with an exploration of two studies related to emerging markets.
The Importance Of The Book-To-Market Ratio
Michael Keppler and Peter Encinosa, authors of “How Attractive Are Emerging Markets Equities? The Importance of Price/Book-Value Ratios for Future Returns,” which appears in the Spring 2017 issue of the Journal of Investing, provide us with some further insights as to returns we might expect from emerging markets.
For the period January 1989 through October 2016, the authors found that the P/B ratio of the MSCI Emerging Markets Index ranged from a low of 0.90 in January 1989 to a high of 3.02 in October 2007, and averaged 1.75. They then divided the P/B range into three intervals and found:
- For 10 observations, the P/B ratio was below 1.22. The average annual return in U.S. dollars in the four years that followed was 12.9% and never fell below zero.
- For 273 observations in the second interval, the P/B fell between 1.22 and 2.76. The average annual return in the four years that followed was 9.4%.
- In four observations, the P/B ratio exceeded 2.76. The average annual return in the four subsequent years was -5.1%, and was always negative.
Wide Dispersion Of Outcomes
As noted earlier, the current P/B ratio is 1.5, near the bottom of the range for the interval during which the MSCI Emerging Markets Index returned 9.4% over the succeeding four years, and not that far above the interval that produced 12.9% returns over the succeeding four years.
Keppler and Encinosa concluded that there has been a negative relationship between the P/B ratio and future returns in the emerging markets. They also warn investors that focusing on average returns hides a wide dispersion of outcomes.
For example, while their regression analysis led them to forecast a return of 12% per year for emerging markets over the ensuing four years, the data from the prior 28 years indicate the extreme outcomes lie between an annual loss of 8.8% and an annual gain of 36.9%.