Are Emerging Markets Still Cheap?

February 22, 2006

As EEM’s asset count tops $12 billion, we ask: Are emerging markets still a good deal for investors?

I'm hearing more and more talk these days about an emerging markets bubble.  It's easy to see why.  All the markers are there: the overconfidence, the magazine covers, the dreams of never-ending 30 percent returns. I'm starting to hear stories from friends and relatives about their favorite Russian mutual funds, Indian bank stocks and Brazilian petrochemical giants. That always makes me nervous.

Emerging markets went up 56 percent in 2003, 26 percent in 2004, and 34 percent in 2005 … and those returns have grabbed investor attention, and attracted investors' assets.  The iShares MSCI Emerging Markets (EEM) exchange-traded fund (ETF) is one of the fastest growing mutual funds in the world, with assets already over $12 billion. And it's not the only fund doing well: So far this year - and it's only February, remember - investors have socked $15.8 billion into emerging markets, according to Emerging Portfolio Fund Research.  That's half as much as they fed into domestic funds in all of 2005.

Of course, as an indexer, this is all nonsense.  The most sensible investment strategy is to stay the course - to maintain a small but steady exposure to emerging market economies.  Emerging markets represent about 6.5 percent of the world's gross domestic product, so one reasonable approach would be to assign about 6.5 percent of your portfolio to the emerging markets sector.

But the huge returns - and the huge claims made by proponents - merit further investigation.  Even indexers don't like to get swept up in bubbles.  Are emerging markets still a good deal?  Are they way overblown? 

As an added bonus, I thought I'd look under the hood of the EEM ETF, to see what exactly you get when you invest in the world's leading emerging markets portfolio.

Are Emerging Markets A Good Deal?

It's a rare investment that can shoot up 162 percent in three years and still be considered a good deal.  But the iShares MSCI Emerging Markets fund just might pull it off.

Thanks to strong performance by the underlying equities, and very low original valuations, the index enters 2006 trading at just 15 times trailing earnings.  For comparison, the S&P 500 trades for 19 times earnings. In fact, according to State Street Global Advisors (SSgA), the amazing run in emerging market stocks over the past three years has hardly changed the valuation of the index at all.

MSCI Emerging Markets Index

Jan. 2003

 Jan. 2006

Price/Earnings Ratio



Price/Book Ratio



Price/Cash Flow



Dividend Yield




The price/book ratio has risen significantly, but even that has not moved beyond global norms. For comparison, the MSCI Developed Markets ex-US index (EAFE) trades at the same 2.4 times book value (as well as a richer17 times earnings and 10 times cash flow, with a 2.3 percent yield).

SSgA expects earnings growth for emerging markets to top 14 percent in 2006, leaving EEM with a price-to-earnings-growth (PEG) ratio of 1.1.  By contrast, U.S. equities are expected to grow earnings just 10.8 percent in 2006, creating a PEG ratio of 1.76.

In sum, equity valuations don't seem to support the hypothesis of a bubble.

"Valuations make it more difficult to argue for dramatic outperformance of emerging markets, but otherwise the fundamentals still look reasonably good," says Brad Ahram, head of emerging markets at SSgA. "With good global growth and continued low interest rates, there appears to be little to derail emerging markets other than the psychological burden of three good years of performance."

Among individual markets, Ahram is most worried about India, which trades at a relatively high book value of 4X, and 15X cash flow.  Then again, one would expect India's market to trade at a relatively high book value, given its focus on information technology and its relative lack of resource intensive industries.  India is expected to be the second fastest growing country in the world next year, behind China.

A Word About Debt

The one data point that does speak to a "bubble risk" lies in the fixed-income market, where the spread between emerging markets debt and U.S. Treasuries is the lowest in history.  Investors are demanding just 211 basis points in excess return to hold emerging markets debt, suggesting that the risk premium assigned to emerging markets (against the U.S.) is the lowest ever.

There are three possible explanations:

1) Less risk: One theory is that, after the Asian crisis of 1997, emerging market economies got their collective act together, floated their currencies, and embraced basic market reforms. Towards this end, some analysts expect certain "emerging market economies" - such as South Korea - to graduate into the "Develop Markets" index in the coming months.

2) More risk in the U.S.: Treasuries are supposed to be the safest investment in the world.  But with spiraling deficits, an ever-growing derivatives market and emerging entitlement overhang, some risk premium could be creeping into our bonds.

3) Bond holders are nuts: The risk premium shrunk before the 1997 crisis, and the bond market was left with egg on its face and holes in its pockets.  Bond traders are fallible.

The dimishing spread between U.S. and Emerging Markets debt doesn't necessarily mean that investors are ignoring risk, but it might. Credit spreads are often a barometer of the market's risk tolerance, and 211 basis points looks a bit complacent.

What Is The MSCI Emerging Markets Index?

The most common way for indexers to get exposure to emerging markets is through the iShares MSCI Emerging Markets fund, or EEM. This ETF is one of the fastest growing mutual funds in the world, and boasts assets of more than $12 billion.  But not all investors take the time to learn what they're buying before they jump in. Here's a look under the hood.

The MSCI Emerging Markets Index is a free-float index covering 26 different emerging economies:  Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey and Venezuela.

The index aims to capture 85 percent of the publicly available market capitalization in these countries.  The impact of that qualification is two-fold: 1) The index ignores the smallest, least liquid names; 2) The index doesn't hold shares in (wholly) government owned companies, which in some countries, represent the largest firms (Mexico's PEMEX oil and gas company comes to mind).

The iShares fund tracking the index only holds 21 of the 26 economies: Columbia, Egypt, Jordan, Morocco and Pakistan don't make the cut, thanks largely to investing restrictions against foreigners. That's too bad, as those countries performed incredibly well in 2006: Egypt was the best performing market in the world, up 162 percent, while Columbia (102 percent), Jordan (93 percent) and Pakistan (62 percent) weren't shabby either. I couldn't find the performance of the Moroccan market.

For people who don't follow the index closely, the country weightings can be a surprise.



South Korea


South Africa


















* Source, BGI. As of 12/31/05.

The BRIC countries that grab the headlines when people talk about emerging markets - Brazil, Russia, India and China - represent just 28 percent of the index. That's less than the two "souths" - South Korea and South Africa, which represent over 30 percent of the index.  I'd guess many of the investors in EEM think they're buying BRIC exposure, when they'd be better off piecing that together through a variety of funds.

In fact, one Korean company - Samsung - has more weight in the index than either Russia and India, and nearly as much weight as China. As of February 22, Samsung represent 6.62 of the index.

The index is fairly well balanced on a sector level, with large holdings in a number of industries.





Semiconductors & Semiconductor Equipment


Telecommunications Services








Technology Hardware and Equipment


Software and Services


Pharmaceuticals and Biotechnology




The fund charges 0.75 percent per annum.

Among other choices for index investors is the Dimensional Fund Advisors Emerging Markets Value Fund (DFEVX). Like other DFA funds, DFEVX is only available through DFA-registered financial advisors.  Since the launch of EEM in 2003, the two funds have more or less tracked one-another. In fact, they were exactly tied at the start of this year.  In the past six weeks, however, the DFA fund has pulled slightly ahead. Like most DFA funds, DFEVX tilts towards small caps and value stocks: Morningstar calls DFEVX a "mid-value fund," while EEM is a "large-blend fund."

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