You have a choice to invest in asset class A, which has a one-year forward-looking price-to-earnings (P/E) ratio of 10.6; or asset class B, with a P/E of 15.7. The P/E of B is 48% higher than it is for A. You then look at another valuation metric, the price-to-book (P/B) ratio. You find that A has a P/B of 1.1, while B has a P/B of 2.5. The P/B of B is 2.3 times that of A. And for investors focusing on dividend yields, the yield on A is 2.9% versus 1.9% for B.
A is cheaper by all three metrics. However, perhaps B has better growth prospects? The weighted average historic three-year earnings growth of A was 16.1%, 45% higher than the 11.1% growth for B. The weighted average estimated three- to five-year growth of earnings for A is 15.7%, 21% higher than the 13.0% estimated growth for B.
Comparing the P/E relative to expected earnings growth (the PEG ratio), we find that the forward-looking PEG for A is 0.68 (10.6/15.7) versus 1.21 for B (15.7/13.0). Relative to forecasted growth in earnings, B is trading 1.78 times higher.
Here are some other interesting facts:
- As a group, year-over-year growth in real gross domestic product (GDP) for the countries in A was 5% versus 3% for B.
- The countries in asset class A make up about 28% of the global GDP, higher than the 25% share for B. However, A makes up not much more than 10% of the global market capitalization, while B makes up more than half.
Emerging Markets Vs. US
By now you likely have figured out that A is emerging market stocks, as represented by the S&P Emerging BMI, and B is the S&P 500 Index. All data is from S&P Dow Jones Indices’ Indexology blog. We can add one more valuation metric, the cyclically adjusted price-to-earnings (CAPE 10) ratio, which is as good a predictor of long-term real returns as we have. CAPE 10 ratios as of the end of October 2018 for emerging markets and for the S&P 500 Index translate into forward-looking real-return forecasts of 6.8% and just 3.4%, respectively.
Despite representing about one-eighth of global equity market capitalization, and despite the attractive valuations and growth prospects, the vast majority of U.S. investors have portfolios that dramatically underweight emerging market stocks. In addition to fears of a global trade war and increased competition from rising U.S. interest rates (which help explain the current low valuations, meaning those risks are already priced into the market), the underweighting often is a result of two mistakes.
The first, and most prominent, is the well-known home country bias, which causes investors all around the globe to confuse familiar investments with safe investments. Surprisingly, investors tend to believe that not only is their home country a safer place to invest, but it will produce higher returns—defying the basic financial concept that risk and expected return are related.
The second mistake is that investors are subject to recency—allowing more recent returns to dominate their decision-making. From 2008 through October 2018, the S&P 500 Index returned 8.1% per year, providing a total return of 133%. During the same period, the MSCI Emerging Markets Index returned just 0.3% a year, providing a total return of just 3%. It managed to underperform the S&P 500 Index by 7.8 percentage points per year and posted a total return underperformance gap of 130 percentage points.
Compounding the problem was that not only were investors earning much lower returns from emerging market stocks, but they were experiencing much greater volatility. While the annual standard deviation of the S&P 500 Index was about 15% per year, that of the MSCI Emerging Markets Index was about 22% per year. Not exactly a great combination—lower returns with 50% greater volatility. What’s to like?