Will the U.S. Remain Supreme Against Emerging Markets?
GuruFocus.com
With global markets being dragged down by a slowing China, many are worried about the spillover effect into other developing economies. Unfortunately for emerging market investors, the negative effects wouldn't be the start of underperformance. For a decade, emerging market equities have lagged those of developing markets.
How did this happen? Are emerging market equities now a bargain? In his latest quarterly letter, GMO's Jeremy Grantham (Trades, Portfolio) pondered the same question:
"Relative to what we were thinking five years ago, emerging equities have done surprisingly badly, and the U.S. equity market has done surprisingly well. Was that the luck of the draw, which has no bearing on future returns? Was it a temporary phenomenon that will soon reverse? Or does it tell us something important about emerging being a value trap and/or the U.S. being extraordinary that we need to take into account in our forecasting of the future?"
To estimate whether a stock is overvalued or undervalued as a whole, Grantham typically recommends calculating a true book value and estimating a typical, long-term ROE. While this is easier said than done, it allows investors to know what they're paying for the business in comparison to its current value, while also placing a premium or discount on shares based on future growth.
One of the biggest contributors to the decade-long fall of emerging markets has been a decline in ROEs. If a company can't earn as much on its asset base, shares are of course worth less. GMO has done their best to calculate a "normalized" ROE for emerging markets, and it's remarkably close to today's actual rates. This suggests the last decade of ROE declines may not be an anomaly.
Even worse, emerging markets typically can't retain 100% of their returns on equity. For example, many firms need to divert returns not just to shareholders, but to other stakeholders such as government projects (Grantham gives the example of Gazprom and Russia). This makes actual emerging market returns much less than the theoretical return on equity. Over the past 20 years, GMO estimates that real local returns on emerging market stocks has been roughly half of what typically can be expected of a firm retaining all of its profits.
So, the decade-long decline of emerging market equities may be largely warranted, due to diminishing returns and an inability for those companies to utilize those returns. Relative weakness to U.S. markets, however, may have less to do with emerging markets than with the U.S. itself.
For whatever reason (demographic, geographic, fiscal, cultural, or a combination), the U.S. stock market has been an anomaly in global markets, finishing 1.2 standard deviations above average country returns since 1990. Much of this outperformance has come in the past 25 years.
One of the biggest reasons why this has occurred has been a consistently higher return on profits compared to both European and developing countries. ROEs in the U.S. have also risen steadily on average over the past 40 years, resulting in a higher valuation multiple, pushing returns up even more. But is U.S. supremacy here to stay?
As mentioned, the two factors driving U.S. outperformance are higher earnings and higher valuations. The chart above shows ROEs near all-time highs, while the Shiller P/E (below, which estimates long-term market valuations), is also nearing historic highs. These two factors may not last the next decade, though.
U.S. corporate profits as a percentage of GDP (below) is nearly two standard deviations away from its long-term average. If this figure reverted, the supremacy of U.S. equities would surely come to an end. If you believe that the past decade's levels are here to stay, here are some of investings most respected minds on its proclivity to mean-revert:
"In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well.
- Warren Buffett (Trades, Portfolio), Mr. Buffett on the Stock Market (November 1999)
Jeremy Grantham (Trades, Portfolio), 2006
"Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly."
- Jeremy Grantham (Trades, Portfolio), Barron's (c. 2006), via Katsenelson, The Little Book of Sideways Markets.
John Hussman (Trades, Portfolio), 2013
"In general, elevated profit margins are associated with weak profit growth over the following 4-year period. The historical norm for corporate profits is about 6% of GDP. The present level is about 70% above that, and can be expected to be followed by a contraction in corporate profits over the coming 4-year period, at a roughly 12% annual rate. This will be a surprise. It should not be a surprise."
- John Hussman (Trades, Portfolio), Two Myths and a Legend (March 11, 2013)
While these famed invesors have been clearly wrong over the past decade, capitalism would have needed to go through a structural and permanent shift for profits to remain as elevated as they are today. If this is the case, perhaps emerging markets will continue to lag behind a significantly more lucrative U.S. market. If valuations and earnings revert, however, it could provide the backdrop for a resurgence in emerging equities. Based on current fund allocations, it doesn't appear as if many managers are betting on that outcome. Only time will tell if playing the contrarian results in outsized profits.
