A close look at history suggests this may not be the case.
Emerging-markets stocks are typically viewed as an asset class offering the potential for higher, albeit volatile, returns, and as a source of diversification. While these traits may still generally hold, this asset class has evolved significantly over its relatively short life span, so any analysis of current valuations of emerging markets should be viewed in this context.
Like any asset class, the long-term performance of emerging-markets stocks is driven by current valuations. At this time, the most common barometer of developing markets' stocks, the MSCI Emerging Markets Index, is trading at a trailing P/E ratio of 12, below its 18-year average of 16. Its discount relative to the MSCI USA Index, which is currently trading at 19 times, is also near eight-year highs. Current valuations would seem to suggest that emerging-markets equities are poised for strong absolute and relative performance over the next decade. However, a closer examination of the history of the emerging-markets asset class suggests that they may not be cheap after all.
Emerging Markets: A (Short!) History
Emerging-markets stocks, as an investable asset class, are only about 25 years old. The first emerging-markets funds available to U.S. investors had their inception in the mid-1980s, and the MSCI Emerging Markets Index launched in 1988. At its inception, the MSCI Index included 10 countries, with Malaysia (33%), Brazil (19%), and Chile (9%) representing its three largest country constituents. Current heavyweights such as China, Taiwan, and South Korea were not added until 1996.
In the early years, emerging-markets stocks suffered some serious growing pains, including hyperinflation in Brazil, the Mexican peso crisis in 1995, the Asian financial crisis in 1997, and Russia's debt default in 1998. Suffice it to say, investors didn't really take to the asset class during that period, and, by the end of 2000, assets in U.S.-domiciled diversified emerging-markets funds were still low, at $16 billion (versus $385 billion at the end of 2013).
The "growth" story really took off about 10 years ago, thanks to a confluence of factors. First, the Chinese growth machine was operating at full speed. Annual gross domestic product growth rates were clocking in around 10%, thanks to economic reforms, strong export growth, and heavy investment in factories, infrastructure, and housing. Export growth was supported by low interest rates in the developed world, which drove a multiyear consumer spending boom. And thanks to China's capital investment spree, commodity prices skyrocketed, benefiting resource-rich countries such as Brazil, Russia, South Africa, and Indonesia. Emerging-markets sovereigns were also growing more fiscally stable. After the crises of the 1990s, many developing nations began to address their fiscal and balance-sheet issues, which resulted in a more stable macroeconomic environment and less currency volatility. And overall growth was strong--annual GDP growth rates in many emerging markets were trending in the high single digits.
All of these positive trends translated into exceptional equity market returns. From 2001 to 2010, the MSCI Emerging Markets Index (in U.S. dollars) returned an average of 15.8% a year, compared with the MSCI USA Index's 1.5%. Strong GDP growth and stellar equity market performance combined with improved access to the developing world's capital markets resulted in strong investment flows. By the end of 2010, assets in U.S.-domiciled emerging-markets funds had risen almost 20 times, from 10 years prior, to $300 million. Emerging-markets stocks were having their heyday.
- source: Morningstar Direct and MSCI
While the MSCI Emerging Markets Index was generating annual returns of 20% to 50% from 2003 through 2007, valuations remained "reasonable" on both an absolute and relative basis. From 2001 to mid-2007, the MSCI Emerging Markets Index's trailing 12-month P/E ratio ranged from 11 to 16 times and was consistently lower than the P/E ratio of the MSCI USA Index.