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Shifting Sands in Foreign Equity Markets

The landscape has changed just as much outside of the U.S. in the five years since the credit crisis.

Five years from the nadir of the global financial crisis, American commentators have focused their postmortems mostly on what has happened in the United States. While the shifts have been tectonic here, everything from a rethink of housing to unprecedented Federal Reserve intervention, the upheaval in financial markets has been just as significant overseas. In some ways, the remodeling outside of the U.S. has been even more fundamental.

Emerging Markets: Beyond Oil and Ore
What these changes mean for investors is that they may need to redraw their mental maps of overseas markets. Nowhere is this more true than in emerging markets. Many long-held assumptions about emerging markets no longer apply five years after the crisis. For years, many thought of emerging markets as fairly homogenous economies dominated by commodity-oriented sectors such as energy and materials. The precrisis boom in commodity prices and the resulting growth in places like Brazil and Russia likely reinforced this perception.

But overall, emerging markets are now less driven by those two sectors. In October 2008, energy and materials stocks consumed nearly a quarter of the MSCI Emerging Markets Index. Today, that combined weighting is below 20%. The recent bankruptcy of Brazilian Eike Batista's oil company OGX is a symbolic epilogue to the mid-2000s boom.

Instead, less commodity-oriented businesses have become much more prominent in emerging markets. Technology companies have made some of the biggest strides, with Samsung Electronics,  Taiwan Semiconductor Manufacturing (TSM), and Tencent Holdings now qualifying as three of the five largest companies in the MSCI Emerging Markets Index. Granted, Samsung and Taiwan Semiconductor are mature companies, but Tencent has grown rapidly in the nearly 10 years since it went public and now has a market cap close to $100 billion. Technology's standing in the index is likely to continue growing with Chinese e-commerce company, Alibaba, set to go public in the coming weeks.

These trends are reflected in the index's composition. Technology stocks now account for nearly 15% of the MSCI EM Index, up from 11% in 2008. That weighting isn't that far below the 17.8% that technology occupies in the S&P 500, and it's miles ahead of the 3.2% tech weighting in the MSCI Europe Index. But emerging-markets companies remain scarce in health care. That sector makes up just 1.6% of the index versus 13.0% of the S&P 500.

Branded Companies Thrive on Wealthy Consumers
One common theme across markets has been the increasing prominence of branded consumer-goods companies. Although many people have struggled as their incomes have stagnated or fallen since the crisis, wealthy consumers have been thriving globally. Even as growth has slowed in emerging markets, many consumers there now have the disposable income to spend on branded products, many of which are produced by companies based in developed markets.

Luxury brands have fared best, particularly those from Europe. The shares of upscale spirits companies  Pernod Ricard RI and  Diageo (DEO) have doubled during the past five years, thanks largely to their growth in emerging markets. Such stocks now count for a larger share of the major indexes. Consumer discretionary and consumer staples stocks combined now account for a slightly larger 22% share of the MSCI EAFE Index versus less than 19% in 2008.

Even though there are still few global consumer brands emanating from emerging markets, these two sectors have grown even more there. The combined consumer discretionary and staples weighting has increased from 11.5% of the MSCI EM Index in 2008 to 17.0% currently, benefiting from the emerging middle class.

Financials Increasing Share in the Emerging World
Sure, the share prices of U.S. and European financials have begun to recover after being decimated by the crisis. Bank stocks such as  Wells Fargo (WFC) and  JPMorgan Chase (JPM) in the U.S. and  Lloyds Group (LYG) and  Credit Suisse in Europe have all rebounded since 2008.

But, at least in the developed world, financials still claim a far smaller share of their respective indexes. Whereas financials accounted for 30% of the MSCI EAFE Index in early 2007, today they're less than 26%. The decline has been even more pronounced in the U.S., which is somewhat surprising considering that American financials have been lauded for recovering relatively quickly. Nevertheless, financials currently account for just 16% of the S&P 500 after claiming more than 22% of the index in early 2007.

With economic growth creating greater demand for financial services, that sector has actually grown in emerging markets. It has increased its share of the MSCI EM Index to more than 26% from 21%. That growth was helped along by Agricultural Bank of China's record $22 billion IPO in 2010, although the share price has fallen since then.

Price Multiples No Longer Depressed Overseas
Following the crisis, the U.S. rebounded more quickly than the other developed markets. U.S. markets hit bottom in March 2009 and, despite corrections in 2010 and 2011, the bull market has entered its fifth year. The road out of purgatory was slowed significantly in Japan and Europe because of the Fukushima disaster and Greece's debt crisis in 2011. While these events--along with domestic wrangling over the debt ceiling--hit all markets, the U.S. quickly escaped the mire (at least for the time being).

With foreign stocks on a slower trajectory, their shares looked comparatively cheap heading into 2012, especially those in Europe. At the Morningstar Investment Conference in June 2012, Leuthold's Doug Ramsey said that European stocks were the cheapest they had been in decades. Indeed, the average stock in the MSCI Europe Index was trading at just 10 times earnings and the average price/book was less than 1.4 times, slightly below where it had been during the worst of the credit crisis.

Those who acted on Ramsey's advice have plenty to smile about, with the MSCI Europe Index up 42.7% since then versus the S&P 500's 37.4% gain. Not surprisingly, European stocks are no longer the bargain they once were. Price multiples have increased in many equity markets, but especially for European shares. The average P/E for the MSCI Europe Index is now above 15, its highest level since year-end 2006.

Morningstar's own stock research corroborates this. The 205 companies in the MSCI Europe Index that are currently covered by Morningstar analysts have an average price/fair value estimate of 1.05, which is in line with the 1.04 for the entire coverage universe. A case could be made that emerging markets look cheaper with lower average price multiples. But after a recent rally, even the average emerging-markets stock covered by Morningstar has a price/fair value of 1.01.

Where stock prices and valuations go from here is anyone's guess, but bargains are undoubtedly harder to find internationally than they were five years ago, or even 18 months ago.

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