Much has been made recently of the weak performance of Emerging Market (EM) equities both on an absolute and a relative basis.  As we can see in the following chart, through February 2, 2014, Emerging Market equities (as measured by the iShares MSCI Emerging Market ETF – EEM) are down 14.5% since the beginning of 2013.  On a relative basis, EM has underperformed US Small Cap stocks (as measure by the Vanguard US Small Cap ETF – VB) over the same time period by 45.2%.

Source: Kwanti

 

As is so often the case with financial market turbulence, Wall Street and the financial press aren’t short of material to describe the causes of unusually strong or weak market performance.  As an example, a recent Barron’s blog post included this section to help investors “understand” why EM equities have been so weak.

This year, we’ve had a series of unfortunate events that caused a broad-based emerging markets sell-off. We have more evidence of Fed tapering from the central bank’s meeting in January; a worse-than-expected manufacturing PMI reading from China, a potential $500 million trust loan default rescued at the last minute; and political turmoil in Turkey and Ukraine as well as devaluation from Argentina and Venezuela.

Source: Barron’s  – “EM’s Contagion Risk May be Low Despite The Turmoil”, 2/4/14

The underlying premise here is that this information will help investors make better portfolio decisions.  In practice, however, it does the complete opposite. How?  By implying that investors should avoid EM equities either because of bad fundamentals or weak performance.

We can use a simple valuation equation, the Gordon Growth Model, to illustrate the flaw in this premise.  The Gordon model calculates the present value of any asset with future cash flows that grow at a constant rate in perpetuity, and discounted at the required rate of return.

P = D/(k-G)

Where:

P = Present value of future cash flows

D = The next period dividend (cash flow)

k = Required rate of return

G = Expected growth rate

We can rearrange the terms to solve for k.

k = D/P + G

The required rate of return on the left side of the equation can also be thought of as an expected rate of return as they are two sides of the same coin. On the right hand side, D/P is the dividend yield and G is the expected growth rate in dividends.  We use GDP growth rate as a proxy for the dividend growth rate (a reasonable proxy as these are broad-based index funds).

 

iShares Emerging Market ETF (EEM)
  1/1/13 2/3/14
D $0.74 $0.85
P $44.35 $37.09
D/P 1.7% 2.3%
G (real) 5.5% 5.1%
Inflation (US) 1.6% 1.5%
G (nominal) (US) 7.1% 6.6%
 
k (US Currency) 8.8% 8.9%

Source: iShares, International Monetary Fund, Federal Reserve

 

Vanguard Small Cap ETF (VB)    
  1/1/13 2/3/14
D $1.50 $1.42
P $80.93 $104.31
D/P 1.9% 1.4%
G (real) 2.6% 3.0%
Inflation 1.6% 1.5%
G (nominal) 4.2% 4.5%
 
k 6.1% 5.9%

Source: Vanguard, International Monetary Fund, Federal Reserve

 

What is interesting here is that despite the recent headlines and weak performance, the required rate of return on EM equities is roughly the same as it was a year ago and higher than US Small cap stocks.

If the chart above portrays a “problem”, it is with US Small cap stocks, which have returned a much higher rate over the past year or so than could reasonably be expected as calculated using the Gordon Growth Model.  On the other hand, the calculated required rate of return for EM equities suggests, at least on a relative basis, a better opportunity for long-term investors.