Emerging Markets Look Cheap

12/16/2008 1:25 pm EST


Carlton Delfeld

Editor, The La Jolla Letter and Pacific Gains

Carlton Delfeld, editor of Chartwell Global ETF Advisor thinks value has returned to select emerging markets.

Using the best historic measures—normalized earnings, book value, and free cash flow—stocks around the world are very cheap, but not as cheap in absolute terms or versus interest rates as they were in the 1930s or at the 1974 bottom.

Nevertheless, the 3% dividend return on the Standard & Poor’s 500 exceeds the yield on the ten- and 30-year Treasury bonds for the first time in 50 years.

If emerging market equities, where the growth is, at six to eight times earnings, are not cheap, I don’t know what is. This chart shows some earlier major draw downs in emerging markets.

China’s growth rate will fall to 7.5% next year—its slowest for nearly two decades—the World Bank recently said. I suspect that it will be no more than 5%. The sharp cut reflects the rapid deterioration in the Chinese economy over the past two months, as a slowdown in the local housing market has combined with weaker demand from export markets.

The Chinese economy expanded by 11.9% last year and has been growing at double-digit
rates since 2002, although activity was cooling gradually in the first half of the year before the international crisis deepened. Even the reduced growth rate next year would rely heavily on higher public spending, the World Bank in Beijing recently said. While government spending contributed 1.5 percentage points of growth last year, it would add four percentage points in 2009.

My current pick, WisdomTree Emerging Market SmallCap Dividend (NYSEArca: DGS), has far smaller investments in the vulnerable Chinese, Mexican, Indian, and Russian markets than its rival large-cap funds.

It also has far less exposure to commodities producers or telecoms relative to emerging-market large caps. Instead, it concentrates in local consumer and business services, which should hold up relatively well as growth in emerging economies slows.

The companies in the DGS basket are collectively trading at a P/E ratio of seven times and a surprising low price/cash flow ratio of 4.7x.

Investors are realizing that smaller emerging market companies are more attractively priced and somewhat insulated from the turmoil in global markets. As a hedge, couple DGS with the inverse emerging market large-cap brother Short MSCI Emerging Markets ProShares (NYSEArca: EUM).

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