Good prices, CAPE Ratios, and why I buy Emerging Market stocks.
It is a common adage to buy low and sell high. We also know that trying to time the market is a bad strategy. Right now, the United States market feels expensive. Many different analysts have expressed fear that the United States stock market is either at or approaching the end of a cycle, which could lead to slower stock market growth or dropping stock prices in the future. It is important to make sure that your asset allocation is set so you do not have all your eggs in one basket. Specifically, you want to make sure that you own the parts of the world that are currently cheap so that you can participate if they begin to gain in value.
Buy What’s Cheap
To buy what’s cheap, you must first know how to find it. This is a challenge. Low prices often reflect fundamental problems which can drive prices even lower. The challenge of finding what good value instead of bad companies is sometimes known as the “value trap.” One way to measure what’s cheap in terms of countries or regions is to use a CAPE ratio, which basically measures how expensive a country’s markets are as a whole. Right now, the United States is on the expensive side when compared to both Developed and Emerging Markets. While there is always a possibility that an asset class could be a value trap as a whole, diversified exchanged traded funds will normally hold more of the big names which perform well for their regions.
For example, in the Emerging Market space, Alibaba, Tencent, and Baidu are have performed extremely well in the past, have moats that protect them from competitors (think of the enormously popular game Fortnite by Tencent).
CAPE Ratios are a Good Way to Measure Cost of Stocks
The CAPE ratio is calculated by using real earnings per share over a 10 year time period. In other words, it is a measure of how expensive stocks are. Here are some current CAPE Ratio numbers for different markets as of October 31, 2018. Lower numbers are less expensive.
All of the above data is from StarCapital Research.
Clearly, Emerging Markets are on sale right now, and some Emerging Market countries, like Russia, are extremely inexpensive. US stocks are also quite expensive, although not nearly as much as Ireland.
I believe that starting at a lower relative valuation leaves much more room to grow in the future. Because of this, I am holding approximately 10% of my long term portfolio in emerging markets stocks. Cambria Funds’ Meb Faber has actually published numerous pieces on how emerging markets are inexpensive. You can find these on his website, mebfaber.com. Of course, low starting valuation does not mean the stocks will do well, it just means that they are starting at a more palatable valuation for long term growth.
Exchange Traded Funds Offer a Low Cost Way to Buy Emerging Market Stocks
First of all, there are two main index families that are used by most Exchange Traded Funds which purchase Emerging Markets. They are MSCI and FTSE. A quick Google search can tell you which index the ETF you want to buy uses. Importantly, MSCI and FTSE disagree on which countries should be classified as developed vs emerging vs frontier. This means that mixing ETFs from both indexes could make you accidentally double weight a country or purchase none of a country (like South Korea). This could create higher country risk than you may want. In other words, stock to only FTSE or MSCI ETFs in your portfolio for developed and emerging markets unless you have a good reason to do otherwise (like to avoid a tax “wash” sale).
Here are three of my top choices for ETFs and one bonus:
SCHE: The cheapest of the bunch at 0.13% in annual fees. This one is my number one choice. It is market weighted and almost identical to the next fund from Vanguard, making the largest holding Tencent.
VWO:– You can never go wrong with Vanguard indexes, especially not the broad ones. This is also very cheap at 0.14% in annual fees and is a good buy if you prefer Vanguard. This index is also market weighted.
FNDE: This fund is priced at 0.39% making it more expensive than the market-weighted indexes from Schwab and Vanguard. Instead of weighting by market price, it weights companies by fundamental size and other factors. The benefit of this is that you are less concentrated in the largest Emerging Market companies like Tencent which also tend to be more speculative. In this fund, the current largest holding is Samsung, and Tencent is not even in the top 10 holdings. This fund is based on excellent research by Research Affiliates and Rob Arnott.
EYLD: This ETF from Cambria Funds is the most expensive of the bunch at a 0.69% expense ratio but it uses an interesting strategy of dividends plus buybacks to invest in Emerging Markets. This strategy should focus on companies with both quality and low financial leverage which could help avoid certain bad apple emerging market companies. This fund is based on research from Mebane Faber and Cambria Funds. Neither Samsung nor Tencent is a top 10 holding in this fund and the largest holding is Transcontainer PJSC, a Russian company.
I do not think that your whole portfolio should be Emerging Market stocks, however, I do think that you should have a sizable exposure. They are valued quite low right now when compared to other stocks from Developed Markets including the United States. I personally hold around 10 percent in Emerging Markets. The important thing is that you have some foreign exposure outside of your own home country.
I recently wrote a piece on My 2018 Investment Portfolio in which I discuss what else I invest in outside of emerging market.
Disclosures: I am long SCHE, VWO, and FNDE.