GMO favors emerging markets value stocks

If the U.S. stock market seems overvalued to you, some prominent analysts are recommending a low-cost alternative — emerging markets stocks.

If that seems like lighting a damp Yule log with jet fuel, consider this: The price-to-earnings multiple on emerging markets stocks in February 2016 was lower than it was at the bottom of the 2009 stock market bottom. And earlier this year, U.S. stock market valuations were 120% higher than emerging markets stocks.

“It certainly indicates an old-fashioned level of extreme market inefficiency at the asset class level,” Jeremy Grantham, co-founder of GMO and chief investment strategist for the firm’s asset allocation team, writes on the firm’s website.

GMO’s seven-year projection for emerging markets value stocks is a 6.7% average annual gain after inflation, as opposed to a 4.4% average annual loss for U.S. large-company stocks. Note that GMO is recommending emerging markets value stocks: He projects a 2% average annual gain for all emerging markets stocks.

“We think that emerging markets are cheap relative to the rest of the world — not cheap-cheap,” said Peter Chiappinelli, member of GMO asset allocation team. “Only when we get to the value portion is it cheap, and relative to the rest of the world, it’s phenomenal.”

MSCI’s Emerging Markets Value Index has a trailing price-to-earnings ratio of 11.38, compared to 15.39% for MSCI’s Emerging Markets Index and 19.7% for the S&P 500. Its technology weighting is 12%, and its largest sector is a 35.2% weight in financials.

(For the risk-averse, it’s worth noting that 28.3% of the broad MSCI emerging markets index is technology — far more than the S&P 500 index’s 20% tech weighting.)

SHORT-TERM CAVEAT

In a short-term downturn, emerging markets are likely to fall more than U.S. stocks, Mr. Chiappinelli said. On the other hand, value investing typically rewards investors for buying cheap assets in the long run. “And if your time period is six months, what are you doing in equities?” he said.

For investors, the problem is getting a decent long-term return on their portfolio. Most pensions define that as about 4.5% annually after inflation. Given the outlook, that requires fortitude for advisers: What requires good long-term returns in the future might be scary. Mr. Grantham likened it to running Stalin’s pension fund. Good performance would get you a dacha on the Black Sea. Bad performance gets you dragged out into the garden and shot.

GMO isn’t the only group telling advisers to back up the truck for emerging markets. Research Affiliates projects a 5.9% average annual return from emerging markets the next decade, and a 0.3% average return for large-company stocks the same period. Looking at 10-year returns and looking for about 10% volatility, the company’s asset allocation model tilted heavily towards emerging markets — and avoided U.S. stocks entirely.

Related Topics: GMO LLC