MSCI EM Valuation Triangulation – Upside After Four Year Decline?

Using a triangulation of three value philosophies, viz.: mean reversion, P/E model, dividend discount model, analysts at Goldman Sachs peg the fair value of the MSCI EM at 882, translating into a 6% upside potential.

Caesar Maasry and colleagues at Goldman Sachs in their October 9, 2015 research report titled: “EM Valuation Triangulation” remain focused on identifying a stabilization in the emerging markets growth cycle before turning more positive.

MSCI EM valuation triangulation

Maasry et al. point out that EM assets have been under pressure for almost five years, with MSCI EM touching a peak on May 2, 2011. The analysts note since April 2015, MSCI EM has dropped 25% and investor focus has shifted to the question of downside support and valuation.

Though there is no dearth of literature or methodology concerning equity market valuation, the GS analysts aim to accomplish three goals: (a) to adopt a standardized methodology to value EM equity across regions, (b) to interpret different methodologies and explain why they give different results, and (c) to combine the approaches to compute a reasonable ‘fair value’ estimate for MSCI EM.

Starting with mean reversion, Maasry and team point out that on a forward P/E basis, MSCI EM has crossed over its long-term mean of 11.9x a total of 19 times since 1989. The analysts note the frequency with which valuation mean-reverts is quite irregular. They also note that valuation stayed well below mean from 1999 through 2005 and from 2009 through 2014.

Since the information content of a cyclically-adjusted P/E ratio is found to be quite similar to that of a P/B ratio and given the simplicity of calculation of the latter, the analysts prefer to include that metric in their mean-reversion model:

Maasry et al. point out that the mean reversion model suggests 17% upside for aggregate EM. However, they reiterate that this model would have suggested buying EM since 2011 (a false signal most of that period) and offers little insight as to the catalyst that would likely drive EM equity prices higher:

EM has 6% upside

Focusing on their second value philosophy, the GS team argue that the ‘fair P/E’ model suggests that MSCI EM should be valued at 10.7x forward earnings, roughly in line with the current 10.8x PE. They point out that their model depends much more on long-term GDP growth expectations than ‘year-2’EPS. Keep in mind that the results of their model are broadly in line with the relationship between valuation and macro variable observed in Asia. For instance, longer-term GDP has the largest positive impact to valuation, while a discount factor has a negative relationship with equity valuation:

Delving deeper into their dividend discount model (DDM), Maasry et al. anticipate EM ‘local risk free’ rates to be 4.7%. Based on their DDM, the analysts believe MSCI EM at current levels is pricing in roughly a 5.0% risk-free rate, or 30bp of tightening. By holding all else equal, the analysts observe that 1% higher risk-free ratesdetract 8pp from fair value in their DDM analysis:

By putting together their three models, Maasry and colleagues suggest EM has 6% upside to its ‘fair value’:

Abrazos,

PD1: Y sin embargo, invertir en EEUU tiene cierta estabilidad también, ya que las subidas siempre son mucho mayores que las bajadas…

The Power of Defense

Good defense is more important than good offense not just on the football field, but on the investing field as well. Stocks experienced double-digit drawdowns in each of the last eleven decades, with the pain averaging -38%. Let’s take a look at some of the gains and losses to get a better feel of how debilitating these declines can be.

From November 1903 through January 1906, the Dow Jones Industrial Average gained 127%. Over the next twenty-two months, the Panic of 1907 brought about a 43% decline, which wiped out nearly eighty percent of the advance generated through the previous bull market.

The entire bear market from 1966-1982 was particularly excruciating with vicious rallies and disgrosting drawdowns. The selloff from December 1972 through September 1974 ripped a 40% chunk out of the index. The 65% gain over the following 27 months wasn’t enough to make investors whole again.

The table below shows the max gains and drawdowns buy and hold investors would have received over each of the previous eleven decades.

Here are a few caveats to the table:

This is price return only (using monthly closing prices), max gains would be even more enticing using total returns.

Nobody bought and held the Dow in 1905.

Nobody actually measures investment returns from decade to decade; this is a mental exercise, leave it at that.

I highlighted two examples (1907, 1974) where 60%+ gains were no match for forty percent drawdowns. However, the truth is that many of these declines were but a pimple on a bull market.

The average intra-decade gain was 223% and lasted for 73 months. The average intra-decade decline was 38% and lasted for sixteen months. Each decade looks vastly different, indicating that one of the only constants in investing is change.

Having a diversified portfolio is the best way for 99% of investors to play defense. There are legitimate ways to limit drawdowns, but of course nothing works every time. It’s likely that in an attempt to avoid volatility, most investors end up avoiding returns. While it’s true that stocks have been in at 20% drawdown 21% of the time, I believe that investors are best served focusing on the fact that stocks have been at or within 5% of all-time highs 43% of the time

PD2: Expectativas de revalorización de los mercados:

Los mejores son los emergentes, que se estima una rentabilidad real (descontada la inflación) del 8%, mientras que en EEUU no alcanzará ni el 1% real en 10 años, ¡Ay!

Esta ha sido la historia, recuerda, la historia, que quizás no se repita: