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Cheap Emerging Markets? Not With These ETFs

August 28, 2013 1:36 pm
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Cheap Emerging Markets? Not With These ETFs

There is no shortage of emerging markets that can be considered cheap or inexpensive when traditional valuation metrics are applied.

Nor is there a dearth of developing world equity markets that are currently in tailspins. Interestingly, not all slumping emerging markets are inexpensive on valuations. Actually, some of the worst offenders can still be considered expensive.

As is the case with those markets that are currently trading at discounts, much of the explanation for why some developing world equity markets are expensive has to do with which sectors loom large in those markets. Said another way, just as not all emerging markets are cheap, not all sectors within those markets are discounted, either.

Related: Inside Why Some Emerging Markets ETFs Are Cheap.

Sectors that currently trade at noticeable discounts to long-term averages, include energy and financial services, which is significant because those are two of the three sectors that usually dominate single-country emerging markets ETFs. However, the third sector, materials, had a P/E ratio of 18.7 at the end of July compared to a 10-year average of 13.6, according to WisdomTree data.

The other sectors that look richly valued in the emerging world are not surprises. Utilities had a P/E of 18.6 at the end of July compared with a 10-year average of 16.5 while staples checked in 24.4, well above the 10-year average of 19.4, according to WisdomTree. That shows investors will have to pay up to play defense regardless of where they want to play that defense, in the U.S. or emerging markets.

What Countries Are Expensive?
“The sector with the worst cumulative performance over the prior three years was Materials, down almost
25%. However, the sector’s P/E ratio as of July 31, 2013, is almost 40% above its 10-year average. How can this be? This is a good example of a sector that has seen earnings depressed during this latest cycle, which can push up the overall P/E ratio even in the face of falling prices. Brazil offers another, similar example, in that its P/E ratio is currently about 12% above its 10-year average and yet it has the worst three-year cumulative performance of all the country indexes we show,” said WisdomTree Research Director Jeremy Schwartz and analyst Christopher Gannatti in the research.

The iShares MSCI Brazil Capped ETF (NYSE: EWZ) allocates nearly 18 percent of its weight to materials stocks, the ETF’s second-largest sector weight behind financials. Slumping materials shares have been part of the reason EWZ and other Brazil ETFs have struggled so much this year.

If not for India, Brazil ETFs would be the worst performers in the BRIC group. The MSCI Brazil Index had a 13.7 P/E at the end of July, 12.3 percent above its 10-year average and well above the 11.3 P/E on the MSCI Emerging Markets Index.

Contributing to the rich valuations on EWZ is an almost 16 percent allocation to consumer staples. Speaking of staples leading to higher valuations, that is the case with the iShares MSCI Mexico Capped ETF (NYSE: EWW). EWW allocates 24.3 percent of its weight to consumer staples. Not surprisingly, Mexico is not cheap compared to other emerging markets. The P/E on the MSCI Mexico Index at the end of July was 29.3 percent above its 10-year average at the end of July.

EWW, which has lost nearly 11 percent this year, also allocates 17.2 percent of its weight to the materials sector.

Accessing Expensive Emerging Markets
Investors looking to access pricey emerging markets without the burden of managing single-country risk can consider the newly minted WisdomTree Emerging Markets Dividend Growth Fund (NASDAQ: DGRE). DGRE is underweight BRIC, which means cheap China and somewhat expensive India barely combine for 10 percent of the new ETF’s weight.

However, even more discounted Russia and expensive Brazil combine for 26.7 percent of DGRE’s weight. South Africa, Indonesia and Mexico, all of which had P/E ratios that were above their 10-year averages at the end of July, combine for 35.6 percent of DGRE’s weight.

At the sector level, DGRE does a good job of balancing discounted and expensive groups. Materials, staples and utilities are the emerging markets sectors that trade furthest above their 10-year averages, according to WisdomTree. Those sectors combine for about 34 percent of DGRE’s weight.

The most discounted emerging markets sectors are financials, telecom, energy and technology. Those groups represent 47.7 percent of the new ETF’s weight.

For more on ETFs, click here.

Disclosure: Author owns none of the securities mentioned here.

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