No More Bears for Emerging Markets Unsettles Investors

Harris Associates LP’s David Herro
“After all this money has flooded in, with everyone in love with them and all the euphoria surrounding them, it’s hard to find fundamental value,” said Harris Associates LP’s David Herro. Photographer: Jeff Carlick. Bloomberg

Individual investors are pouring money into emerging-market stocks at the fastest pace since 2007 as the biggest rally in 16 years spurs three of the world’s largest banks to predict shares will hit record highs next year.

The last time investors were this bullish, the MSCI Emerging Markets Index sank 11 percent in three months, data compiled by EPFR Global and Bloomberg show. The gauge trades for 2 times net assets, within 4 percent of the most expensive level on record versus the MSCI World Index of developed-nation shares, according to MSCI Inc.

“After all this money has flooded in, with everyone in love with them and all the euphoria surrounding them, it’s hard to find fundamental value,” said Harris Associates LP’s David Herro, who was named international stock fund manager of the decade this year by Morningstar Inc. “Growth in emerging markets is greatly helping the world, but you can overpay for it and that’s what’s happening.”

Herro, whose $6 billion Oakmark International Fund in Chicago beat 82 percent of peers this year, has reduced emerging-market stocks to about 4 percent of holdings from more than 20 percent in the late 1990s as inflation spurs China and India to raise interest rates and Thailand and Brazil to boost taxes on international investors. Moving away from the fastest-expanding economies puts him at odds with strategists from UBS AG to Citigroup Inc.

The MSCI emerging-markets index dropped 0.6 percent to 1,113.63 at 9:40 a.m. in New York, following a 0.8 percent decline yesterday. The MSCI World index slipped 0.1 percent today.

Coca Cola, Colgate

Jack Ablin, the chief investment officer at Harris Private Bank who said emerging-market stocks were too expensive a month before they peaked in 2007, favors shares of U.S. companies that sell to developing nations.

Coca-Cola Co., the Atlanta-based beverage maker, is valued at an 18 percent discount to the MSCI Emerging Markets Consumer Staples Index after trading at an average premium of 74 percent since 1995, price-earnings ratios compiled by Bloomberg show. New York-based Colgate-Palmolive Co., the world’s largest toothpaste maker, trades at a 25 percent discount to the emerging consumer stock gauge, compared with a historical premium of 70 percent.

Both companies get about 50 percent of their operating income from emerging markets, data compiled by Bloomberg show.

Bullish Strategists

“Yes, I believe that the emerging economies will outpace the developed world,” said Ablin, who helps oversee about $55 billion at the unit of Canada’s BMO Financial Group. “But I still don’t want to chase these valuations because a lot of optimism is priced in.”

Emerging-market stock strategists at UBS, Citigroup, JPMorgan Chase & Co., Credit Suisse Group AG and Morgan Stanley are more optimistic than their counterparts following the U.S. and Europe.

The average of five estimates for the MSCI index next year is 1,463, or 30 percent higher than yesterday’s level and 9.3 percent above the all-time closing high on Oct. 29, 2007. Strategists are calling for a 9.9 percent gain in the Standard & Poor’s 500 Index and a 14 percent advance for the Stoxx Europe 600 Index, according to the average of estimates in Bloomberg surveys.

“There’s a growing realization that in some ways emerging markets are a safe place to be,” said Mark Mobius, who oversees about $34 billion as executive chairman of Templeton Emerging Markets Group. “I’m quite optimistic.”

Lower Debt

The MSCI emerging-market index has surged 136 percent from its March 2009 low as developing economies exited the global recession in better shape than advanced countries by almost every measure. Government debt will probably amount to 37 percent of emerging-market gross domestic product next year and budget deficits will be 2.9 percent, compared with levels of 101 percent and 6.7 percent in advanced nations, the Washington-based International Monetary Fund predicts.

Emerging economies may expand 6.4 percent in 2011, almost three times the 2.2 percent rate for developed nations, the fund’s October forecasts show. Developing nations are growing faster partly because rising consumer demand at home has reduced reliance on exports to the U.S. and Europe, Goldman Sachs Asset Management Chairman Jim O’Neill said in a Dec. 6 interview with Bloomberg Television.

Faster economies have helped emerging-market companies find more profitable expansion opportunities than developed-nation firms. The return on equity for companies in the MSCI gauge for developing nations has climbed from 10 percent at the end of last year to 14 percent, or about 3 percentage points higher than in the MSCI World index.

‘Heavy Inflows’

Emerging-market equity mutual funds are attracting money at an accelerating pace even after gains in the MSCI emerging-markets index slowed to 13 percent this year from 75 percent in 2009. Inflows from individuals into funds during the past three months topped $12 billion, the highest level since the three-month period ended December 2007, according to data compiled by Cambridge, Massachusetts-based research firm EPFR.

“Heavy inflows of equity capital into emerging markets suggest a more cautious stance is appropriate,” Ian Scott, the London-based global equity strategist at Nomura Holdings Inc., wrote in a Dec. 5 research report. He cut developing-nation stocks to “underweight” from “overweight,” saying they’re vulnerable to rising borrowing costs and capital controls.

China’s central bank raised benchmark lending and deposit rates in October for the first time since 2007 and Indian policy makers have lifted interest rates six times in 2010.

Capital Controls

Brazil raised taxes on foreign investments in fixed-income securities this year. Thailand removed a 15 percent tax exemption for foreigners on income from domestic bonds. Countries from Taiwan to South Korea have intervened in foreign-exchange markets to stem currency gains, according to traders.

Herro, whose Oakmark International Fund climbed 16 percent this year, said he’s finding some of his best investment opportunities in Japan even as the IMF forecasts economic growth of 1.5 percent next year.

His fund owns shares of Tokyo-based Daiwa Securities Group Inc., which trades at a 66 percent discount to Beijing-based China Construction Bank Corp. and is 69 percent cheaper than Banco Bradesco SA, based in Osasco, Brazil, according to price-to-book ratios compiled by Bloomberg.

China’s economy may expand 9.6 percent next year while Brazil’s grows at a 4.1 percent rate, according to IMF forecasts. India may expand by 8.4 percent, the fund predicts.

‘Late to the Party’

Ablin of Harris Private Bank said a losing investment in Chinese stocks for his personal account in 1993 showed him that economic expansion doesn’t always translate into stock-market gains. While the Chinese economy posted average annual growth of 12 percent in the four years through 1996, trouncing the global rate of 3.1 percent, Ablin’s bet on the China Fund Inc. lost 50 percent of its value.

“I had pretty much bought into the consensus and I was late to the party,” he said. “That lesson told me there’s a big difference between the fundamental economic backdrop and the valuation of stocks.”

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