At the recent MoneyWeek Conference in London, I had the opportunity to listen to Russell Napier, a well-known stock market strategist, who is highly regarded in the City. I have read his reports for many years and appreciate his incisive comments about Asia, central banks and the lessons we can learn from previous bear markets in America.
And it was a very interesting talk that Russell gave (you can actually listen to the whole thing, as well as my own talk on my favourite stocks in Asean on the MoneyWeek conference recording – click here to claim a copy).
But as Russell went on I found myself disagreeing more and more with him. It smacked too much of what my former Thai colleagues used to refer as ‘hua kae’ (literally ‘old heads’) – old thinking.
Specifically, Russell used a valuation tool – known as the Shiller price/earnings ratio – to point a cheap opportunity in European stocks, and particularly in Italy.
Today I want to tell you why I think the Shiller PE ratio is unreliable – and an example of the kind of thinking that distracts UK investors from the real opportunities in stocks right now. And this is particularly pertinent to emerging markets.
Pax Americana
“To be born an Englishman”, Cecil Rhodes once claimed, “is to win first prize in the lottery of life”.
That is perhaps an offensive comment in modern times, but could possibly be justified during the Pax Britannica (‘British Peace’), the period between 1815-1914, when the British Empire controlled most of the global economy and key maritime routes.
However as early as 1880s, America’s manufacturing productivity exceeded Great Britain, paving the way for Pax Americana. The superiority enjoyed by the United States of America was set in place.
At the turn of the 20th century a large influx of immigrants from Europe, who often brought with them the latest know-how and best practices helped America to become an economic miracle.
Why is this important, you may ask?
Well it points to a major problem with using traditional valuation methods such as the Schiller price/earnings ratio. This is a ratio based on average inflation-adjusted earnings from the previous ten years, known as the cyclically adjusted price-to-earnings (Cape) ratio.
Using historical price data going back to 1881, the current Schiller Cape ratio is 23.9 times, versus a mean of 16.5 times (and minimum of 4.8 times in December 1920 and maximum of 44.2 times in December 1999). As a result the US market is deemed ‘expensive’ and some European markets, where similar data is available, such as Italy, are seen as ‘cheap’, as Russell Napier points out.
But this ignores the fact that the Schiller p/e ratio valuation benchmark coincides with the period of Pax Americana – an exceptional period for that country – and therefore is likely to be a very poor guide for future performance.
Pax Emerging Markets
In December 1991, the world watched with bewilderment as the Soviet Union disintegrated into 15 separate countries. There was a ripple effect across most emerging economies and many countries started to liberalise their economies, loosening their political systems and adding a couple of billion workers and consumers.
The outcome is well known: a surge in outsourcing from the West, stupendous economic growth in previous shackled economies and the establishment of emerging markets as a separate asset class.
However this new world – ‘Pax Emerging Markets’ – is something that seems to have been hard to accept by global (mostly Western) investors.
Since 1989 global institutional investors have underperformed the MSC AC World Index (MSCI ACWI) about two thirds of the time. Interestingly the absolute underperformance seems to have increased after 2001 when China became the 143rd member of the World Trade Organisation (WTO).
The truth is that our own economies and companies are being transformed by emerging markets.
Morgan Stanley points out that European companies have diversified their revenue exposure from Developed Europe from 71% in 1997 to 46% in 2013. In other words more than half of their revenues come from outside Europe.
The big winner is emerging markets, which are estimated to contribute 33% to sales, representing an increase by 2.8 times in 16 years.
Indeed since 2005 developing Asia has the highest increase of all regions, followed by the Latin America. There is a new Europe emerging – tied to the fortunes of emerging markets – which makes it hard to justify the use of any historical valuation matrix like the Schiller PE, as the composition of our industries are so fundamentally different from the past.
‘Change is the only thing worth living for’
I think the main lesson is that we have a new world in the making. And it is important to acknowledge that – regardless of whether you are an emerging market investor or prefer to invest closer to home.
In Asia the number of established markets has more than tripled and the importance of Western buying has diminished. The success of this region is no longer about attracting investment from the West. With the radical integration of Southeast Asia, it’s Asian money that is booming. Southeast Asia is becoming an emerging new powerhouse.
When talking to my peers in the City I am always taken aback how these senior people anchor their thinking around cataclysmic events in the West such as Wall Street 1929, Black Monday 1987 and the global crisis in 2008. Or the Asian financial crisis in 1997-98, suggesting that should be the benchmark for these economies, companies and stock markets.
In Asia, I find that people tend to look forward and are more optimistic. They do not think about what happened in America or Europe during the last century. Historical comparisons for them are centred on local and regional issues and prospects of improving old trade linkages that existed prior to the Europeans coming to their region.
Behavioural finance teaches us that we all ‘anchor expectations’ in order to simplify and make sense of the world. We need to take a new approach if we are going to capitalise on the new world and its investment opportunities.
My approach is to adhere to the advice given by my favourite writer, Bruce Chatwin, who said, “Change is the only thing worth living for. Never sit your life out at a desk. Ulcers and heart condition follow.”
I am at the foreground of things changing. I live in Iskandar, in Malaysia, and chose to live here because I knew big things were happening. And it’s just one area which stands to profit from the emerging ASEAN trade bloc.
Luckily you don’t have to travel to this region to find great opportunities – although I recommend that you do. I can send you dispatches from Southeast Asia, helping you to invest as the rail lines, property developments are built and regional tourism takes off.
So keep reading The New World. And if you really want to find out about my street-level research in Asia and the specific stock recommendations I make, then you should click here.
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