I had a good laugh at a meme posted by the Instagram account of Wallstbets today:

The caption may be prescient. It brought me back to the famous Business Week cover that proclaimed “the death of equities” just before equities took off on a 20 year bull market in the US that saw equities increase 2,700% and over 17% annually.

I have been writing about emerging markets turning the corner for some time now. The sector has been a loser for about a decade since the financial crisis while US equities have been on a tear. The logic behind the comment in the caption on emerging markets is that emerging market funds are full of “old economy” stocks like metals and mining which operate outside the hot sector of tech. It’s a bit of a false equivalent. There are many emerging market stocks that look like value stocks right now, especially due to sectors that predominate some emerging markets: energy and materials. Overall though, tech is still richly valued globally, even in foreign countries. Names like Alibaba and MercadoLibre have just as lofty valuations as the big tech companies in the US.

Value has been on a 25 year losing streak and there has been a lot written about the underperformance and even the “death” of value investing. Rather than get into a discussion on value and whether it will make a comeback, I want to dive into emerging markets which encompass both value and growth. There are a number of forces, both political and economic that are starting to differentiate emerging markets from developed ones. Especially when we look into the breakdown of the emerging market indexes, we find some interesting valuations as well as some reasons to be cautious.

Moving Away from the US Exchanges

There were two important events in the past year that may presage investors starting to move more aggressively into emerging market stocks down the road. The first was the IPO of Saudi Aramco. Although this was another old economy stock, it was the largest IPO in history at the time but was not available directly to US investors through a direct listing on the New York exchanges or ADR’s. Rather, the only way for US based investors to get their hands on Aramco shares was to either have a Saudi brokerage account or invest through an emerging market fund or ETF.

Now the same is becoming true for the multi-exchange IPO of Ant Group. The financial company is set to reap $35 billion from its upcoming IPO which, due to the tensions between the US and China will be completely off the New York and London exchanges.

It used to be the defining and coming of age moment for large global companies: a listing on the largest equities market in the world, the New York Stock Exchange (NYSE). Listing in the US has become more expensive and time consuming though, especially since the early 2000’s which requires more transparency. Since the financial crisis, the US has also ushered in additional reporting requirements. Add to that the US government’s zeal in finding any excuse to get involved as global prosecutor, whether it’s because a transaction was done in dollars or a company has securities listed on a US exchange. This poses a risk for a company from a country to which the US government is hostile to, such as China, to put ones self at risk in such a way may not be the ideal move for a company or its shareholders.

What kept companies coming back despite these hurdles and risks however was the quality and depth of the US market which was like nowhere else in the world. In the case of Saudi Aramco, which wanted to avoid some of the transparency requirements set in London and New York, the Saudi royal court had to press local and regional pensions and fund managers to purchase Aramco shares which flooded and dominated the entire market cap of the local market. The liquidity just wasn’t there and it took a lot of arm twisting to push the IPO through.

In the case of Ant however, a dual listing on the Hong Kong and Shanghai exchanges has led to an over subscription of shares in Shanghai and a likely one in Hong Kong. Investments have not been limited to domestic investors either. The Shanghai listing includes institutional investors such as GIC which represents the State of Singapore, Abu Dhabi Investment Authority and the Canada Pension Plan Investment Board. Jack Ma, founder of Alibaba noted that a massive IPO like this couldn’t have been possible outside of the US, 5 or even 3 years ago. Some have commented that this IPO has singlehandedly modernized the Chinese equities market. Meanwhile the US State Department brought up plans recently to blacklist Ant in the US.

In fact, the largest IPO’s ever, most of which have come to market in the past 6 years have been dominated by foreign listings off or split with the US exchanges.

This is creating a bifurcated global market for tech: one on the American side and one on the Chinese side. The American side being more global and shut out of markets like China, whereas China is more inward looking, championed by the state and ahead in terms of blurring the lines between the social, financial and consumer discretionary industries by offering all these to customers through one or only a few apps.

With a billion customers to try and grab, there is more than enough room for Chinese companies to try and chase these customers on their own without having to worry about foreign markets. Despite this, Chinese companies like Bytedance have found a global audience with apps like Tik Tok. The reception of its popularity in the US by the US government and the quasi-forced sale are prime examples of the risk of these Chinese companies moving into the US market.

The Other Big Shift

Another shift of big consequence in the recent past as well has been the embrace of Chinese A-shares by the index makers for inclusion in the Emerging Markets Indexes. A-shares are those that were typically available only to Chinese citizens and were traded on the Shanghai and Shenzhen exchanges. These shares are traded in Chinese currency (RMB) as opposed to B-shares which can be quoted in foreign currencies such as the dollar and are easily held by foreign investors. Chinese citizens are limited to purchasing A-shares only which means that the two classes of shares often trade at different valuations for the same company.

The shift to admit A-shares has drastically changed the makeup of these indexes from China influenced a decade ago to China heavy now. To give you an example, I took a look at the Vanguard Emerging Markets ETF (VWO) which tracks the FTSE Emerging Markets Index, an index which includes those Chinese A-shares.

China now makes up 45% of the entire index. If we lump Taiwan into China, then these two make up 60% of the index. Maybe not exactly the diversity that investors are looking for when delving into emerging markets thinking they are getting exposure to places like India and Brazil, which together make up only about 15% of the index.

So China throws off the country diversity in the index. So maybe we can look at it as more of a China plus emerging markets fund. In that light, and given the bad rap that emerging markets have garnered over the past decade in terms of returns I decided to compare this ETF to its US counterpart: the Vanguard Total Stock Market ETF which tracks a basket of stocks intended to track all those traded on the entire NYSE. The results were somewhat surprising.

There is no country table because it’s all US, this hides the fact that a third of the profits from the S&P 500 come from overseas but we will ignore that factor for now. What’s interesting is that tech makes up a similar proportion of the index compared to the US. Consumer discretion does as well. Combined, these sectors make up around 40% of each index. The main sector differences are in healthcare, financials and industrials. The US being heavier in industrials and healthcare while emerging markets being heavier in financials.

This would seem to be an advantage for the US given that financials have been the biggest loser other than energy over the past 5 years. However keep in mind this is partially driven by low rates in the US which has hurt banks. The situation is different in emerging markets where rates have fallen but aren’t at zero yet. The customer dynamics are different as well, meaning there is still market penetration left to grow as emerging countries get richer, although tech still poses a threat to banking globally in my opinion.

The other point worth noting is that the median market cap in the US is around $100 billion where in emerging markets its $24 billion. This means the size of company in the emerging markets index is more weight towards small caps which tend to outperform in the long run. It’s the valuation metrics where things really stand out though.

A P/E ratio 61% higher in the US, P/B 78% higher with comprable return on equity, earnings growth rate and volatility, it’s actually quite surprising how similar these indexes are both in terms of their sector weights as well as their earnings. The only big difference being in those two sector weights I noted and the valuation. Of course valuation is backwards looking and if investors feel the growth prospects are stronger in the US, they will naturally overweight that market.

At this profitability with such a disparity in terms of valuation and new opportunities, it seems to be a question of when rather than if the valuation metrics become to tempting to ignore anymore and investors start to move into the also tech heavy and China heavy emerging markets index.

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