The Contrarian Play: Emerging Markets Energy Sector

Research Affiliates analysis shows U.S. stocks have trounced emerging markets over the past three years, and energy is the most unloved EM sector

Emerging markets natural resource companies can be dirty companies, but they’re dirt cheap.

So says Research Affiliates’ Ryan Larson, essentially anyway, in the fundamental indexing firm’s June newsletter.

The Newport Beach, Calif., firm regularly emphasizes the return advantage of contrarian investment plays that involve selling popular high-performing stocks and buying unloved, poor performers.

The firm’s chief investment officer, Chris Brightman, made that point explicitly with reference to emerging markets natural resource companies in a debate with dumb beta proponent Rick Ferri.

The pain of contrarian investment decisions, Brightman said Thursday, would be “like buying [Russian oil producer] Lukoil today. Does that feel like a comfortable trade? No. It means selling Internet stocks in the late ’90s, buying emerging-market resource stocks today.”

That pain, and potential gain, is described in greater detail in Larson’s analysis.

“Not since the Asian Contagion and Russian ruble crises of 1997–1998 have emerging market stocks underperformed U.S. stocks by as much as they have over the past three years,” writes Larson, noting a nearly 60% return premium for U.S. stocks versus their emerging-market counterparts.

“Through March 31, 2014, the three-year cumulative return of emerging market stocks as measured by the MSCI Emerging Markets Index is –8.35%, while that of U.S. stocks as measured by the S&P 500 Index is 50.73%,” he details.

Larson argues that two factors driving stock market returns over the long-term—mean reversion and valuations—both favor investing in emerging-markets, particularly its most battered natural resources sector.

As to mean reversion, net earnings in the U.S. are 50% above their historic average while they are 10% below trend in emerging markets. And, Larson adds, today’s globalized economy tends to homogenize profit margins from region to region, so one should not discount emerging-market earnings because they are not advanced economies.

As to valuations, using Shiller CAPE, the U.S. stock market trades at a multiple of 25 compared to a multiple of just 14, nearly half, in emerging markets.

The view is starker still on a price-to-book basis: “fundamentally weighted emerging markets portfolios trade near book value, levels touched in the depths of the Global Financial Crisis in February 2009.” Larson hastens to point out how well (fundamentally weighted) emerging markets performed in the immediate aftermath of the crisis, rising almost 150% from February 28, 2009 through end-year 2010.

“What is more likely to have a positive surprise: a market with high valuations, above trend profits, and high expectations, or a market with dirt cheap valuations, below average profits that can revert to the mean, and overwhelmingly negative sentiment?” Larson writes.

But the Research Affiliates analyst does not rest his case merely with the attractiveness of emerging markets.

Like Brightman, he drills down a little further to show divergences within emerging markets where consumer stocks and high tech are actually trading at high multiples, whereas natural resource stocks are experiencing death throes.

“Led by high-flying Internet companies, tech stocks are the top performing sector in the emerging markets, up nearly 40% over the past three years,” he writes, pointing out that a company like South Africa’s Naspers sports a nosebleed P/E ratio of 90.

In contrast, emerging market energy stocks have fallen 33% over the past three years, even as they have risen 18% in the U.S., a variance of over 50%. On a price-to-book level, emerging-market energy stocks are 60% less valued.

This gap suggests to Larson that it is reasonable to anticipate emerging-market outperformance at some point.

And yet investors are highly reluctant to invest in places that are “full of problems.”

It is precisely such emotions, though, that push prices down.

Citing a Credit Suisse study that looked at returns in the period 1976 through 2013  based on dividend yields and currency, the analysis found an annualized return advantage of about 20% in buying high yield and weak currency, two measures of investors’ skittishness.

“The reason high yields and weak currencies are profitable is that they are a by-product of fear and pessimism, emotional responses that lead to low prices and create opportunities to earn a higher risk premium,” Larson writes.

Like his colleague Brightman, Larson concludes that the discomfort one feels is a validating signal of a contrarian strategy like fundamentally weighted indexing that explicitly rebalances into low P/E and low P/B stocks.

-- Check out Brightman, Ferri Slug It Out Over Smart Beta

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