Contributed by John E. Rice, CFA, CFP®Recently our investment strategy team and Investment Committee decided to increase exposure to emerging market stocks in portfolios. Why now?
We have long believed that holding a well-diversified portfolio of stocks and bonds and other asset classes is a good path to growing wealth. Along with diversification and risk control, we believe it is important to seek areas of high potential growth. Emerging market countries offer some of the best growth opportunities available in the world stock markets.
So what are emerging markets? The term “emerging markets” refers to the stocks of the emerging market countries. Emerging market counties are the countries that have publicly available stock markets, but their economies and stock markets are not as fully developed as the group of approximately 20 countries with the largest and most developed stock markets in the world.
The developed world contains countries like the US, Canada, Japan, and the UK. There are actually just over 20 countries that are classified as developed, using this methodology. It is not based on size of country, economic output, population or region of the world. The developed world in terms of investments is defined as countries that have open architecture stock markets that allow investors to own and freely trade stocks.
Some of the largest emerging market countries are China, India, Russia and Brazil. China for example, is the largest country in the world by population and the second largest country based on economic output, but its capital markets are still not well developed so it is defined as an emerging market country.
Over the years we have held significant positions in stock markets around the world. Emerging market stocks represented a larger than market neutral portion of the mix. We kept a constant allocation to emerging markets, and rebalanced regularly, so our allocation to emerging market stocks has come more into line with market neutral allocation. By increasing the allocation to emerging market stocks now we bring this asset class back up to a higher than market neutral allocation.
By way of example, if an investor, from anywhere in the world, wanted to purchase a portfolio of stocks that contained a “market neutral” weight of emerging market stocks, the investor might own a portion of emerging market companies equal to approximately 13% of their total stock allocation. Another 44% might be allocated to US companies and another 42% to other developed countries around the world. These numbers change as currencies and stock markets rise and fall relative to each other, but the trend into emerging market has grown over the past 10-20 years.
So why add more exposure to emerging market stocks now? One aspect of emerging market companies is that they have been traditionally more volatile than developed country stocks. They have years of strong increases and then dramatic pullbacks. During the first half of 2013 we have seen strong growth in US stock markets but emerging market stocks are either flat or down in many areas of the world. Valuations also look attractive. One measure of valuation is a ratio known as Price to Earnings or P/E ratio. Based on data from JP Morgan and MSCI the forward looking P/E ratio for US stocks was 14.2 and the P/E ratio for emerging market stocks was 9.8 in the middle of 2013.
Overall, we believe that a healthy allocation to emerging market stocks is going to provide a long-term benefit to client portfolios and we believe that now is an attractive time to increase this allocation.