Emerging markets used to be known as the markets you couldn't emerge from in an emergency. They are now mainstream. Consultants are recommending greatly increased allocations to take advantage of the hottest growth story of our times. Mutual fund investors are syphoning money from developed markets and pouring it into EM funds – just as 10 years ago they cashed out of “old economy” stocks to chase the dotcoms.
As always, companies and investment banks have no trouble in meeting the new demand. Emerging market IPOs have been running at double the cash value of developed market IPOs, in spite of the much smaller market scale. What's wrong with this picture? Plenty. Academic studies have shown there is no positive correlation between gross domestic product growth and stock market returns – if anything the correlation is slightly negative. Professor Jay Ritter of the University of Florida is the author of one study that has analysed 100 years of data from 16 countries. His conclusion is clear: “Countries with high-growth potential do not offer good investment opportunities unless valuations are low”.
The reason for this counter- intuitive finding is that you do not buy shares in the statistical construct known as GDP. You buy the shares of real world companies. In immature fast-growing economies, the companies that end up winning the struggle for survival may not even exist yet. That was certainly so in the case of Japan's economic miracle. In the 1950s there were more than 100 motorbike companies. The market leader, Tohatsu, was driven out of business by the cut-throat pricing of a flaky upstart called Honda.
Rich and stable cash flows are much rarer in emerging economies than in mature economies. So even the companies that survive and prosper – the emerging world's emerging champions – will likely finance their growth by repeatedly raising large amounts of new capital. This is of no benefit to shareholders without an overall improvement in return on capital.
The macro picture is that emerging economies have large reserves of under-utilised savings and human resources. Mobilising them is both the key to success and the guarantor of mediocre investment returns. Why waste time attempting to raise returns on your existing capital when you can easily access more?
So are valuations low enough in the emerging markets to offer good investment opportunities? In less popular areas, perhaps yes. But the biggest of them all, China, is in a bubble phase. At its 2007 peak, the Shanghai A-share index traded at more than seven times book value, far above the five times reached by Japan's Nikkei Index at its peak 20 years ago.
Having subsequently halved, Chinese stocks are no longer quite so expensive. However, the adjusted “Graham-and-Dodds” price-to-earnings ratio – a time-tested indicator of value which uses an average of 10 years' earnings – remains at a dizzying 50 times. Compare that with about 15 times in the US, itself by no means cheap in historical terms.
Residential real estate appears to be even more overvalued. In bubble-era Japan, a byword for manic real estate speculation, apartment prices peaked at 12-15 times average household income. In major Chinese cities, the multiple is now 15-20 times. Asset market bubbles of any scale and duration usually have their equivalents in the real economy. The biggest distortion in the Chinese economy is the explosion in fixed asset investment to an eye-popping 50 per cent of GDP. By comparison, Japan in its miracle decade clocked up economic growth rates similar to China's today by investing between 30-35 per cent of its GDP.
