Emerging Markets Exposure – Direct vs Indirect

This article is Part 2 of a 3 part series on Emerging Markets Exposure: Where & How Much?

 We have two ways to gain emerging markets exposure in the portfolio:

• Direct Exposure – we can purchase individual stocks by country (China, Brazil, India) or region (an ETF)
• Indirect Exposure – a well-diversified position can be achieved through U.S. multinational companies

The four factors we discussed (see Emerging Markets – High GDP not equal to High Stock Returns) guide our current decision to have indirect exposure. Here is our rationale.

1.  Valuation

The U.S. has tremendous competitive advantages – property rights, legal protection, resources, infrastructure, educated labor, and entrepreneurial spirit. Therefore the risk premium to invest directly must be adequate. We don’t think it is. Let’s consider forward P/Es. The U.S. is 15.4. Emerging markets is 10.2. The gap appears promising from a risk-premium standpoint but bear in mind that emerging markets data is highly skewed. While the forward P/E in China is 9.0, the P/Es in most other areas are much closer to that of the U.S. (offering little or no risk premium). While China may appear attractive from a valuation standpoint, its high GDP expectations are already “priced in” to the market. Brazil may appear attractive, but it is highly susceptible to investment outflows should U.S. interest rates rise (see Interest Rates). India now offers little risk premium.

2.  Growth Surprises

Let’s look at current GDP (source: The Economist) for the main emerging markets countries: China (7.7%), India (4.7%), Indonesia (5.7%), Malaysia (5.1%), Singapore (5.5%), South Korea (4.0%), and Brazil (1.9%). We don’t see potential positive growth surprises with any of these countries right now. No one stands out.

3.  Globalization

There is a lot more foreign and emerging markets exposure in our portfolio than meets the eye. Our current emphasis is on large multinational U.S. companies. As mentioned earlier, these companies average 40% of their earnings from outside the U.S. Consequently, the portfolio will benefit should emerging markets out-perform, albeit indirectly. If we had a current emphasis on smaller U.S. companies, their internationally-based revenues would be less than 20% and we would be less positioned to benefit from a bump in emerging markets. Taking globalization into consideration, we can achieve better emerging markets diversification and portfolio risk control indirectly versus directly.

4.  Interest Rates

We believe U.S. interest rates will rise by 2015. Coupled with Fed tapering, this could trigger an outflow of investment capital from emerging markets. We are better protected with indirect emerging markets exposure.

To learn more about Dan Laimon, view his Paladin Registry profile.