In prior blogs
about the current state of the emerging market equity landscape, we pointed out a number of particular findings:
• The emerging markets look inexpensive, in my view, based on an analysis of historical dividend yields
• Some of the lowest price-to-earnings (P/E) ratio
sectors and countries within emerging markets (as represented here be the MSCI Emerging Markets Index
) are also those with relatively higher betas
WisdomTree’s Landscape of Broad Emerging Market Indexes
WisdomTree has a number of broadly focused emerging market equity Indexes. Below, I contrast the Indexes from the standpoints of valuation
criteria (dividend yields and P/E ratios), beta (market risk
) and growth
It is difficult for any one index to be strong on all these fronts, as there are trade-offs between valuation-focused indexes and growth-focused indexes. This blog post tries to explain attributes accentuated in current portfolios and the underlying index methodologies for the following indexes:
• MSCI Emerging Markets Index (MSCI EM)
• WisdomTree Emerging Markets Equity Income Index (WTEMHY)
• WisdomTree Emerging Markets Dividend Growth Index (WTEMDG)
• WisdomTree Emerging Markets SmallCap Dividend Index (WTEMSC)
Dividend Focus as a Foundation
Each of the WisdomTree Indexes shown here includes only dividend-paying companies. These Indexes can help position investors for the attractive dividend yields discussed in our prior blog. At its core, WisdomTree’s dividend-focused, rules-based methodology allows the underlying constituent Index weights to be rebalanced back to a concept of relative value
—critically outside of share price. If dividends grow faster than share prices, this typically signals an increase in weight at the rebalance; if prices grow faster than dividends, this typically signals a decrease in weight at the rebalance. An essential element of our dividend focus lies in our annual rebalance, where these weights are refreshed.
Characteristics of WisdomTree Emerging Market Indexes Compared to MSCI EM as of 7/31/2013
1Median price-to-earnings (P/E) ratio: P/E ratio of index constituents where 50% of constituent values fall above and 50% fall below.
2Beta relative to MSCI EM: Of the specified index, based on its 7/31/2013 constituents, relative to the MSCI Emerging Markets Index.
3Median long-term earnings growth expectations: Compilation of analyst estimates of the growth in operating earnings expected to occur over the company’s next full business cycle, typically three to five years. Value reflects the point where 50% of values are above and 50% are below.
4Median dividend yield: Value of the trailing 12-month dividend yield for a given index for which 50% of values are above and 50% are below.
5Median earnings yield: Earnings per share divided by share price. Value reflects the point where 50% of values are above and 50% are below.
6PEGY ratio: Ratio of the median price-to-earnings (P/E) ratio divided by the sum of the median long-term earnings growth expectations and the median dividend yield. Lower numbers indicate lower prices relative to the median long-term earnings growth expectations and median dividend yield of the underlying stocks.
7Median dividend yield/median earnings yield: Meant to calculate the median payout ratio, which is the median dividend per share divided by the median earnings per share.
• WTEMSC for Small Caps—A Unique Option with the Lowest Beta of the Indexes Shown:
It is counterintuitive that the lowest beta Index shown—the only one below .9—is focused entirely on small-cap stocks. WTEMSC also has a P/E ratio below that of the MSCI EM and long-term earnings growth expectations in double-digit territory. We believe that WTEMSC’s lower beta is largely due to the fact that its exposures steer it away from Russia and China and toward Taiwan, its largest absolute weight, and also gives a nearly 10% weight to Malaysia, an equity market with a beta of below .7 as of July 31, 2013. It is also worth noting that WTEMSC has the lowest PEGY ratio of all the indexes shown, indicating that the median long-term growth expectations and median dividend yield are particularly high relative to the current median P/E ratio.
• WTEMHY for Value:
WTEMHY has the lowest median P/E ratio and the highest median dividend yield, but to be fair, it also has the lowest long-term earnings growth expectations, in part due to a median payout ratio of nearly 55%, nearly twice as high as that of the other indexes shown. When indexes have higher payout ratios, constituents are reinvesting a lower percentage of their earnings to fund future growth opportunities. WTEMHY’s underlying focus on valuations—by sorting the market by dividend yield and selecting the highest dividend yield stocks as part of its selection process—drives this result. The best valuations are currently found in Russia and China on the country side, and in Energy on the sector side, so it makes sense that WTEMHY’s beta is above 1.00, given what I detailed in the prior blog post about how these countries and this sector all have betas above 1.00.
• WTEMDG for Growth:
WTEMDG has the highest median P/E ratio and the lowest current median dividend yield, but its higher long-term earnings growth expectations
compared to the other indexes shown is also important. This illustrates a potential trade-off in the financial markets: high current yield (WTEMHY) or future growth potential (WTEMDG). Quantitatively, this can be shown through the lower PEGY ratio for WTEMDG compared to both the MSCI EM and WTEMHY, meaning that if one accounts for the higher median long-term growth expectations and median dividend yield, price levels for WTEMDG are actually lower. Relative to WTEMHY, WTEMDG has less exposure to Russia and Energy stocks and more exposure to Indonesia, Mexico and Consumer Staples. WTEMDG basket trades at a higher median P/E ratio but has a lower expected beta. WTEMDG includes historical three-year average return on equity (ROE)
and return on assets (ROA)
as part of its selection criteria—and these stocks often sell at higher multiples and deserve the premium multiples1
. The ROE/ROA focus of the WTEMDG methodology reminds me of the famous quote from Charlie Munger:
“We’ve really made the money out of high quality businesses . . . If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.” – Charlie Munger at USC Business School in 1994
With the plethora of emerging market equity indexes that have come into existence, there are more options for fine-tuning the type of emerging market exposure desired. Each individual has his or her own goals, and it is important to focus on the indexes with exposure characteristics most closely aligned with those goals.
Read the full research paper here
The terms "higher multiples" and "premium multiples" refer to the P/E ratio.