B. Malkiel & J.P. Mei, "Global Bargain Hunting",Ch.2, 1999.
The Price Is Right On The Other Side
SUCCESSFUL INVESTMENT DECISIONS in the stock market have two important elements. First, the companies in which you invest need to produce substantial growth. And we believe that emerging markets now provide the most exciting growth prospects in the world. This fact does not, however, rule out investment mistakes. You can always lose money if you pay too much for your purchases, and you can even do so if you buy a stock that doubles its earnings. Suppose, for example, you pay 100 times earnings for the initial stock purchase and that earnings per share double as anticipated. Does this mean the stock price doubles as well? Almost certainly not. Indeed, after such a dramatic earnings spurt, prospects for future growth will moderate and the earnings multiple will often decline, say to 25. If so, you would lose half your original investment. So before you send your money overseas, you need to ensure that the second element of successful investing is met: be sure that your purchases are made at bargain prices.
Throughout the 1980s and most of the 1990s, the stock markets in most of the developed world have been booming. As stock prices have soared, especially in the United States, bargain hunters have been given a golden shopping opportunity in emerging markets. Relative to stock markets in the developed world, stocks of several emerging markets have rarely been so cheap. That is why we believe many emerging markets offer the best bargains available for the investing public. The standard measure used by financial analysts to determine whether a common stock is reasonably priced is a ratio rather than the absolute price of the stock. It is called the price-earnings (P/E) ratio. If IBM, for example, sells at $80 per share, this tells you nothing about how it is valued in the market. Only when we compare IBM's stock price with its earnings per share can we get a sense of its valuation. P/E ratios also create a mechanism for comparing the value of one company with another and one national market with another. For example, if IBM's earnings are $5 per share, we can calculate its P/E ratio as 16 (80/5). The P/E ratio allows us to compare IBM with other U.S. companies as well as with Japanese computer makers, such as Fujitsu and Hitachi, and with emerging-market companies, such as Korea's Samsung. Such a broad, overall comparison shows that common stocks in emerging countries tend to sell at lower multiples of company earnings and at lower prices relative to the value of the assets owned by the corporations. In short, some of the most attractive growth companies in the world are available at bargain prices.
As with all measures, however, the P/E ratio is not perfect. Peter Lynch, one of the few investment professionals who deserves a place in the "Portfolio Managers' Hall of Fame," devised a very simple, but quite successful, refinement and used it to locate undervalued stocks. His measure took predicted growth into account. He recognized that stocks with high growth rates tend to sell at high P/E ratios. It stands to reason that if two stocks have the same earnings but one is expected to grow much faster than the other, this one would fetch a higher price. After all, in a few years the faster-growth stock would have the higher earnings. Lynch spent his career attempting to find stocks that promised to deliver high long-term growth yet had relatively low P/E ratios. The ratio of a stock's expected long-term growth rate to its P/E ratio is Lynch's measure of value suppose, for example, that IBM and Intel had the same P/E ratio of 16 times earnings. If IBM were expected to have a long-term growth rate of 8 percent per year, the ratio of growth to the P/E ratio would be 8/16, or 0.5. Let's say that Intel, on the other hand, has an expected growth rate of 16 percent per year. Its growth-to P/E ratio is thus 16/16, or 1. According to Lynch, Intel would be the better buy because it has a higher growth-to-P/E ratio.
The beauty of buying stocks with high potential growth ratios at low P/E ratios is that as the growth is actually realized, the P/E ratio may rise. As investors become more confident of the growth, stocks are often rewarded with higher ratios. On the other hand, "growth stocks" at very high ratios present substantial risks. Suppose, for example, that in a particular period, growth is not achieved and earnings actually fall. Investors are likely to be hit with a double whammy: the price of the stock is likely to fall even more sharply than the earnings, as the P/E ratio will also shrink. Thus, stocks with high growth-to-P/E ratios offer both greater rewards and less risk.
We think so highly of Lynch's measure that we used it to judge valuation relationships in emerging markets relative to developed ones. The results show that growth-to-P/E ratios tend to be higher in emerging markets and clearly support our thesis that bargain hunters need to look beyond the stock markets in the developed world.
We started our analysis with forty-six relatively large firms in emerging markets. Their growth rates were obtained from the International Brokerage Evaluation Service (IBES). This organization collects five-year growth projections made by financial analysts for different companies and averages them to give a composite projection for each company studied. The P/E ratios were more easily obtained. We simply divided the stock prices of the forty-six firms by their earnings per share. We then picked a sample of forty-six similar firms in developed markets and obtained the same data. Each emerging-market firm was coupled with a developed market firm located in the same business and industry. For example, AT&T in the United States (10 percent expected growth, P/E ratio of 24) was coupled with Telecom Argentina (13 percent ex-growth, P/E ratio of 13). Figure 2-1 presents the results of our analysis, showing that growth-to-P/E ratios tend to be considerably higher in emerging markets. Emerging-market stocks tend to have higher growth rates and lower P/E ratios. Investors seeking the best values will have to look beyond their local stock markets to find the best bargains for the twenty-first century.
In another analysis, we compared entire markets rather than comparable companies. This comparison is shown in Figure 2-2. Here the average P/E ratio is calculated for each national market index. The growth rate is the projected five-year growth rate of each country's GDP. Since corporate earnings and the GDP tend to move together, the GDP growth rate is a good proxy for real earnings growth (growth net of inflation). On the Lynch measure of value, emerging markets again win hands down over the developed stock markets. That is, growth can be purchased at a far lower price in emerging markets than it can be bought in the United States and western Europe.
Another valuation measure also suggests the attractiveness of emerging markets. One compares the price of a company's stock with the value of the assets it owns. Thus, if a stock sells at a price per share of $20 and has assets per share (on its accounting books) of $16, the stock is said to have a price-to-book-value (P/BV) ratio of 1.25 ($20/$16). It turns out that this ratio has proved somewhat successful in predicting differences in security returns in the United States. Equities that sell at low prices relative to their book values have tended to produce superior performance. Of course, one should maintain some degree of skepticism that this relationship will continue to be reliable since recent waves of downsizing and plant write-offs have made book value an unreliable guide to the true worth of a firm's assets. Nonetheless, the P/BV ratio remains a crude and still somewhat useful guide to value.
The investment firm of Smith Barney found that the P/E and P/BV ratios were both useful in predicting differential returns in emerging markets. The P/BV results are shown in Figure 2-3. Note from the figure that, at least for some periods in the past,
there has been a good deal of predictability of stock returns from different emerging markets based upon the average P/BV ratio at the beginning of the period. When stocks could be bought at low P/BV ratios (as well as low P/E ratios), they tended to produce relatively high subsequent returns, as was the case for Argentina. On the other hand, when stocks in national markets tended to sell at very high P/BV ratios (for example, in Taiwan), subsequent returns tended to be very low. However, given the extremely wide differences in accounting practices among nations, it would not be wise to put complete reliance on any single valuation factor. Nevertheless, the closeness of the correlations of returns with the P/BV and P/E ratios, plus the fact that such ratios in emerging markets tend to be lower than in developed markets, add a powerful argument that global bargain hunters need to be aware of the values that exist in emerging stock markets.
A whole panoply of ratios and indicators show the values that exist in the rapidly developing parts of the world and the tendency of attractively priced stocks to generate very high returns. Today, the world's securities markets are like a huge shopping bazaar, and the real bargains are usually not found close to home. In our increasingly global economy, many of the "home run" investments of the future will be found by expanding one's horizons well beyond national borders.