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Emerging markets surge

Equities in emerging markets were badly mauled when stocks tanked last year. Investors were dumping riskier assets, raising cash and heading for safety. The reason for selling off this previously-prized asset category was less to do with a sound assessment of their actual prospects than the need by hedge-fund managers for liquidity to meet urgent demands. And when the selling got going, others jumped on the bandwagon.

After the correction was over, investors came back searching for value. And looking at the emerging markets shop window they certainly found mouth-watering deep discounts on display. The nibbling started in the dying months of 2008 and has turned into wholehearted chomping this year. Apart from a few periods of hesitation, investors' enthusiasm has put emerging-market stocks among the leaders in the rally.

The MSCI emerging markets index (ticker: EEM), which is widely used by fund managers as a benchmark, has roundly outperformed the broad world index. Year to date - as at close of trade on November 20 - it has outdistanced the MSCI world index by a whacking great margin of 31.9 percent. The only other regional index that comes close, is Pacific ex Japan (ticker: EPP), outperforming by 29.3 percent. Other regions have, of course, underperformed, with Japan being easily the worst of the lot.

The reason for the renewed faith in emerging markets is related to their rather attractive characteristics. Comparisons with the developed world illustrate the stark contrasts. The global recession and financial crisis was centred, not in the developing universe, but in the leading economy of the West, spreading infection everywhere. And in the current recovery, many developed countries are wracked by splitting headaches caused by zombie banks surviving on state aid, gaping fiscal deficits and fearful consumers.

However, most of the countries in the developing world share few of these problems. Their growth rate has picked up rapidly and prospects for the future are very good, as modernisation of the infrastructure and productivity improvements take hold. Sure, there are a number of rotten apples among them, but the majority show great promise of realising their potential.

In a desperate attempt to goose up economic activity, developed-market central banks have released a flood of liquidity into the system. And this has been one of the principal drivers of asset prices worldwide, including emerging-market stocks and bonds. The rapid run-up in asset prices has caused concern among some policymakers in developing countries, inducing them to implement restrictive measures to slow down the flow of "hot" money. One of their concerns is that a sudden outflow of such funds by flighty investors could cause disruption in asset prices and the exchange rate.

One look at the EEM index should dispel the thought that the emerging universe is populated only by teeny-weeny family firms. We are increasingly witnessing the presence of corporations with very substantial market capitalisation that can hold their own on the world stage. What's more, given the high growth rate, their impact on the global economy is sure to increase in the future.

Many of these firms have very attractive growth and valuation metrics. And the quality of financial information is certainly improving, with the introduction of more rigorous standards. But there are still some issues with the adequacy of corporate governance and the provision of oversight on exchanges, though there are major differences among individual countries. On the subject of outright fraud, the Indian firm Satyam comes to mind but so do Enron and WorldCom in the United States. Among the chattering classes there has been much talk recently about markets evidencing bubbly characteristics. And there is some truth in the view that the extra doses of liquidity pumped into the system have resulted in too fast an increase in asset prices that may be running ahead of actual prospects for economic recovery.

But the contention that emerging markets are now too expensive relative to the world index does not stand up to closer scrutiny. To sort out the issue and make a proper assessment, using the price-to-book ratio is preferable to the price-to-earnings ratio, as it is a more reliable indicator of value in current circumstances.

However, the problem with utilising the PB ratio is that, by itself, it is not a sufficiently good barometer of value. Firms may have low market value relative to book simply because their ability to generate profits is limited. In other words, they are cheap for a good reason. So, to arrive at a better valuation assessment we must also take return on equity into account.

On the basis of the price-to-book ratio, emerging markets are selling at a premium to the world index. But they also have a substantially higher ROE than their counterparts in developed countries, and when this is factored into the calculations emerging markets are found to be selling at a discount, even after significant price rises over the past year. One reason why the Japanese stock market finds so few buyers, despite a low relative PB ratio, is that the return on equity is not sufficiently attractive.

Iraj Pouyandeh is a strategist and senior portfolio manager at LOM Asset Management. He manages the LOM Global Equity Fund. For more information on LOM Asset Management please visit www.lomam.com.