Stocktake: Investing divisions in emerging markets

We have been noting that emerging markets are cheap, but not uniformly so. Some countries are cheap, others are expensive.

Cyclically sensitive EM stocks are cheap, defensive companies are not. Deutsche Bank analyst John-Paul Smith points to another divider – state-controlled companies and private firms.

Smith cites China, where tech shares have rallied 150 per cent over the last three years even as state-owned enterprises (SOEs) tanked.

The valuation gap between China’s technology and financial sectors is now at its widest since 2001. Although he has long warned of the danger posed by governance problems, Smith is now more concerned by the high valuation of private sector stocks, not the low-priced SOEs.

The biggest losses have been in emerging markets like China, Brazil and Russia, where state control is largest. As for the MSCI emerging markets index as a whole, Smith notes non-state stocks are flat since late 2011, while state-controlled stocks have recorded double-digit losses.

The contrarian label is fashionable, but it takes nerve to do what a true contrarian would do here – invest in the most state-controlled stocks in the most state-controlled countries.

End of an era for small-cap stocks?

US markets hit new all-time highs again last week but the small-cap sector, as measured by the Russell 2000 index, sits below its recent peak, having recently suffered a six-day losing streak.

The sector has outperformed large caps for 14 years – over twice the average cycle – and is now priced to suffer years of underperformance. The Russell 2000 soared 39 per cent last year, has rallied for an unprecedented seven straight quarters and is up 250 per cent since 2009.

It trades on 49 times reported earnings, Bloomberg reports, even higher than the multiple of 39 in 2000 and way above the S&P 500's multiple of 17. Now, that may be misleading – earnings data vary and it trades on a less-testing forward ratio of 19.

Even that is well above its long-term average, however, and the real figure may be higher again, given high earnings expectations.

Jeremy Grantham’s GMO has been sounding warnings for some time now, describing US small caps as the most overvalued asset class on the planet. After inflation, they will return a negative 5 per cent annually over the next seven years, says GMO.

Late last year, the Leuthold Group warned the “final gasp in small-cap leadership” may be near. It’s hard to disagree.

Active funds underperform yet again
It is almost admirable how active fund managers keep a straight face as they promise market-beating returns, given decades of data showing just the opposite.

Take the recently published scorecard of S&P indices verses active funds, which found 55 per cent of US large-cap funds and 68 per cent of small-cap funds underperformed last year. Of all US funds, 77 per cent underperformed over the last three years.

And of the 17 different categories of equity funds tracked, there was no category where more than half of funds beat indices over a five-year period.

That’s worth repeating – none.

Just-Eat valuation is pie in the sky
The Just-Eat website is handy if you want to order a takeaway, but it's not worth £1.5 billion. Last week's flotation was the biggest UK tech IPO in eight years.

Just-Eat trades on more than 100 times earnings – slightly mad, given “it’s a bloke with a server putting you in touch with a bunch of kebab shops”, as one analyst put it.

AO World, the online retailer of fridges and washing machines (another not-so- revolutionary business model), trades on a similar multiple.

So does Boohoo. com, which faces stiff competition in its bid to sell clothes to fickle young people.

Back in the dotcom days, investors could plead they didn’t understand what they were investing in (a poor excuse, but better than nothing).

Just-Eat's valuation, however, is obviously pie in the sky – a pun that is, like the stock price, unjustifiable.

Betting on reversals
Should short-term index traders buy into momentum or bet against it? The Quantified Strategies blog investigated by backtesting a simple mean reversion strategy – if the S&P 500 is down three days in a row, buy at the close on the third day and sell at the market open the next day. The trade has triggered 200 times since 2005 and been consistently profitable, delivering a smooth, upwardly sloping equity curve.

Additionally, average gains per trade were almost twice as high on the MSCI emerging markets index. In fact, a similar version of the trade whereby one bets against rising markets also proved profitable. Average percentage gains are obviously very small, given the short timeframe, so this is one purely for futures traders paying dirt-cheap commissions. If you are going to play that game, such strategies – mechanical, unemotional, logical and tested – are always preferable to just going with your gut.