On the Case for EM Equities; Vegan Diets and Prostate Cancer!

From: aditya rana
Date: Sat, Dec 12, 2015 at 2:16 PM
Subject: On the Case for EM Equities; Vegan Diets and Prostate Cancer!
To:

Hi!,

Emerging markets have had a difficult year with the MSCI EM stock index being down 19% year to date, resulting from sharp declines in currencies and stock markets in contrast to much smaller declines in the US and European stock markets. So what are the prospects for EM equities and currencies going forward? Ben Inker, CIO of the famed asset manager GMO, analyses the prospects for EM assets in their recent quarterly:

-As the chart below exhibits, EM stocks have underperformed developed market stocks over the last five years, losing by 12.2% per year, causing some investors to call into question their allocations to EM assets.

-History tells us that the timing of such sentiments tends to occur at the wrong times, with the question “why bother with non-US stocks” being prevalent just prior to the market top in 2000. So the key issue to address is “are EM stocks a value trap”?

-There are three aspects to consider here : 1) are the true “normalized” earnings lower than what are assumed by valuations models, 2) are investors getting the full benefit of corporate earnings growth?, and, 3) does the currency effect nullify gains in the local currencies for a dollar based investor?

-Looking first at ROE (ex- resources and financial) as a proxy for normalized earnings, as the chart below exhibits, current earnings actually look slightly better than normal. Resource companies are excluded, given that they had extraordinary profits from 2005-2012 thereby pulling up the average, and their profits going forward are likely to be much lower than the average over the last decade. Financials are excluded because they tend to be over- levered with highly pro-cyclical ROEs.

-Looking at other measures to estimate normalized earnings, the results are not that far from the assumed number as the table below illustrates:

-But profits are only part of the story and for some EM companies, earning yields can overstate the returns earned by outside investors , as the company’s priorities can be influenced by government policies than purely maximizing return on capital (i..e Gazprom).

-Does this phenomena apply to EM companies in general? Looking at the data over the past 20 years, as the chart below exhibits, the “slippage” is 0.4% return per annum which is similar to the global average of 0.5% per annum. The 6.7% average earnings have been adjusted to account for the downward shift in valuations (which led to rising earning yields over the period) which have reduced returns by 3% per annum. However, the returns are in real local currency terms, so the next question to ask is if the currency effect has distorted the picture?

-Currencies have been a major driver of EM returns in recent years, and about two-thirds of the negative return this year have been due to falling currencies. However, hedging the currency risk has been consistently a bad idea (see graph below) over the last twenty years, with EM real returns of 3.0% per annum being reduced to 0.9%.

-Given that the currency returns have been so close the equity returns, are EM currencies a better way to invest in EM? To analyse this, sources of currency returns can be broken down into real interest returns and changes in the real exchange rate, and the graph below shows that almost 100% of return has come from real interest rates.

-However, looking at the real interest rate component of currency returns (see chart below) for different EM countries , it is apparent that some countries like Argentina, Turkey and Brazil have had unusually high level of real rates (as they have been through recent periods of hyperinflation), while Russia has been the outlier in terms of negative real rates.

-Excluding these four countries, the resulting returns are lower as shown in graph below but still providing a risk premium over US cash. This is what one would expect given that emerging currencies are risky and require high rates to attract capital.

-Are valuation estimates of EM currencies good predictors of future returns? Looking at historical data (see two graphs below), subsequent 1 year returns for EM currencies based on how cheap or expensive they were at the start (measured by standard deviations move in the index versus the US dollar), it is clear that value has been a good predictor of emerging currency returns.

-Currently EM currencies are 1.3 standard deviations below fair value, and historically this has been associated with a 4% real return over the subsequent year. Analysing the poor relative returns for EM equities over the last five years, 60% of the 31% drop in EM currencies has come from a move back to fair value (from a 2 standard deviation overvaluation in 2011), while the rest has been an overshoot to undervaluation.

-In summary, EM equities have a meaningful risk premium (about 4%) over currencies once you adjust for the valuation drop over the last 20 years, and their returns have been fairly close to their valuation adjusted earnings yields as you would expect in other equity markets. EM currencies have also delivered a return over US cash and are likely to continue doing so given the capital needs and riskiness of emerging countries.

-Looking forward, EM equities are expected to deliver real returns of 4.6% per annum over the next seven years, compared with US equity expected returns of -0.6%. In addition, EM currencies are also expected to provide a positive real return due to their current levels of undervaluation.

-Fascinating research, and makes a persuasive case for EM equities to take advantage of both undervalued equities as well as currencies. So the case for a core holding in EM equities, as part of diversified portfolio comprising Europe, Japan, and some US equities is strong and should yield superior returns over time for the patient investor.

-Looking at year-to-date global equity returns (see table below in local currency), it is interesting to observe that that the top performing market in US$ terms has been the Chinext (+78% ) followed by the Shenzen SME (+45% ), while Japan is the only major stock market (+9% ) in the top 10. Amongst the smaller markets, Argentina (+34%), Hungary (+28%) and Ireland (+17%) have posted superior returns. The worst performing stock market has been Brazil (-39%), and with the latest OECD leading economic indicators update, economic activity in Brazil finally seems to be stabilizing providing the potential for a surprise upside move in 2016.

Vegan Diets Protect Against Prostate Cancer:

Interesting results from a study, published in a prestigious journal, which show that vegan diets reduce the risk of prostate cancer by 35% compared to other diets.

PRCM, Nov, 2015:

Tantamango-Bartley T, Knutsen SF, Knutsen R, et al. Are strict vegetarians protected against prostate cancer? Am J Clin Nutr. Published online November 11, 2015.

-A vegetarian diet lowers your risk for prostate cancer, according to a study published online this month in the American Journal of Clinical Nutrition. Researchers compared several dietary patterns and cancer incidence rates for 26,346 participants from the Adventist Health Study-2. Those who followed a vegan diet were less likely to be obese and experienced a 35 percent lower prostate cancer risk than those following a nonvegetarian, lacto-ovo-vegetarian, pesco-vegetarian, or semi-vegetarian diet. Researchers suspect higher intakes of fiber, soy, and anti-inflammatory antioxidants from fruits and vegetables and lower intakes of saturated fat, animal protein, and serum insulin-like growth factor 1 from dairy products from a vegan diet contributed to lower cancer risk.

Here’s to adding more vegetables and fruits in your diet at the expense of meat and dairy.

I would like to wish my readers happy holidays and best for 2016! The next newsletter will be sent out on January 9th.

Regards,

Aditya

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