Our emerging markets investments were the main cause of our portfolio pain this year, and that follows a multi-year string of disappointments for EMs. At the end of 2015, EM stocks had returned -16% over one year, -25% over the past 5 years, and -31% since the 2007 peak. 2
After that stretch, some investors are wondering why invest in EM's at all.
The answer, in brief, is that past returns are in the rear-view mirror. What we care about are prospective future
returns. For EM's, these look quite promising, because years of bad returns have left EM valuations at very attractive levels.
For instance, the institutional investment firm Research Affiliates uses valuations to estimate 10-year forward returns for a wide variety of asset classes. Out of all the investments Research Affiliates provides forecasts for, EM stocks have the highest forecast at 7.9% per year plus inflation over the next 10 years. (Compare this to an estimate of just 1.1% per year for US large cap stocks). 3
This isn't based on an expectation of blazing EM economy growth; it's just a function of starting valuations. The cyclically-adjusted price to earnings ratio for US stocks is an unusually high 24.6, while for EM stocks it's an unusually low 10.6.3
We are the first to agree that US stocks "deserve" to trade at somewhat of a premium to EM stocks, but the current 132% premium is way
out of line with historical valuations.
The below chart from another institutional investment firm, GMO, shows that the last time EM stocks went through a really rough 5-year period and were declared dead, they went on to deliver outstanding returns: (read more)