Financial Times Column on emerging markets June 21st 2011
http://www.ft.com/intl/cms/s/0/e9788ae0-9bf5-11e0-bef9-00144feabdc0.html#axzz1WG7oGpKH
How much more “emerging” have the emerging markets left to do? Probably not much, given the vast amount of capital and hope invested in the asset class already.
The extraordinary scale of what has occurred is evident from the equitization ratio – a broad-brush indicator of financial development that measures the market capitalization of a country’s stock market in relation to its GDP. According to Warren Buffet, this ratio is “probably the best single measure of where valuations stand at any given moment.”
Different economic structures lead to different levels of equitization – a small country like Switzerland that hosts a number of large multinational companies would be expected to have a higher ratio than, for example, Italy. The same goes for a country like the UK which offers its stock market as a platform for companies from all over the world.
These, though, are all high income economies. Historically it was normal for low income economies to have low equitization ratios. The reasons are obvious. By definition, poorer countries lack the ability to accumulate substantial stocks of financial assets. Weak governance and political instability mean high risk premiums. Banks, often subject to political influence, dominate the financial system.
Large equity markets require large institutional investors, which in turn require a large middle class willing to hold long duration assets such as equities. Even in the case of a highly equitized economy like the United States the ratio remained below 80% from 1930 to to 1996, the year of Alan Greenspan’s famous “irrational exuberance speech.” Spells above that level – 1929, briefly in the early 1970s and the dotcom bubble – have heralded lousy long-term returns.
As recently as 2003 many emerging markets – including all four “BRICs” – had equitization ratios below 50%. Now Brazil, India, Thailand, South Africa, Saudi Arabia and Korea are among the second-tier markets that have seen their equitization ratios rise above the 80% level that proved so crucial for the US.
In a stunning reversal of fortune it is the slow-growth mature economies that now have the low equitization ratios. Germany, which generates real GDP per capita of $37,000, has an equitization ratio of 47%, whereas the Philippines, with a per capita GDP of just $3,700, sports a ratio of 66%. Likewise, Japan is now less equitized (63%, on GDP per cap.of $34,000) than Peru (75%, on GDP per cap of $9000.).
The chart below shows how the relationship between GDP per capita and the equitization ratio has changed for the world’s largest markets.
China has been central to the emerging markets boom yet four years of bear market have left its own equitization ratio at a subdued 62% – well down on the 140% which marked the Shanghai market’s peak in 2007. Instead it is the countries that satisfy China’s ravenous appetite for resources that have seen their stock markets continue to balloon. Malaysia, Canada, and Australia all have equitization ratios north of 130%. Chile, with a stock market worth 185% of its GDP, is in a class of its own.
If Australia and Canada removed from the data set (on the grounds that though high income countries, they have become part of the BRICs complex), the correlation between wealth and stock market size evaporates entirely.
Markets appear to have discounted a smooth and painless path to development for the entire emerging world. At first glance valuations may not look especially demanding, but at the height of a decade-long boom this can be deceptive. Commodity-reliant companies in the developed markets – like the Japanese trading houses or RTZ – trade on price earnings ratios of 5-8X, reflecting investors’ nervousness about the durability of the commodities cycle. Entire countries whose prosperity depends on the same cycle are valued more than twice as much, leaving ample room for disappointment..
The same could be said for political and governance risk. A crisis of confidence has already occurred in US-listed China plays, where instances of dodgy accounting have led to a sharp sell-off. As a result, the Bloomberg China Reverse Merger Index, which tracks 78 such stocks, now trades on a historic PER of just 5X. It is not ridiculous to envisage some of today’s hottest emerging markets trading on similar valuations after eruptions of political risk.
Like all investment manias, the emerging markets boom began with a good and timely idea. Valuations were low in 2003 and the equitization process had yet to get going. Now the tide of global liquidity has surged into previously neglected locations, inflating stock market capitalizations, creating real estate bubbles and bringing high potential for dislocation and disillusion.
When the tide reverses, as one day it will, the beneficiaries are likely to be blue chip companies in the unfashionable, modestly equitized markets of the developed world.