The last blog on emerging market equities discussed my view of being bullish on emerging market equities for 2013 because of relatively attractive valuations and an analysis of forward returns from similarly attractive price points.
Yet there are segments within the emerging market equity space that I believe are more attractive than others. The “defensive” stocks in the universe look like they have stretched valuations compared to the “cyclical” stocks.
According to a great study on this topic published by Jonathan Garner and his team at Morgan Stanley, for the period from December 31, 1995, to January 31, 2013, “defensive stocks” within the MSCI Emerging Markets Index universe traded at a price-to-earnings (P/E) ratio approximately 1.3x that of “cyclical stocks” from the same universe.
The current valuation multiple is 1.6x, which has already started trending down from recent highs of 1.8x.
Historical Premium for Defensive Stocks
• The P/E ratio for defensives versus cyclicals is likely to remain above 1.0x. Emerging market equities tend to be riskier than equities in other regions in the world, and investors may be willing to pay a higher price to gain exposure to more defensive stocks within this space.
• Starting in 2011, emerging market defensive stocks traded at a more significant premium multiple than cyclical stocks. Obviously, this happened before, but there has been a tendency for the relationship to revert toward 1.3x and sometimes well below that level.
Put simply, according to the historical relationships exhibited between cyclical and defensive stocks in emerging markets for the period shown in the preceding figure, defensive stocks are currently “too expensive.” There are two ways that this situation might correct itself and return to its historical average:
• Defensive stocks become less expensive relative to their earnings.
• Cyclical stocks become more expensive relative to their earnings.
History Has Shown a Tendency for Correction
Research shows that when defensive stocks have traded at such expensive multiples compared to cyclical stocks in the past, their forward-looking relative performance has suffered: