Monday, July 20, 2009 4 comments ++[ CLICK TO COMMENT ]++

Everyone needs to know the game they are playing - P/E vs EPS growth

Now that this blog has a lot of new readers, I should point out that you, as an investor, needs to figure out if what I say is correct but, more importantly, whether my strategies are relevant to you. I'm sure that no one blindly follows anything I say, especially given my questionable record, so the first point is well understood. Regarding the second point, I think it is important to think about whether my strategies and outlook really applies to you.

I encounter many articles in the media, or thoughts on blogs, or words on a message board, and I dismiss some of them because it doesn't fit my investing style. Similarly, anyone reading this should do the same.

I am writing this message after thinking about something that a reader, MrParkerBohn, noticed. He noticed that I am always bearish on emerging markets. This is sort of true and it implies two things.

The first thing to realize is that I could be completely wrong. For example, I have been bearish on China for a long while, and even after the 70% collapse in their market last year, I was still bearish. It's possible that I may turn out to be wrong so you should form your own independent view.

The other thing, and this is what I wanted to write about, is that I may be playing a different game from you. By that, I mean to say that my investing style and strategies could be different from another.

My Game

Like most newbies, my investing has changed significantly over time. So things may yet change as I improve my investing skills. There was a time I was more of a macro investor and was primarily influenced by people like Jim Rogers and Marc Faber (if you look at my holdings in 2004 and 2005, they are mostly commodity businesses). Then I became more of a value investor, influenced primarily by Bill Miller, Martin Whitman and Warren Buffett. There was actually a time, pre-dating this blog, when I paid a bit more attention to technical analysis; now I rarely pay attention except on the very-large macro level (i.e. if a technician says we are in a 9 year bear with a peak set in 2000; or if one says that Dow Transports are weak while Dow Industrials are rallying; or whatever).

I'm not a pure value investor; I'm more influenced by macroeconomics and political actions. I'm primarily a contrarian by nature (in real life too) so I'm more attracted to stocks that are cheap. You can see this in my comments. I rarely am bullish on companies, industries, or countries with high p/e (unless they were cyclicals.) Of course, this is not a magic bullet, given how low p/e leaves you open to catching falling knives or falling into value traps.

I'm also a concentrated investor (with questionable results so far). If you are a diversified investor, some of what I say may not apply to you. For instance, I don't like India as an investment because its P/E is high, it runs a current account deficit*, and its government debt is totally out of control (if I recall India's soverign rating is BBB but rating agencies have threatened to cut it to junk.) But if you are diversified investor putting 5% into an Indian fund, it may be ok. Even if it blows up, it won't impact you much. But a concentrated investor, like me, would likely avoid it because a mistake will be very costly.

P/E Ratio vs Future EPS Growth

Anyway, MrParkerBohn was wondering when a China ETF like GXC would interest me. A 25% decline? Or more? Or less?

Well, I am really bearish on China because I am concerned that it may be building a huge bubble in fixed assets like roads, malls, residential real estate, and so forth. I am also concerned about political stability and property rights of shareholders. But for the sake of argument let's ignore those issues.

The thing is, I don't think I will ever be interested in China (or India or other high flyers) any time soon. I'll probably miss out on any upside but it's just not my game. Investing in those countries is pretty much growth investing, and these countries are not contrarian at all (even after the 50% fall of the Chinese market in the last two years, it was not contrarian IMO.)

The chart below, from an HSBC report, plots estimate of next year's earning growth and 2009 P/E for various emerging markets. It's not clear if this is current P/E or if it is estimated 2009 P/E but it doesn't matter for our discussion here. I really do not like looking at near-term P/Es and would rather look at long-term estimates but I don't have those numbers or a chart like this.

Countries on the left are likely cheaper than countries on the right. Countries near the top are more attractive than countries near the bottom.

One can't blindly rely on a P/E ratio. Low P/Es are generally more attractive but not so much if it is due to the country being discounted for political risk (e.g. Turkey) or if it is because it is a cyclical country (e.g. Russia (commodities) and Japan (export-oriented industrials)--Japan not shown).

Ignoring the political risk or cyclical aspect of these countries, the most pricey would be India, Malaysia, and China, with Taiwan and Chile also being questionable (but the latter two have very high earnings growth). The cheapest would be Russia, Egypt, Israel and Korea (it's not a coincidence that most of these have dark political clouds swirling around them).

I would have to say that I would probably not invest in anything on the right half. This doesn't mean it won't work out in the long run; it just means that it is not my game. China has a p/e of around 15.5 and is forecast to grow earnings by roughly 18% next year. This is better than some country like India, which is forecast to grow earnings a few percentage better while having a significantly greater P/E ratio.

If you invest in some country like China you are basically betting on the EPS growth remaining high. To me, that is a risk I am unwilling to take and is inconsistent with my investing strategy.

The most attractive country to me, at least based on this limited chart, is Brazil. Brazil P/E should get a slight discount because it is somewhat cyclical (oil & gas; iron ore; ship and airline manufacturing; etc) but it looks good on the surface. I am doing research on Brazil and I'm becoming more and more impressed with the country. For instance, I was surprised to learn how much of a dynamic local economy Brazil has. It relies far less on commodity exports than I imagined (this is actually good in my opinion; but bad for someone like Jim Rogers who values those industries). It has high corruption and all sorts of social problems but which emerging market does not?

Ideally, one would want to look at a chart like this with 10 year forward estimates of EPS growth. That is really the true picture. If you look at one year, the earnings may simply be bouncing off a trough (like Taiwan and Korea).

If I was forced to put all my money in one of those countries on the chart, I would put it in Brazil. Not China. Not India. But, overall, I would prefer a country like USA over any of these.


* I have seen some argue that developing countries running current account deficits is not a bad thing. The thinking is that foreign capital is financing the development of those countries. Without the deficits, they won't be able to build productive capacity to the same extent. I haven't given it much thought, or read up on this issue, to say how much of a benefit this is. All I know is that current account deficits leave the country vulnerable to foreign capital outflows and I think that is actually a significant risk.


4 Response to Everyone needs to know the game they are playing - P/E vs EPS growth

July 20, 2009 at 7:27 PM

Thanks for the response.

One of my strategies is basically country rotation based on PE and growth rates.  At one point I had almost no money in this strategy, but after the crash last October I put about 25% of my money into emerging markets based on similar data to the chart you displayed.

About half of that went into broad emerging markets ETFs, and the rest into China and India.  I missed some other oppurtunities, such as Brazil and Mexico, simply because I wasn't paying enough attention to notice the single digit PEs.  Others, such as Russia, never interested me for political reasons (though I suppose if the price was right...)

At the time I bought India, its PE was around 10, which looked like a no-brainer.  I've sold India a few weeks ago.  At a PE of 18, India looks fairly valued or even a bit cheap, if you believe the rosy growth projections.  If like me you are a skeptic, then India looks a bit expensive (but not bubbly), which is why I sold it.

I also bought China at a PE of around 10 (in February 2009), which looked like a bargain to me.  Its PE is around 15 now, which I consider to be fairly valued.  This is close to the long-term average PE for the US, and the demographics in China suggest long-term economic growth.

If China can grow at 5% real (I agree with you that 10% real growth is absurd), plus 1-2% currency appreciation per year, plus 2% in dividends, then I'm riding 6-7% real return.  This is quite satisfactory to me, and in the long run will matter more than short-term PE fluctuations.  That said, if China will drop back to a PE of 10, I'll probably pick up some more shares, and if it rises to a PE of 20, I'll be pretty tempted to sell.

Some of this shows my philosophy of investing.  If I think China is fairly valued, I could sell it and buy into a country I think looks cheaper, such as Brazil.  But I like to see myself as a long-term investor, and for some reason I still have the belief that most of my profits will come from riding long-term economic growth, and not from trading in and out.

I tend to only buy when the valuation screams at me (such as China at PE 10).  For the same reason, I tend to only sell when a security exceeds fair value, unless I see it as a especially risky asset, in which case I will sell at fair value.

I also have a bid in on GULF, which on your chart most closely resembles GCC ex Saudi.

July 20, 2009 at 7:30 PM

Make that 8-9% real return for China

5% real growth
1-2% currency appreciation
2% dividends

July 20, 2009 at 7:47 PM

On Brazil:

I hesitate on this one because I don't understand what's going on with their currency.

From 2000-2003, BRL dropped 50% vs USD
From 2003-late 2008, BRL rose 240% vs USD
In a 3 month period in late 2008, BRL dropped 40% vs USD
In the last 5 months, BRL has risen 23% vs USD.

WTF is going on with their currency?  I know emerging market currencies are unstable, but this is extreme.

My historical currency graphing resource:

Sivaram Velauthapillai
July 21, 2009 at 10:14 AM

I think your strategy is what I call sector rotation. Technically you are rotating across countries but it is similar to rotating sectors. I tried doing a bit of that early on and felt I wasn't really skilled in it. The difficulty I had was figuring out what was "cheap". A P/E of 10 may look cheap but pre-2004 or thereabouts (before the current boom and bust), a lot of countries with low P/Es went nowhere. Keep me posted on how you are doing. I'm curious to see how well this works out if the synchronized world boom has indeed ended.

I thought about the Brazilian currency issue yesterday night and I'm not sure what the answer is...  I was thinking the Real may be tracking commodities but the huge moves pre-2004 does not seem consistent with either the crude price moves or the CRB index moves...

Brazil had political uncertainty and high inflation in the early 2000's so I wonder if that had something to do with that. (One of the risks with Brazil is that I'm not sure future governments will behave similar to the Lula government or if they will go back to their "old ways" of inflating their way through everything.)

Anyway, if I ever decide to do anything serious with Brazil--I was thinking of investing in their bonds believe it or not, assuming small investors have access--I will research the currency issue much further. Inflation, past as well as future, is something one needs to get a handle on.

Post a Comment