Reduced Risk and Increased Return Using Country Specific Emerging Market Investing (FCHI, EWZ, ECH, TUR, EPU, VWO)

Over the past 5 years (since June 2009) the slow growing and challenged US economy has outperformed the much faster growing and demographically superior emerging markets by 70% in terms of stock market performance. This performance gap was even more pronounced over the past 1 ½ years, with the US market returning 34% and the broad emerging index actually down 1%. Another mark of the growing disparity between the US and emerging markets are recent CAPE (cyclically adjusted P/E) levels. These are price to earnings ratios that smooth out the effects of more short term cyclical ups and downs in earnings. The latest CAPE for US stocks stands around 25 (well above average) while CAPEs vary widely among emerging countries but most are between 5 and 20 with many in the 10-15 range. So with this seemingly large valuation advantage in emerging market countries should one simply go ‘all In' and invest in something like the Vanguard FTSE Emerging Market ETF VWO? One could probably do a lot worse, but I think there is a better way. By researching and tracking several metrics on ‘easily investable' individual emerging countries an investor can greatly increase their chances at making greater returns and reducing risk versus owning a market cap weighted emerging index. Below are the metrics researched for each country along with a brief explanation of each. • Demographics: In general the younger the population of a country, the better for the economy, growth, and the stock market. We look at the percentage of the population below 25 years old and above 54 years old. The below age 25 data point gives a good idea of potential labor force growth. The older than 54 data tells us how significant the burden of an older (non-working) population will be on the overall economy. • Real Interest Rates: The higher the REAL interest rate in a country relative to other countries the more attractive investment in that country becomes. The Real interest rate is defined as what return you can receive on cash/short term bonds minus inflation in that country. Currently most emerging markets have low to mid single digit RIR's while the majority of developed countries have negative RIRs. • Recent Performance: All else being equal we like a recent underperformer vs. an over performer. We like to take advantage of mean reversion and the over reaction of most investors to past news. • Subjective View on The Country: An investor does not just want a purely number driven analysis. Many different subjective factors such as the politics of the country, quality of accounting, risk of war, corruption levels, etc. should be rolled into the overall analysis as no matter how cheap a stock market if it is completely corrupt no price is justified. • Valuation of Stock Market: As with any investment the actual valuation analysis of the countries' stock market is very important to the overall process. Several different data points are used to come up with a county stock market valuation including dividend yield, earnings yield, CAPE, and the price to book ratio. • GDP to Debt Ratio: The lower the debt to GDP ratio of a county the better. This is fairly obvious as lower debt allows easier future credit/government spending growth, much more flexibility in addressing economic problems, and a lower debt burden to the population. • GDP Growth: Obviously, all else being equal, the higher the GDP growth of a country in the future is better for the health of the economy and the stock market. • Currency Outlook: This is one of the hardest but most important aspects of this analysis. Even if the investor was spot on in their analysis of the country itself, valuation, etc., the currency affect can overwhelm. Therefore in analyzing the strength of the local currency we look at many factors including real interest rates, inflation, purchasing power parity, recent performance, etc. Currently our model is overweight Peru EPU, Turkey TUR, China FCHI, and Brazil EWZ. Although since most of the countries have performed very well over the past 3 months or so the magnitude of overweight has come down across the board. Since February we had an overweight to Chile ECH but after a ~15% return in the ETF since then this is no longer a preferred position. Eric Mancini, CFP is Director of Investment Research at Traphagen Financial Group (www.tfgllc.com).