Often companies in emerging markets look deceptively cheap if you don’t consider the macro background. For example, we were recently looking at buying stocks in Uzbekistan. We found a rapidly commodity exchange business that was trading at 4x P/E. But is 4x P/E really cheap if inflation is rampant, and the currency is rapidly depreciating?
You need for the company to be able to grow earnings fast enough to more than compensate for the inflation and currency depreciation. That’s a high bar that few companies will be able to get over.
A framework to analyze inflation and currency depreciation
Warren Buffett first wrote about inflation’s implications for equity investors in a 1977 Fortune article: How Inflation Swindles The Equity Investor. Buffett’s analysis argues that return on equity typically does not increase along with inflation. Hedge fund manager Lyall Taylor also wrote a detailed analysis on the interaction between PE ratios and inflation that is essential for understanding today’s market. PE ratios are based on multiples of nominal, not real earnings. A high nominal return on equity is low in real terms in an inflationary environment. Since PE ratios are based on multiples of nominal earnings they are justifiably lower when inflation is high in order to compensate. Lower PE ratios also reflect a higher cost of capital in an inflationary environment.
Emerging specialists probably incorporate this into their process. Yet “tourists” that only occasionally invest in emerging markets sometimes make conceptual valuation errors in high inflation countries.
According to Lyall Taylor:
A serious valuation mistake made by many investors based in developed markets when they invest in high-inflation emerging markets, is to seriously misprice stocks by not taking into account inflation differentials. Places like India have been an obvious example. I have seen many typically first-rate DM investors argue certain stocks in India are cheap at 20x P/E, because they are growing at 15% a year with 15% RoEs (3x book), but that growth was being struck in an environment of 6-7% inflation. The real RoE was closer to 8-9%; real EPS growth was 8-9%, and the real P/E was therefore closer to 35x. Would they pay 35x for a company with a 8-9% RoE in the US/Europe?
Lyall Taylor makes a similar point regarding currency depreciation:
The difference between perceived value and actual value has been reflected in substantial currency depreciation over time (the Indian rupee has fallen from 40 vs. the USD to 70 since 2010, due to elevated inflation differentials, not mean-reversionary currency volatility), which unsurprisingly given the valuations paid, has yielded poor returns over the past decade on a dollarized basis. “Our stock picks have performed well, we merely lost money on the currency”, is a common refrain. Well, of course you did! You also see the same mistake made whenever you read a headline that says ‘EM markets trade at a significantly lower P/E to DM’, implying that that makes EM cheaper. Until you adjust for inflation, you cannot make such a proclamation.
Search For Growth
The best investments in emerging markets are inflation beneficiaries. A commodity exchange seems like it potentially could, at least better than most businesses. It should at least be an inflation beneficiary, even though it will still face rising labor costs and the need to upgrade technological infrastructure. However, with local inflation running so high relative to the rest of the world, it does seem reasonably likely that Uzbekistan will continue its trend of steady currency depreciation since the 2017 devaluation (a lot of emerging and frontier/emerging markets could end up in sort of a mini currency war in the 2020s). And there is always the risk that they suddenly make it hard to get money out if there is a real crisis. With a frontier market you can never really escape worrying about macro issues.