A Different Approach To Low Emerging Markets Valuations

One benefit to the ongoing slide in emerging markets equities is that valuations continue careening lower. Sure, the claim that emerging markets are inexpensive relative to developed counterparts is a familiar battle cry of emerging markets bulls, but the claim has merit.

The price-to-earnings ratio on the MSCI Emerging Markets Index is around 11, well below the P/E's found on major developed markets benchmarks. As just one example, Russian stocks have long traded with a P/E well into the single digits. Investors can also use dividend yield as a way of finding emerging markets value.

A good place to start is with the WisdomTree Emerging Markets Equity Income Fund (NYSE:DEM), which sports a distribution yield of 3.8 percent, or 155 basis points above the trailing 12-month yield on the MSCI Emerging Markets Index. Interestingly, when emerging markets stocks start a year with dividend yields that are considered high, that scenario usually gives way to solid returns.

Actually, we started 2015 not only with a high dividend yield but with one above 3.0%. There have been only five such years before, and although past performance can never predict future returns, the returns were strong in those years, averaging 58%. The lowest return of any of these years was 2012, when the MSCI Emerging Markets Index was up over 18%, said WisdomTree in a note out Tuesday.

A Closer Look

DEM has tumbled 11 percent this year, a decline that can largely be pinned on the ETF's above-average exposure to Russian stocks. DEM's Russia weight is almost 19 percent, making the country the ETF's second-largest geographic weight behind China. By comparison, the MSCI Emerging Markets Index allocates less than 4 percent of its weight to Russian stocks and the country is that index's eighth-largest geographic weight.

As a predictable byproduct of its large Russia exposure, DEM also features big energy exposure. That sector is almost 19 percent of DEM's weight, more than double the energy allocation found in the MSCI Emerging Markets Index.

DEM's underlying index, the WisdomTree Emerging Markets Equity Income Index (WTEMHY), ranks companies by dividend yield and weighs them based on annual cash dividends paid.

DEM's risks are not confined to Russia. Like other emerging markets ETFs, the fund needs clarity on Federal Reserve interest rate policy and some stability in emerging markets currencies, among other factors, before its compelling valuations are widely embraced.

While we strongly believe that emerging markets will come back into favor, it is extremely difficult to predict when this turnaround will occur. There remain very real risks, but the more critical question regards whether the higher dividend yield reflects these risks, adds WisdomTree.