Capitalize on Cheap EM Materials Names With This ETF

The rally in U.S. equities has, in large part, been lead by defensive sectors such as consumer staples and health care. As a result, valuations for stocks in these sectors are looking a tad frothy. For example, the Consumer Staples Select Sector SPDR (NYSE:XLP) currently sports a price-to-earnings ratio of about 16.7.

With a P/E of 15.52, the Utilities Select Sector SPDR (NYSE:XLU) is also richly valued by the historical norms of that stodgy sector.

Stretched valuations among defensive issues compared to cyclical names is a theme that is also popping up among emerging markets equities as WisdomTree Research Director Jeremy Schwartz notes. Citing Morgan Stanley research, Schwartz says for the period from December 31, 1995, to January 31, 2013 defensive stocks in the MSCI Emerging Markets Index typically traded at a P/E ratio of about 1.3 times that of cyclical names.

The current valuation multiple is 1.6x, which has already started trending down from recent highs of 1.8x, according to Schwartz.

That valuation spread could spell opportunity for investors willing to embrace emerging markets ETFs with higher allocations to cyclical sectors such as energy and materials. Those two sectors along with financial services often dominate many of the most popular diversified and country-specific emerging markets ETFs.

"The P/E ratio for defensives versus cyclicals is likely to remain above 1.0x," said Schwartz in a research note. "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."

Noteworthy is the fact that over the past two years, defensive emerging markets equities have traded at even more noticeable premiums relative to their cyclical peers.

"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,'" Schwartz said.

Comparing two major, diversified emerging markets ETFs in this situation could useful. The WisdomTree Emerging Markets Equity Income Fund (NYSE:DEM), the dominant large-cap developing markets dividend fund, currently allocates more than 36 percent of its weight to materials and energy stocks. Staples and telecom names combine for just 8.4 percent of that ETF's weight.

By comparison, staples alone account for almost nine percent of the iShares MSCI Emerging Markets Index Fund's (NYSE:EEM) weight. EEM is not short on materials and energy name, but at a combined 23 percent of that ETF's weight, those sectors do not loom as large as they do in EEM.

Still, EEM is not overvalued with a P/E ratio of 18.36 and a price-to-book ratio of three. However, DEM's P/E was just 10.8 with a price-to-book ratio of just 1.51 at the end of last year, according to WisdomTree data.

Despite the noticeably higher allocations to high-beta sectors such as energy and materials, the WisdomTree Emerging Markets Equity Income Index (WTEMHY), DEM's underlying index, has been less volatile since inception than the MSCI Emerging Markets Index. The WisdomTree Emerging Markets Equity Income Index, which debuted in June 2007, has been about 500 basis points less volatile than the MSCI Emerging Markets Index on an annualized volatility basis, according to WisdomTree data.

Highlighting the potential rewards of owning DEM or other emerging markets with lower defensive sector exposure going forward are historical performances. Schwartz notes that when defensive emerging markets names have previously traded at premiums to cyclical names similar to what is currently seen, the defensive stocks proceed to lag by significant margins over the next six- and 12-month periods.

"While there is no way to know future performance with certainty, history has shown a tendency for defensive stocks within the emerging markets to be about 1.3x as expensive as cyclical stocks on a P/E ratio basis," said Schwartz. "As of January 31, 2013, this figure was over 1.6x, indicating to us that defensive stocks may be expensive in historical terms. While no guarantee of future performance, this makes us supportive of WTEMHY's current positioning with some of its largest weightings in the Energy and Materials sectors."

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