Inside Why Some Emerging Markets ETFs Are Cheap

It has been noted time again this year that stocks in select emerging markets are trading at substantial discounts to historical norms.

Over the past month, the Vanguard FTSE Emerging Markets ETF (NYSE:VWO) and the iShares MSCI Emerging Markets ETF (NYSE:EEM), the two largest ETFs by assets tracking developing world stocks, are down 6.2 percent and seven percent, respectively.

That says there is an excellent chance valuations that were previously deemed attractive are probably even more so today. Finding emerging markets that sport discounted valuations is not hard. There is no geographic cap on the exercise as stocks in China, Russia and South Korea, among others can be considered cheap.

Discovering the reasons, often revealed at the sector level, why some emerging markets trade at discounted valuations can be instructive for investors looking to exploit said valuations. However, it is worth remembering that P/E ratios can be low not just because of falling share prices, but also because of rapidly increasing per share earnings.

At the end of July, the MSCI Emerging Markets Index had a P/E of 11.3 compared with a 10-year average of 13.4, according to WisdomTree data.

Cheap Sectors Among the most deeply discounted sectors were technology at an almost 47 percent discount to its 10-year average, financial services at a discount of 31.7 percent and energy at 24.5 percent, the WisdomTree data reveal. Depressed valuations for emerging markets energy and financial stocks are particularly important because those sectors, along with materials, often dominate both diversified and single-country emerging markets ETFs.

"On the country side, Russia, Turkey, China, Poland, India, Chile and Taiwan have below-average P/E ratios. Of those, Russia and China clearly exhibited the deepest discount. It's also of interest that Russia (the least expensive country equity market) and Energy (the least expensive sector equity market) have betas substantially above 1.00," said WisdomTree Research Director Jeremy Schwartz and analyst Christopher Gannatti in the research.

Indeed, Russia, the world's largest oil producer, often trades at discounts to the MSCI Emerging Markets Index. The MSCI Russia Index had a P/E of 4.6 at the end of July, well below the 10-year average of 8.7. Gannatti highlighted Russian stocks trading at a discount to their historical standards back in March.

Despite high oil prices and favorable valuations, Russia ETFs have struggled this year. The Market Vectors Russia ETF (NYSE:RSX) is down 15.6 percent.

Investors looking for exposure to the "R" in the BRIC acronym without the commitment of a single-country ETF can consider the WisdomTree Emerging Markets Equity Income Fund (NYSE:DEM). Among major diversified emerging markets ETFs, DEM has the largest weight to Russia at 19.2 percent and energy stocks account for over 21 percent of the fund's weight.

Importantly, Russia is showing itself to be a growing dividend destination. WisdomTree recently noted the country was fastest-growing dividend payer in dollar terms in the WisdomTree Emerging Markets Income Index, DEM's underlying index.

Asia With emerging markets technology names trading at a significant discount to historical norms, it is not surprising that Taiwanese shares are also trading at a slight discount with a 20.8 P/E at the end of last month compared with a 21.6 10-year average. The iShares MSCI Taiwan ETF (NYSE:EWT) is one of the few country-specific emerging markets weights that is not heavily weighted to energy, financials or materials. Rather, EWT has a 52.2 allocation to the tech sector.

China, another market that has become notoriously, may be the world's second-largest economy, but many of its U.S.-listed ETFs are heavily tilted toward financials. With that sector deeply discounted, Chinese stocks traded at 33.5 percent discount to their 10-year average, according to WisdomTree.

"Russia and China stand out with the steepest discounts to their 10-year average P/E ratios. Both of these equity markets exhibit a beta above 1.00 relative to the MSCI Emerging Markets Index, with Russia's even greater than 1.30," said Schwartz and Gannatti.

Financials account for 25.6 percent of DEM's weight and China is the ETF's second-largest country weight at 17.6 percent. That makes sense as China is largest dividend payer in dollar terms in the WisdomTree Emerging Markets Equity Income Index. Taiwan is DEM's third-largest country exposure at 13.4 percent.

Three Russian energy stocks and three Chinese banks are found among DEM's top-10 holdings. The $4.68 billion ETF has a distribution yield of 7.7 percent, according to WisdomTree data.

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Disclosure: Author is long DEM.