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Emerging Markets Stocks May Be Best Bet Now

Last year’s losers, emerging markets may be this year’s winners.

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A new Morgan Stanley report concludes that emerging market stocks look much more attractive than equities in the United States, Europe and Japan.

Morgan Stanley analysts compared and ranked the four regions using a variety of standardized accounting, valuation and growth metrics.

They found emerging market stocks are cheap and have the second most attractive valuation among the regions, after Europe.

Emerging market also got the highest scores for profitability, leverage and growth. The region has the highest operating margin, which averaged 11.9 percent since 1995.

However, emerging markets have scored worst on the earnings quality and volatility.

Is this enough to offset all the other metrics?

“The market thinks so today, but probably won’t several years from now, if earnings quality improves,” concludes the report.

Europe was ranked second by the Morgan Stanley analysts. It was seen as cheapest across a range of valuation metrics with the highest dividend yield and lowest trailing P/E ratio.

Europe also showed relatively good earnings quality and relatively low earnings volatility.

Moreover, “Europe does derive the highest percentage of revenue from the emerging markets, a positive for relatively long-term future growth relative to the other developed markets”, says the report.

However, its track record in terms of growth, profitability and leverage is inferior to other regions.

Ranks

Valuation (30%)
Profitability (25%)
Leverage (10%)
Quality (20%)
Growth (15%)
Final Rank
Emerging Markets 2 1 1 4 1 1
Europe 1 3 3 1 3 2
U.S. 4 2 2 1 2 3
Japan 3 4 4 3 4 4
Source: Morgan Stanley

The U.S. multiples are among the least appealing. While, profitability is high, and earnings quality and credit ratings are more compelling, growth relative to the emerging markets has been very weak over the last ten years.

Morgan Stanley analysts expect this trend to continue as U.S. exposure to emerging markets is below that of Europe.

On the positive side, the U.S. has shown significant improvement in cost management, especially in more recent years. Its margins averaged 10.4 percent since 1995 and are forecast to be at record levels by analysts this year, according to the report.

Japan came in last, getting lowest scores on profitability, leverage and growth. It ranked as third on valuation and earnings quality.

“Although its valuations are cheap to its own history, they are not attractive versus other regions,” says the report. Morgan Stanley analysts believe it’s a function of both “strength of the Yen, as well as supply side issues.

Japan’s margins averaged only 5.9 percent since 1995, around half the operating margins currently of the other three regions on average.

Japan is also doing poorly on the global IPO market. Its share remains very low compared to other regions.

On the other hand, emerging markets have been making substantial gains, growing to 35 percent in 2011 from 11 percent in 1995.

Europe’s share in global IPO market has come down to 25 percent from 48 percent in 1995; and U.S.’s current share is down from 2001- 2003, but at similar level to that in 1995.

The MSCI Emerging Markets Index is up 14 percent so far this year, compared to 8 percent for the World Index.

Last year, emerging markets were down 20.4 percent, Japan was down 13.9 percent, Europe was down 13.8 percent, while returns in the U.S. were flat.

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