Introduction to the Paperback Edition: Recent Crises Present Historic Opportunities
In the first edition of Global Bargain Hunting, we wrote not only of the large, long-run growth opportunities in the stock markets of emerging countries, but also of the enormous risks involved. We indicated how political and currency instability could sour many investment opportunities and how lawlessness and corruption made many emerging markets a particularly dangerous jungle. Unfortunately, investors in early 1998 experienced only the risks of emerging-market investing -- not the rewards. While the first edition was published after the initial currency devaluation in Asian markets, we did not foresee the magnitude of the meltdown and severe recession in the Asian markets during the first half of 1998 or the spread of the virulent Asian flu to emerging markets in Latin American and Eastern Europe.
Today we better understand the crisis that has gripped the developing world. Moreover, we can reassess whether the fundamental growth case for emerging markets remains intact. Our conclusion is unambiguous. The growth opportunities in emerging markets are perhaps as great as they were when we wrote the first edition, and the bargains appear to us to be better than ever. We are convinced that all investors with long-term horizons who are able to tolerate the volatility and risks so characteristic of these markets should hold a portion of their portfolios in emerging-market securities.
Few analysts foresaw the dramatic collapse that toppled emerging markets in Asia in 1997. Looking back, we can now see that the Asian Tigers and Tiger Cubs who had pegged their currencies to the dollar were becoming less competitive as the dollar appreciated. But inflation was low, and government budgets were more or less in balance. What is now very clear is that private borrowing by banks and corporations was excessive. Moreover, borrowing was often short- rather than long-term and was usually done in dollars rather than in domestic currencies. Overexpansion in industries such as computer chips and excessive real estate speculation could have been absorbed had they been financed more prudently. But they proved toxic as the initial currency depreciations made dollar-denominated debt even more burdensome and currencies even more suspect. The resulting panic led to an investor stampede. The abrupt reversal of foreign investment helped push these economies into a deep recession in 1998.
Complicating a resolution of the crisis and a quick recovery of the Asian economies was the continuing slump in Japan and considerable criticism of the role of the International Monetary Fund in bringing Asia back from a full-fledged collapse. Many investors concluded that the emerging Asian economies are nothing but a house of cards and that long-term investment in these markets is extremely unwise.
Our view is that the Asian crisis and its spread to Latin American and Eastern European emerging markets have created an unprecedented buying opportunity. No one can forecast whether the June 1998 lows in the emerging stock markets will prove to be the bottom. But the biggest long-term gains from equity investing are likely to come when the clouds appear darkest. While critics are now quick to dismiss the Asian miracle, it is well to remember that these economies have achieved increases in living standards in one generation that took several generations for Western countries. And even if growth rates in all emerging markets slow dramatically in the future, they are still likely to far exceed those for the developed world once a recovery begins.
Moreover, investment risks are by no means unique to emerging markets. Excessive risk taking, high financial leverage, and investor panic also exist in developed markets. The near collapse of Long Term Capital Management has certainly highlighted the huge financial risks that exist in today's global capital markets. While the U.S. equity market has continued its fourth consecutive year of 20 percent gains, it is highly unlikely that Wall Street can continue its high-wire act. With market valuations in the United States at their historical highs, it is certainly prudent for the long-term investor to take a closer look at emerging markets.
The fundamental strengths of the emerging economies remain intact. Labor costs are low, work ethics are strong, and the people are thrifty and have a commitment to education. Taxes are relatively low compared with those of the developed world, and entrepreneurs have sprouted like wildflowers. The recent currency depreciations have made these economies extremely competitive in world markets.
The chart that follows shows labor costs in some developed countries and some emerging markets. It is clear that products with a large labor cost component can be manufactured in emerging markets at a fraction of the cost to make them in developed markets.
1997 Hourly Wage Costs in U.S. Dollars for Selected Countries
United States $18.24
Hong Kong 5.42
It is also the case that the currency depreciations suffered by many emerging markets during 1997 have dramatically enhanced their competitive positions. The "Big Mac" index illustrates relative price levels in various countries in the developed and the developing worlds. The exhibit shows prices converted to U.S. dollars for a big McDonald's hamburger. The index suggests that many emerging currencies are currently undervalued. Whether it be investment assets or products or services, the price levels in the developing world are far below those in the most developed countries.
Adding to the attraction of emerging-market investing is that valuation levels in emerging markets now appear compelling. Many well-managed and conservatively financed growth companies in the emerging markets of Asia and Latin America are now available at far more attractive valuations than those in developed countries.
A 1998 study illustrates the point. We selected forty-six matched pairs of companies -- one from a developed country and a counterpart in a developing country. For each pair we collected security analysts' estimates of the five-year growth rate of earnings as recorded by IBES, an international service that collects data from leading securities firms.
To judge the investment attractiveness of the companies, we used a measure popularized by Peter Lynch, the firm's growth-to-P/E multiple. We found that the expected five-year earnings growth rate for this representative sample of emerging-market companies was higher than that for the equivalent group of companies in developed markets. However, the P/E multiples for the emerging-market companies were substantially lower than the multiples for the companies in developed markets. Thus, higher growth expected from firms in emerging markets can be purchased at far more attractive valuations.
Equity investments in emerging markets are also great diversifiers since these markets tend to have low correlations with the United States and other developed-country markets over the long term. U.S. powerhouses see the current situation as ideal for global bargain hunting. GE chairman Jack Welch writes in his recent annual report that Asia "should provide us with a unique opportunity to make the strategic moves that will increase our presence and our participation in what we know will be one of the world's great markets of the 21st century."
Because investing in emerging markets was much out of favor in 1998, unusually attractive investment vehicles became available for individual investors. Closed-end investment companies that hold diversified portfolios of emerging-market stocks became available at discounts of 20 percent or more. For those with strong stomachs and a long-term horizon, commitments today are likely to prove extremely rewarding over the years to come. So join us on a global bargain-hunting adventure and learn how to access some of the most attractive investment opportunities of the new century.
Copyright © 1998 by Burton Malkiel and J.P. Mei