Blindfold metrics: EMs v the world

A puzzle to begin the week, courtesy of some creative work by analysts at Morgan Stanley.

Conan Carr and colleagues compare stocks in four regions – Europe, the US, Japan and emerging markets – using standardised accounting, valuation and growth metrics. The twist? They disguise the identity of each region, challenging you to figure out which is which. “We expect that like us, some of your preconceptions will be challenged along the way,” they say. Let’s see.

Your first clue: the price-to-book value of each region’s stocks, plotted against their return on equity.

Source: Morgan Stanley

Equities in region A comes across the most expensive, C and D are relatively cheap, and B is just above “fair value”.

Some more information:

• Regions A and C had the strongest earnings per share growth over the last 10 and 20 years.

• Region C has the highest operating margins over the last 15 years, but has lagged behind Region A since 2008 (shown below).

Source: Morgan Stanley

• Region B ranks highest on earning quality – that is, the reasonableness of its equities’ reporting earnings is perceived to be the best of the four regions. Region C ranks lowest.

Or, in table form:

	Valuation (30%)	Profitability (25%)	Leverage (10%)	Quality (20%)	Growth (15%)	Final Rank
Region C	2	1	1	4	1	1
Region D	1	3	3	1	3	2
Region A	4	2	2	1	2	3
Region B	3	4	4	3	4	4

To clarify, each region’s equities are ranked relative to the others, from 1 (best) to 4 (worst). The categories are weighted to give an overall ranking.

All guesses in? Here’s the answer:

Region C, the region that ranked highest overall – emerging markets
Region D – Europe
Region A – US
Region B – Japan

EM stocks have long been touted for their growth potential, of course, but is it a surprise that they rate so well compared to their peers? Here’s Morgan Stanley’s take:

Overall rank = 1. The analysis is consistent with a preference for EM over DM equities. EM is second most attractive on valuation after Europe. Profitability, which may surprise some, leverage and growth components all point toward EM equities as first compared to other regions. However, EM performs worst on the earnings quality and volatility components of the ranking – 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.

Have investors been too cautious, then? It’s worth noting that even after a dismal 2011, in which the the MSCI Emerging Markets Index tumbled almost 20 per cent, investors in EM stocks have celebrated the highest returns of any region over the past 3, 5, 10 or 15 years:

Source: Morgan Stanley

What’s more, the new year has brought a fresh surge of optimism. The MSCI Emerging Markets Index has climbed 14.5 per cent year to date – that’s almost twice as much as the World Index.