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Investors who have long played safe by using shares in Western multinationals to tap into the emerging market boom are looking afresh at buying emerging equities instead, seeing prices as cheap after two dire years for the asset class.
Blue-chip companies such as Procter & Gamble and Unilever have long been regarded as a win-win bet, allowing shareholders to participate in the developing world boom while avoiding currency, political and corporate governance risks.
The trade paid off handsomely, especially in the volatile post-Lehman years. Data from Goldman Sachs shows a model basket of 50 Western companies with high emerging markets exposure would have outperformed a group of pure emerging markets plays by 20 percent since mid-2010.
But the result is that shares in these blue chips are now looking pricey. The multinationals' basket trades on average at a price premium of over 20 percent to emerging markets, based on the ratio of share prices to estimated future earnings.
That price gap, Goldman says, is the widest since 2007.
A discount of that magnitude has historically been a "launchpad" for EM outperformance, according to fund managers at Blackrock who now prefer emerging equities to multinationals with exposure to the developing world.
"Sometimes valuations ... and relative price performance give you a signal as to where you should be tilting your portfolio. The recent price action in emerging markets gives investors a strategic and tactical reason to emphasize direct EM investment," said James Bristow, a portfolio manager with Blackrock's global equity team.
That is especially the case for U.S.-based multinationals such as Colgate-Palmolive which trade at around 20 times forward earnings, more than double the emerging markets' average.
"Mostly for relative valuation reasons, the best way to get into emerging markets and growth markets right now is go there directly rather than using proxy trades," Jim O'Neill, chairman of Goldman Sachs Asset Management and the coiner of the BRIC investment concept, told Reuters.
MULTINATIONALS STLL HAVE FANS
This is not to say that multinationals have lost their entire fan base. First, not all funds have the stomach to invest in emerging markets, where volatile currency and political swings can wipe out bumper gains in a matter of days.
Second, emerging bourses usually are loaded with commodity and industrial stocks. Pure consumer plays such as retailers, which are sought after by foreign investors, are rarer and often trade at a premium.
And, according to Dale Winner, who runs a global equity fund at Wells Fargo, it is possible to buy EM-exposed shares that are reasonably priced, particularly in battered European markets.
"I agree there's valuation pressure in U.S. companies -- look at the premiums they are trading on -- but it's the opposite in Europe, because of a macro discount," says Winner who holds Swiss watchmaker Swatch and luxury goods maker Richement.
Based on a price-earnings or PE ratio, both trade 8-10 percent below their past average, Winner says, in contrast to U.S.-based brands such as Avon or Colgate that are trading at a premium to their history. All these companies get at least half their revenues from emerging markets.
WESTERN MARKETS EXPOSURE A DRAG
Emerging equities' lackluster performance in the past 18 months is partly to do with a slowdown in developing countries' high-octane growth, a weakening that appears to be confirmed by data showing falling exports and retail sales almost everywhere.
The slowdown is hitting once-booming sales of goods, from mobile telephones to cars, and threatens revenues at emerging market companies. It is also a worry for multinationals and the investors who have piled into them.
But Blackrock's Bristow argues that valuation -- how much of the bad news are the shares pricing in -- is key.
"We know global growth is slowing pretty much across the board but ... valuations in emerging markets price in more of an earnings slowdown than in developed markets. That means your margin of safety is already higher," he said.
And multinationals, for all their much-hyped emerging markets exposure, typically still get over half their revenues from Western markets, where debt-laden consumers and governments are in saving rather than spending mode.
Take beverage giant Coca-Cola. In the second 2012 quarter its sales jumped 12 percent in Africa and Asia, grew 1 percent in America and dropped 4 percent in Europe. But the two latter markets account for over half its business.
Similarly, Procter & Gamble, which makes detergent and Olay face cream, has struggled this year due to big falls in the developed markets, which make up 60 percent of sales.
"You can own a multinational and get exposure to emerging markets but it's going to be diluted exposure," said Nick Price, who runs an emerging equities portfolio at Fidelity Worldwide Investments. "You have to accept that 60 percent of business is in places where volume growth is close to zero."