The first thing I do when I’m looking for emerging market stocks to buy, is to rank them based on their “earnings multiples.”
At any given time, a stock trades at a certain multiple of every dollar of earnings it throws off. Sometimes you might pay $200 for a dollar of earnings. Other times you might pay just $20.
Most investors don’t bother to think about the actual businesses behind the stocks they own. They simply buy stocks in the hope that another investor will buy it from them later on at a higher price.
You can make money doing this as long as you have luck on your side. As soon as your luck runs out, so will your investing capital.
The world is full of investors like this. Wall Street has a name for them: the “dumb money.” And professional money managers make a living out of separating these amateurs from their hard earned cash.
The first step to avoiding being a sucker is to understand what a stock’s earnings multiple is…and why it’s so important.
Think of it this way: Say you’re interested in a company that will make $100,000 over the next five years. And say the owner of that company is willing to sell you half of his business. How much would you be willing to pay?
You might think $50,000 is a fair price. After all, you’re getting half of a business that will make $100,000 over five years.
But why would you pay $50,000 now to get $50,000 back over the next five years? This doesn’t seem like a particularly smart use of your money.
But what if you paid just $35,000 for half of the same company? You pay $35,000 now. But you get back $50,000. That’s a profit of $15,000 over a five-year period—or an average profit of $3,000 a year.
This is what investing is all about: buying businesses that are selling below their fair value and making a profit over time as a result.
If you buy a stock with a P/E of 10, you’re paying $10 for every $1 of earnings. In 10 year’s time, if nothing else changes, you’ll have earned your $10 stake back. After year 11, you’ll have made a $1—or a 10%—profit.
Of course, if that company’s earnings grow, so will the profits you make. But the cheaper you buy each dollar of earnings for, the more likely you are to profit—providing you chose companies whose earnings won’t shrink over time.
And the better you are at finding companies whose earnings are set to grow over time, the more you stand to profit.
Below, I’ve listed the “big four” emerging markets in order of their earnings multiples.
What you can see is that Russia is the cheapest of the four big emerging markets. You can buy a dollar of Russian earnings for $10. You have to pay double that for a dollar of Indian earnings.
Russia is the world’s largest oil producer and the world’s second largest natural gas producer. And because so many Russian stocks are energy related stocks, earnings are set to rise as demand for energy increases.
Russia is also the best performing of the “big four” emerging markets over the last 10 years. Over this time the MSCI Russia Index has risen by 18.8% a year, measured in U.S. dollars. That compares to gains of 17% a year for Brazil, gains of 15.8% a year for India and gains of 12% a year for China.
Investors expect the earnings of Indian companies to grow faster than the earnings of Russian companies. That’s why they are willing to pay twice as much to own Indian stocks.
But judging by its commodities strength and its history of outperformance, Russia looks like a much surer bet right now.
If you haven’t already, consider buying into Russian stocks via the Market Vectors Russia ETF (NYSE:RSX). It’s the cheapest big emerging market on the block. And the one with the best track record of profits.