If past events were experiments, the history they leave behind is the evidence of the tests

By FUNDSUPERMART / Pic By BLOOMBERG

There is a lot to learn from history, especially when it comes to investing. Historical events allow us to understand the fundamental forces that drive markets.

If past events were experiments, the history they leave behind is the evidence of the tests.

While we shouldn’t assume history will always repeat itself, past events can serve as a reliable guide in the present day and may be useful in providing context to navigate the ever-changing financial markets.

The lesson history gives often brings us back to the important principle of looking at fundamentals when investing.

Psychological biases may affect our thought processes, and consequently investment action (or lack thereof).

Many would not consider dipping their toes in emerging markets (EMs) in this period, but if we widen our horizon and look beyond the immediate term, the investment opportunities are more than you can imagine.

With the availability of data, it becomes increasingly important for investors to prioritise and sift out the noise. How to decide what data is important? Unfortunately, there is no hard and fast rule to adhere to since economic dynamics vary across markets.

Generally, investors should place higher emphasis on data points that have greater impacts on earnings and valuations for a particular market.

By basing investment decisions on what affects earnings and valuations, it gives us an objective overview on whether an investment is under-valued or overvalued.

Using Indian equity markets as an example, one key data point we believe materially affects the market’s earnings and valuation is inflation.

Given the country’s reliance on oil imports, inflation has second order implications on input costs, cost of financing and ultimately corporate profitability.

In the years leading up to 2011, India was plagued with high inflation due to rising oil price from US$70 (RM294) a barrel to a peak of US$130 from 2009 to end-2011.

In response, India’s central bank significantly tightened monetary policy by hiking rates 12 times from 2010 to end-2011.

Investors’ outlook on Indian equity markets was consequently dampened, thus making Indian markets one of the worst performing in 2011.

While a slower global growth outlook may appear grim to most people, India is likely to benefit as inflationary pressure eases on weaker global oil demand and price.

Any sign of moderation in inflation would be positive for India’s equity markets given it would encourage the central bank to halt, or even reverse its anti-inflationary monetary policies in favour of a more accommodative stance.

The macroeconomic environment moving forward would be positive for both corporate profitability and equity valuations as businesses would likely be supported by lower operating and financing costs.

Even though market consensus expected slower growth outlook for economies in 2012 and beyond, the consensus expected to see healthy growth for the Indian equity markets.

Earnings per share for the Sensex Index was forecast to grow (in local currency terms) by 9.5%, 16.1% and 14% for financial years (FYs) 2011-2012, FY12-FY13 and FY13-FY14 respectively.

While externalities will invariably have some effect on earnings of Indian corporates, the country is still relatively insulated given its consumption-driven economy.

The growth story of India comes not from trade, but the age and size of its population.

Historically, India’s negative excess equity yields (equity earnings yield less bond yield) has been largely a product of the high inflation.

However, the market’s negative excess equity yields eased from negative 3.1% at the start of the year to negative 1.5% by end-2011, mostly contributed by a derating of the price earnings (PE) multiple.

Clearly, negative sentiment ruled the day. However, if we follow our investment thesis of tempering rates in due course as well as forward earnings not to veer too far off consensus estimates, the investment story of Indian equities as an undervalued asset class remains intact.

As equity investors, we are buying into the future earnings of the companies and the expected returns are dependent on the prices we buy into.

At a forward 12-month PE ratio of negative 13.4 times by the end of 2011, the Indian equity markets traded near its -1 standard deviation level below its 10-year historical average.

With a supportive earnings backdrop and softening inflation outlook, fundamental-based investors will find it hard not to dip their toes in this market.

Given our knowledge on how things have panned out for the Indian equity markets thus far, it would not be productive to go into details on the potential returns you could have earned.

Nonetheless, we can use this lesson to draw some parallels with what we are observing in some EMs today.

While the economic situation of EMs is different now, the key elements of fundamental investing has not change. Valuations and earnings should always be at the core of any investment decisions.

Even after accounting for the negative impact arising from the China-US trade dispute, earnings of the EMs markets are still expected to grow at a decent annualised rate of 12% per annum through to 2020.

At current valuations, it implies a PE valuation of nine times and 7.2 times for 2019 and 2020 respectively.

Going along with our target PE of 12 times, the market is currently offering investors a potential upside in excess of 50% by the end of 2020.

While slowing economic data in China and noise from the ongoing US-China trade negotiations may contribute to near-term volatility, we are not expecting a nosedive in growth prospects in China.

Right now, we believe there is an asymmetry between downside risk and upside potential (biased towards the upside) that makes Chinese equities a compelling proposition for investors.