Which risk runs deeper: owning or avoiding emerging markets?
Key Takeaways
- Valuation risk: Developed markets appear safe, but extreme valuations and concentration in US mega-cap tech mask hidden risks. History shows that starting valuations at today’s levels have delivered only low-single-digit returns over the following decade.
- Attractive discounts: Emerging markets trade at steep discounts—nearly 60% cheaper than the US and with undervalued currencies—offering visible risks but positively skewed return potential. From these starting points, history suggests forward returns ranging from low single digits to 15%+ per annum.
- Weighing up the risks: Avoiding emerging markets may be the greater long-term risk, as broader exposure enhances diversification and reduces volatility. Less coverage, inefficiencies, and overlooked compounders also create fertile ground for active managers to generate alpha.
Author: Stefan Magnusson
Stefan joined Orbis in 2003. Based in Hong Kong, he leads the Emerging Markets investment team and is accountable for the Orbis Emerging Markets Equity Strategy. He holds a Master's degree in Business and Economics from Stockholm School of Economics, and pursued graduate studies at University of St. Gallen and University of Melbourne. He also completed the Advanced Management Program at Harvard Business School. Stefan is a CFA® charterholder.
Key Takeaways
- Valuation risk: Developed markets appear safe, but extreme valuations and concentration in US mega-cap tech mask hidden risks. History shows that starting valuations at today’s levels have delivered only low-single-digit returns over the following decade.
- Attractive discounts: Emerging markets trade at steep discounts—nearly 60% cheaper than the US and with undervalued currencies—offering visible risks but positively skewed return potential. From these starting points, history suggests forward returns ranging from low single digits to 15%+ per annum.
- Weighing up the risks: Avoiding emerging markets may be the greater long-term risk, as broader exposure enhances diversification and reduces volatility. Less coverage, inefficiencies, and overlooked compounders also create fertile ground for active managers to generate alpha.
In investing, measures of risk are often expressed as a single number. Calculations of metrics such as volatility, tracking error, and value at risk are learned and memorised by many aspiring young financial analysts, ready to apply their newly honed tools to the world of financial markets. While some of these metrics may serve a purpose, they can also mask the true risks in markets and provide investors with a false sense of security. For emerging markets, traditional risk measures don’t paint a pretty picture. Over the past 15 years, returns from emerging markets have severely lagged their developed-market peers and have also been more volatile. For a rational investor with a reasonable level of risk aversion, emerging markets have been an uncomfortable place to invest. By contrast, backward-looking risk measures point to a much smoother ride for US stocks. Returns for investors in the US stockmarket have been much more rewarding and have come with relatively lower volatility. It appears that for the average investor, the US is a much more comfortable place to be. But that comfort may prove to be an illusion. “It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.” — Mark Twain The US now makes up two-thirds of the world equity index, carried by a narrow handful of mega-cap technology companies. Investors appear to be comfortable crowding into these few stocks and appear certain that growth will continue. But the risk that most investors seem to be ignoring which is masked by aggregated risk metrics is in the valuations. On a cyclically adjusted basis, US shares on average trade at 38 times earnings, a near-record high. Why do these valuations matter? Because they heavily influence forward-looking returns. When US shares were valued at this multiple historically, they reliably returned just low single-digits nominally over the next decade, barely keeping up with inflation.
“It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.”
— Mark Twain
Valuations matter in both the US and emerging markets
Cyclically-adjusted price-to-earnings (CAPE) ratio and prospective 10-year returns.
30 Sep 2025 | Source: Minack Advisors. MSCI, National Bureau for Economic Research. CAPE ratio is based on trailing operational earnings. US$ price indices, with index and cyclically-adjusted earnings deflated by US Consumer Price Index. Data is monthly from 1997 to 2015. Prospective 10-year returns are total returns, calculated using monthly price series of the S&P 500 and MSCI Emerging Markets indices and annualised.
By contrast, shares in emerging-market companies today trade very reasonably. Emerging-market shares change hands at around 16 times earnings on the same basis, below their long-term average and at a steep 60% discount to the US. The currencies look cheap too, with a basket of emerging-market currencies currently close to a 20% discount to the US dollar, based on a simple purchasing-power-parity model. For emerging markets, the range of outcomes for the future is wider but skews more positively, with returns from today’s valuations typically ranging from low single digits to more than 15% per annum.
The approximate discount at which emerging-market equities trade compared to their US peers.
None of this is to deny the risks. Political instability, deficient governance and state involvement are real challenges, and currency swings can magnify volatility. But these risks are visible and, in many cases, already reflected in depressed prices. Meanwhile, government shutdowns, ballooning deficits and debt, government involvement in the private sector, trade policy uncertainty, and the dollar having one of its worst years in decades appear to have had little to no impact on valuations in the US. With valuations where they are, to us, not having enough emerging-market equity exposure may be the deeper risk.
Long-term allocations
Often, investor enthusiasm in emerging markets is narrow and short-lived. In the 2000s, the BRICs (Brazil, Russia, India, China) became shorthand for the unstoppable rise of emerging markets. Investors were ultimately let down as valuations and governance risks reasserted themselves. Today, India has once again become an investor darling, with excitement about its impressive economic trajectory and favourable demographics. But the evidence doesn’t back up the sentiment. In one of investing’s great ironies, there is no reliable link between overall GDP growth and equity returns. High-growth economies often disappoint equity investors if starting valuations are high, competition increases, or poor governance undermines minority shareholder rights. On the flip side, slower-growing economies can deliver excellent returns if shares are cheaply valued. India today trades at a 100% premium to other emerging markets. Those expectations are hard to meet, never mind exceed, perhaps part of the reason India has been left in the dust by markets like China, Korea, and Brazil over the last year. What to do instead? Broader emerging-market exposure, for example through passive exposure, captures a better diversification benefit with less valuation risk. But, as with developed-market indices, emerging-market indices are similarly concentrated. China and Taiwan make up over 50% of the MSCI Emerging Markets Index, of which 11% is in a single stock, Taiwan Semiconductor Manufacturing Company. A passive approach misses the exceptional alpha opportunity in emerging markets. Emerging-market shares often have less analyst coverage, benefit from specialised local on-the-ground research to address challenges like language and governance, and offer a higher proportion of compounders (excellent businesses with very long-term growth potential). For disciplined investors, this is rich ground for finding opportunity. Many of the usual risks associated with investing in emerging markets can be mitigated, if not sidestepped entirely, by being selective. Seeking out emeging-market businesses that are durable and have wide and growing moats, long runways for growth, and able management that are aligned with shareholders can prove highly rewarding.
Emerging markets are already "value"; Orbis Emerging Markets Equity appears even more so
Metrics for Orbis Emerging Markets Equity Fund and selected stock market indices.
30 Sep 2025 | Source: IBES, Orbis. This is not personal advice or an opinion or recommendation to buy, sell or hold any financial product, or to adopt any investment strategy. Past performance is not a reliable indicator of future results. Data is based on a representative account for the Orbis EM Equity Fund. EM = Emerging Markets. In each case, numbers are calculated first at the stock level and then aggregated using a weighted median. Statistics are compiled from an internal research database and are subject to subsequent revision due to changes in methodology or data cleaning. *Based on IBES estimates of current fiscal year earnings per share. ⌃Revenue growth (%), 10-year average. †Return on equity (9), 10-year average.
Breaking the comfort trap
Emerging markets are often avoided because they feel uncomfortable. Volatility, politics, governance—these risks are real, and investors can point to headlines that justify their caution. But in investing, comfort comes at a cost. Global stockmarkets today carry hidden risks in the form of high valuations, narrow leadership, and excessive concentration. By contrast, emerging markets offer visible risks at visible discounts. They bring diversification, compelling forward-return potential, and fertile hunting ground for active managers. At today’s prices, the deeper risk may not be in owning emerging markets but in avoiding them. The comfort trap is seductive—but breaking free of it may lead to stronger, more resilient long-term portfolios.
“EMs can bring diversification, compelling forward-return potential, and fertile hunting ground for active managers.”
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