When the EM Discount Looks Tasty

(Bloomberg Gadfly) -- When investors sense that consumer behavior in emerging markets is changing, they tend to shoot first and ask questions later, potentially missing opportunities.

It's well known that such stocks trade at a discount. The MSCI World With EM Exposure Index, which tracks developed-world shares that rely on emerging markets for revenue, was valued at 16.4 times forward earnings at the end of June, one-third above the 12.2 times for the "pure" MSCI Emerging Markets Index.

The argument for the "Western" stocks is that while they have EM growth, they don't share the developing countries' poor corporate governance. So the likes of Apple Inc. and tobacco maker Philip Morris International Inc. deserve a premium, the argument goes.

What about spinoffs? Take Yum China Holdings Inc., once part of Yum! Brands Inc., and Imax China Holding Inc., which split from Imax Corp. two years ago. The subsidiaries account for about half of their parents' total revenue; in theory have inherited their parents' governance and management style; yet offer faster earnings growth.

For all that, Imax China and Yum China trade at substantial discounts. 

One could argue that intellectual property is part of value: Imax has the display technology, Imax China doesn't. Yum China operates 90 percent of its restaurants in the country, a capital-intensive business, while the parent uses a franchise model -- so Yum China could be viewed as a deadbeat retailer, while Yum is perceived as a (more valuable) software licensing company. 

But what's the value of intellectual property if it doesn't generate growth? 

Imax China's valuation deflated quickly this year because earnings expectations dropped. Analysts cut 2017 estimates by an average 37 percent, according to data compiled by Bloomberg, because Dolby cinemas entered China a year ago and increasingly sophisticated consumers grew tired of Hollywood superhero movies. The company now trades at 21.9 times forward earnings, down from 33 times in late 2015 and well below the parent's 33.7 times.

From an earnings standpoint, though, Imax China is the one with the growth. 

The argument for Yum China is stronger still. The company went public last October, trading at eight times enterprise value to Ebitda because investors were worried China's middle class had had enough of fried chicken. The fast-food chain handily beat earnings estimates for two straight quarters, prompting a re-rating in the spring.

Sentiment remains fragile, suggesting that investors may be too focused on the short term: Yum China stock tumbled 12.9 percent on July 6 after missing second-quarter earnings estimates by only 1.5 percentage points, widening the valuation gap again.

As Gadfly columnist Shelly Banjo argued, Yum China has plenty of potential in China's smaller cities and with delivery services. Over the past year, analysts raised 2017 earnings estimates by 13 percent, while those for the parent were reduced 33 percent. When the market realizes Yum China can deliver consistent growth, there's room for improvement in its multiples.

This may be a case of good things coming to those who wait.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Shuli Ren is a Bloomberg Gadfly columnist covering Asian markets. She previously wrote on markets for Barron's, following a career as an investment banker, and is a CFA charterholder.

To contact the author of this story: Shuli Ren in Hong Kong at sren38@bloomberg.net.

To contact the editor responsible for this story: Paul Sillitoe at psillitoe@bloomberg.net.