It's a Small World After All: Why Emerging Markets Demand Some of Your Investment Attention

Winter 2010 CSANews Issue 77  |  Posted date : Dec 16, 2010.Back to list

You've probably heard talk of the rapid "globalization" of the world economy.  Corporations are becoming increasingly international in scope, operating different divisions in various countries. Economies are becoming increasingly interlinked, with trade being conducted across borders and even across continents. And investors from all over the world are sending their money overseas like never before, seizing investment opportunities wherever they're to be found.

Recently, these vast economic changes have shifted the attention of many financial analysts to those countries just beginning to industrialize…countries in which some of the greatest investment opportunities are yet to be discovered. These are the emerging markets.

What are Emerging Markets?

Very generally, emerging markets can be thought of as countries that are still in 
the process of industrialization and rapid economic growth. That makes them distinct from developed markets in North America and Europe, where the process of industrialization is largely complete and growth tends to be slower.

Just exactly what defines an emerging market remains open to some debate. Different organizations use different criteria to determine which countries make the grade. While most agree that large economies such as China, India and Brazil are all emerging markets, smaller markets such as Argentina or Pakistan are included on some lists, but not on others. Even when it comes to generally accepted members (China, for example), there is debate regarding whether portions of the larger market (Hong Kong, for example) should be considered a distinct market, or whether it should be considered developed or emerging.

The following list of emerging markets is taken from the respected British news magazine The Economist. While lists from other organizations may differ somewhat, the following is a good representation of the countries which investors talk about when they talk about emerging markets.

Brazil
Morocco
Chile
Peru
China
Philippines
Colombia
Poland
Czech Republic
Russia
Egypt
Singapore
Hong Kong
Saudi Arabia
Hungary
South Africa
India
South Korea
Indonesia
Taiwan
Malaysia
Thailand
Mexico
Turkey

However you define the group, there remains a broad spectrum of economic development within the larger group. For example, Asian nations such as South Korea, Taiwan and Singapore have a history of foreign investment and economic progress. In many ways, these countries might more accurately be called developed economies than emerging economies. The former communist states of Central and Eastern Europe (Hungary, Poland, the Czech Republic, Russia, etc.) have all privatized their economies, but some have been more successful in introducing investor-friendly reforms than others. Huge populations and rapid industrialization efforts are fuelling impressive growth in India and China, but the exact form of that growth is vastly different in each country.

Bigger is Better – BRICs

Instead of talking about emerging markets as a whole, some investors prefer to talk about the so-called "BRIC" countries - Brazil, Russia, India and China. Think of these as the "heavy hitters" of the emerging markets; they are by far the largest of the emerging market economies, and the ones that have made the greatest strides in changing their political systems to embrace capitalism.

Each of these countries offers a compelling investment thesis. Brazil is a commodity-based economy (much like Canada and Australia), and the dominant player within the South American economic zone. Over the past decade, Russia has become an oil-and-gas superpower, supplying the bulk of Europe's energy. India is a huge market, and home to the largest concentration of middle-class people on earth. Over the past decade, China has become the manufacturing centre of the world.

In the years to come, the BRIC countries will be an economic force to be reckoned with. They account for an outsized portion of emerging markets capitalization, and are likely to join the club of developed nations relatively soon. They are also among the easiest emerging markets for foreigners to invest in, either directly or through pooled funds such as ETFs (see below).

However attractive they are, they are not a proxy for emerging markets as a whole. Depending on your investment needs, and your belief in the investment thesis for some of the smaller emerging markets, investing in the BRICs may not be a substitute for the overall emerging market.

Frontier Markets

As the years pass and the BRIC economies and other emerging markets become more stable (both politically and economically), investors are turning their eyes further afield, to the so-called "frontier markets."

As their name suggests, these are truly the "wild west" of investing: countries and markets that are often better-known to geographers than to capitalists, with economies still in the earliest stages of economic development.

Much like emerging markets, the exact definition of frontier markets is an open question. Some member countries are relatively open and economically developed, but have stock markets that are too small and too illiquid to be included in the broader category of emerging markets (Estonia, for example). Others are at a much earlier stage of their economic development, and are just now opening their economies for international business (Vietnam would be a good example here).

The following is a list of frontier markets as defined by Morgan Stanley International. As of May 2010, the organization is considering adding Bosnia and Herzegovina, Botswana, Ghana, Jamaica and Saudi Arabia to the list.

Argentina
Nigeria
Bahrain
Oman
Bangladesh
Pakistan
Bulgaria
Qatar
Croatia
Romania
Estonia
Trinidad and Tobago
Jordan
Serbia
Kazakhstan
Slovenia
Kenya
Sri Lanka
Kuwait
Tunisia
Lebanon
Ukraine
Lithuania
United Arab Emirates
Mauritius
Vietnam

If getting in early is the game you're looking to play, frontier markets are the place to play it. Keep in mind, however, that investing in frontier markets is not for the faint of heart. Many of the frontier markets are places in which economic law and investors' rights are not yet fully developed. Investment risk and political risk can be extreme. Then again, so can the potential payoff.

Why Invest In Emerging Markets?

There are several compelling reasons why investors might want to allocate a portion of their portfolio to emerging markets. 

Compelling demographics:

Emerging markets contain three-quarters of the world's population (China and India alone make up nearly a third of the world's population). What's more, that population is growing more rapidly than the population of the developed world, and is considerably younger too. 

These simple demographic facts have profound economic implications: while the developed world deals with an aging population that will likely be a drain on the economy (via health-care costs, old age security and pension payouts, as well as other government benefits for which the working population will have to pay), emerging markets have huge populations that are in the prime of their working years, just now able to acquire the products and services that will drive their 
economies for years to come.

Stronger Growth Rates: 

As emerging markets rush to industrialize, their governments are pouring billions of dollars into public works projects, in order to provide the groundwork for businesses and commercial enterprise. This, in turn, attracts foreign investment (in factories, warehouses, etc.). The result is a "virtuous circle," in which the economy grows at a rapid pace in a short period of time. Contrast this with the developed world, where much of this commercial infrastructure already exists; in such economies, growth is much more muted.

As an investor, the attraction of emerging markets often comes down to simple math - the opportunities for a business are much greater in an economy growing at a rate of 8.6% per year (as India's economy is projected to do in 2011) than in an economy growing by 2.5% per year (as Canada's will in 2011).

Superior valuations:

In developed economies, investors generally pay top dollar for top growth prospects: you might pay 30 times forward earnings for the shares of a company growing at, say, 20% annually. In emerging markets, that multiple is usually much lower.

In part, that's a product of perceived risk. A high-growth company in the U.S. is generally better known and better understood than one in Brazil, for example, and its financial statements are generally more trusted than a company in, say, Indonesia. Because investors are willing to pay higher prices for certainty, the U.S. company's shares tend to command a premium over similar companies in emerging markets.

Even so, if getting the most bang for your buck is important to you, and you believe in buying growth at a reasonable price, companies in emerging markets often offer fairly compelling valuations compared to the developed world.

Limited Exposure to the Credit Crisis:

The credit crisis of the past several years has hit developed nations hard. And while emerging markets have certainly not been immune to the fallout, most of them have been able to put their financial houses in order more quickly than many developed nations.

As Europe and the United States face years of austerity measures and economic cutbacks in an effort to stimulate their economies and clean up their financial systems, emerging markets can concentrate more fully on economic growth and development. Which would you rather invest in?

Diversification:

While it's true that emerging markets can be volatile (particularly the smaller or less-developed ones), allocating a portion of your portfolio to this asset class tends to reduce volatility in your portfolio as a whole. The reason: the performance of emerging markets isn't perfectly correlated with the performance of developed markets.

In other words, when stock markets in the developed world zig, stock markets in emerging markets often zag. This is not to say that emerging markets won't be affected in some way by economic events in the developed world (see our discussion of the credit crisis, above). But the overall effect should be more muted, helping to minimize risk in other areas of your portfolio.

How to invest in emerging markets

There are many ways to put your money into the emerging markets. Not all of these will be suitable for all investors – make sure to do your homework to determine which method of investing is right for you.

Direct investing

For sophisticated investors, the easiest method of investing in the emerging markets is simply to open an online brokerage account and start trading. Of course, this is easier to do in some markets than in others. The BRIC economies, for example, have large stock exchanges with reasonable liquidity, making trading fairly straightforward for Canadian investors. In some of the smaller countries, it's not that easy - you'll likely have to trade through an experienced stockbroker to gain access.

One drawback for direct investors is the question of currency risk; because foreign securities are most often purchased in their native currency, the value of your investment may fluctuate as the exchange rate versus the Canadian dollar fluctuates. So, for example, you might be excited to see your shares in a Brazilian bank rise... but your investment might not pay off quite so well if the 
loonie rises against the Brazilian real.

Exchange-traded funds (ETFs)

ETFs have a significant advantage over individual stocks: they offer immediate and cost-effective diversification. That diversification can be wide (covering all emerging markets, for example) or quite narrow (a specific country, or a specific sector within that country).

ETFs are traded on major North American exchanges, making them easy to negotiate. Some of the less well-known ones can be pretty thinly traded, however, making for large bid-ask spreads. And not all ETFs are hedged back to Canadian dollars, making currency risk a bit of an issue.

Mutual Funds

The incomplete information and heightened political risk of emerging markets require detailed, in-depth knowledge of the risks and opportunities. Those who can analyze a market's political situation and a company's prospects from the ground up have a distinct advantage over less-informed investors.

Mutual funds fit the bill here. There are a number of excellent offerings from well-established fund companies, giving investors access to seasoned experts who are well-versed in the regional political and economic scene. Keep in mind that you''l be paying for such expertise, however. Management fees for emerging markets funds can be quite high when compared with fees for ETFs or mutual funds that invest in developed markets.

Multinational Companies

And then there are those who believe that the best way to gain exposure to emerging markets is to keep their money at home. By investing in well-managed, globally focused companies from developed markets that have significant operations in emerging markets, you can get the best of both worlds: a more liquid investment run by proven management that has exposure to rapid growth, while avoiding some of the risk and guesswork that comes with putting your money to work overseas.

It doesn't take a lot of homework to find solid, blue-chip companies that do a lot of business in emerging markets: Coca-Cola, Nike and Pfizer are some big-name American companies with significant exposure to emerging markets growth. Many Canadian mining and materials companies are in a similar situation – many of their top customers are located in emerging markets (China, in particular).

Before you rush off and send your money on a world tour, you should know that emerging markets aren't for everyone.  It will probably take years for some emerging markets to reach a full state of development, and you can bet that there will be some unforeseen problems (either political or economic) along the way. As a result, volatility in emerging markets is likely to be a good deal higher than it is in developed markets. If your risk tolerance is lower than average, or you need a safe, secure place to put your money, you should probably look elsewhere.

While the exact exposure to emerging markets depends on your individual investment goals and risk tolerance, a maximum of 10% portfolio exposure to emerging markets is probably a good place to start. Those interested in adding more should seek professional advice. Proceed with caution, and you may well be singing the praises of this small world of ours.