The stock markets of emerging economies have been on a roll in recent years, while the economic performance of developing countries has outshone that of developed markets. It is tempting to predict that these trends will continue. But is that realistic?
Probably not. No economy is immune to the business cycle, which is driven by the human tendency to periodically become either too optimistic or too pessimistic.
Even if economic growth continues unabated in emerging markets, there is no guarantee that this growth will lead to rising stock markets. In fact, if we assess economic growth over several decades, one decade at a time, and relate each period's growth to stock market returns, there is little correlation. Decades with higher economic growth don't necessarily enjoy greater stock market returns.
Last year demonstrated once again that high growth doesn't automatically result in big profits for investors. Brazil's stock market was flat and China's market declined by 14 per cent despite huge economic growth in both countries. In contrast, U.S. and Canadian markets produced over 12-per-cent returns despite almost stagnant economies.
Yet everyone is still talking about emerging markets as an opportunity. When investors all focus on the same idea at the same time, prices tend to rise above fundamentals and the risk of a bubble increases.
On average, the stocks of high-growth companies tend to underperform those of low-growth companies over the long run - and this may also be true for high-growth countries. When growth is high, investors get too optimistic, which leads them to bid prices above fundamentals. Over-investment leads to inflation, which, in turn, forces governments to take actions that dampen economic growth.
What To Look For
Rather than simply seek growth, investors in search of high returns in emerging markets should look for countries with the right characteristics. For starters, focus on emerging countries with diversified economies, as opposed to countries where growth depends on resources. Resource prices are volatile and the resources themselves ultimately run out.
Look, too, for emerging countries that have a democratic government or are moving in that direction. This reduces the possibility of your investment being hurt by an uprising, revolution or confiscation of private property.
Finally, look for emerging markets with growing populations and expanding middle classes, with governments that are willing to invest in education and innovation.
By my scorecard, India and Turkey rank more highly than Russia (non-democratic, resource-oriented) or China (non-democratic, low population growth).
Why You Need Emerging Markets
Having said that, emerging markets should play a role in everyone's portfolio because the performance of these markets tends to be less correlated to the rest of the world than developed markets. As a result, holding emerging-market stocks in a portfolio reduces risk.
Moreover, agile investors may be able to find more attractive stocks in emerging markets than developed ones, because these markets tend to be less efficient than their more mature counterparts. Inefficiencies give rise to mispricing and mispricing gives rise to profitable opportunities if you value stocks properly.
But make no mistake. Emerging markets hold many risks - political, economic, and social. They also suffer from problems related to management quality, accounting clarity, corruption, corporate governance, liquidity risk, and so on.
This is particularly true of the so-called frontier emerging markets such as Botswana and Jordan. And that is why, especially when investing in individual stocks, due diligence is of paramount importance.
The Low-Risk Way
A lower-risk way to reap the benefits of emerging markets is to invest in Western companies that do a large portion of their business in these countries.
This approach minimizes some of the political, social and liquidity problems that go along with emerging markets. Especially for small, risk-averse investors with fewer resources and know-how, this may be the best way to capture the opportunities of emerging markets.