How To Invest In Emerging Markets – Part Two
The previous post on this topic argued that emerging markets are essential to the health of capitalism and democracy.
But they can also make above-average returns for savers.
But, as with any proposed investment, the first thing to examine is not the rewards, but the risks.
The most important is that emerging economies are, by definition, in development.
Many benefits to which savers are accustomed in the developed world – political and economic stability, access to information, legal protection, ease of buying and selling – may be compromised.
Consider China, the largest of these developing nations.
It’s a one-party Communist state where information access is limited, even for key economic data.
What is available is often incomplete or inaccurate.
Governance worries are not confined to China
Patchy information applies even to the most prominent Chinese companies.
Ultimate ownership can be hard to determine, and some have undocumented connections with the government or the military.
This concern underlies the current international controversy over Huawei Technologies, the world’s largest maker of telecommunications equipment.
Such governance worries are not confined to China.
Across emerging markets, founders or family control many listed companies.
Their private interests may conflict with those of minority shareholders, i.e., the rest of us.
Patchy research coverage by securities analysts is an exacerbating factor. There is also the problem of liquidity.
It can allow companies to fudge data in their reports and announcements, knowing there are few observers to call them to account.
There is also the problem of liquidity
For many companies in emerging markets, the proportion of their shares listed is itself a minority – sometimes, as little as 10%.
This can happen when a former state-owned enterprise is privatised through a partial public offering.
Or when the founders only want the prestige, rather than the access to new capital, that comes with a listing.
The result is a restricted market, where buying or selling can take considerable time – days, even weeks, are not unknown.
Even in developed markets, none of these risks is absent.
But, if shareholders are harmed, redress can be sought through an impartial legal process.
It’s not so simple in China or India, where the legal processes are state-controlled or just slow.
So, one cannot earn an above-average investment return by seeking below-average risk.
Those who embraced this truth and invested early in the developing world have done well in the long-term, although the ride has been a lot bumpier than in established markets.
More recently, however, the rewards have been harder to achieve.
This is partly because government largesse, in the form of so-called ‘quantitative easing,’ has been a developed-world phenomenon, mainly boosting that sector’s more liquid markets and securities.
This has only been bad news for those who invested in emerging markets during or since the Great Financial Crisis (GFC, 2007-8).
For prospective newcomers, however, those markets, having largely been ignored by international investors since 2011, may be offering exceptionally good value compared with their developed counterparts.
Value is based on four principal measures: dividend yield, asset value, profits, and economic growth.
Yield is, arguably, the most important measure because it shows the return on a company’s shares in terms of the cash paid annually to investors in dividends.
That contrasts with a capital gain that can only be cashed in when shares are sold. Those dividends are only paid from profits.
Latin America has been left behind but is now catching up.
Profits are only made if a company has assets (such as the computer algorithms driving social-media groups), or the more traditional cash, factories, mineral deposits, and shops).
And bigger profits and, therefore, higher dividends can only be achieved if economies are growing.
The starting point is, therefore, economic growth.
The previous part of this story included a chart showing that average annual progress in North America’s economies has more-or-less halved over the past 20 years or so.
The much faster-growing emerging economies have also slowed, but to nowhere like the same degree.
They have continued to outpace the developed world by a wide margin and, as the next chart shows, are considered likely to maintain that lead.
Latin America has been left behind but is now catching up.
Conversely, the current slowdown in China will likely damage emerging Asia and is probably not adequately considered in the 2019 forecast.
Meanwhile, the weaker CEE (Central and Eastern Europe) outlook mainly reflects the continuing problems of Turkey.
So far, so promising, but are emerging markets offering investors a low price for that better outlook?
Taking company profit forecasts and other relevant data from a variety of authoritative sources, such as the World Bank, JP Morgan, and MSCI, this is the picture.
Index | Price/ earnings ratio | Price/ ratio | book Dividend yield |
MSCI Emerging Europe | 7x | 1.0x | 5.3% |
MSCI Emerging Asia | 12.4x | 1.6x | 2.6% |
MSCI Latin America | 13.4x | 1.9x | 3.2% |
USA – S&P 500 Index | 20.8x | 3.2x | 2.0% |
Germany – DAX index | 11.9x | 2.8x | 2.8% |
UK – FTSE 100 Index | 14.0x | 1.7x | 4.0% |
Dividend yield has already been defined. As has the price-to-earnings (or PE) ratio measures the relationship between share price and net profits per share. Price-to-book does the same for net asset (or ‘book’) value.
Brexit-benighted UK is an exception among developed markets, but the overall analysis somewhat favours the developing world, especially emerging Europe.
That region has been unloved by investors longer than any other since the GFC, and its indices still trade well below pre-crisis levels.
How can one invest in emerging markets?
It’s too difficult for individual investors to obtain and analyse the necessary information on 24 economies, 24 markets, and many thousands of companies.
Far better, therefore, to ask an adviser about funds that specialise in those markets. You could also seek one that focuses on a single region, such as CEE.
Its manager should already have what information there is. And the fund should invest in a range of markets and companies, thereby diversifying and reducing your risk.
Above all, any investment in emerging markets must be balanced with the rest of your portfolio.
The position must be no larger than needed to improve returns, but without increasing the portfolio’s overall level of risk.
Paul Connolly
Paul Connolly has been a journalist for more than 20 years, as a reporter and editor for Argus Media, Reuters, The Times, Associated Newspapers and The Guardian. He has covered Islamic Finance for Reuters in the 1990s. Paul has since helped launch three newspapers, as well as reported from Tokyo, Los Angeles and Stockholm.
