Emerging-Market Investing: It’s Not About the Growth; Most investors get burned—over and over—in emerging markets

Emerging-Market Investing: It’s Not About the Growth

Most investors get burned—over and over—in emerging markets

BRETT ARENDS

Dec. 13, 2013 11:32 a.m. ET

IN 2012 THE ARGENTINE STOCK market plunged by 40 percent in U.S. dollar terms. Meanwhile, the stock market of Colombia rose by 30 percent. The Egyptian market rose more than 40 percent, while that of nearby Qatar ended the year in the red. Kenya’s rose 55 percent, while the Ukraine’s was halved. It may be all up and down, but this, not growth, is the prime attraction of investing part of your portfolio in stocks in developing countries. Done right, such so-called emerging- and frontier-market investing can actually reduce the risk in a portfolio, thereby increasing risk-adjusted returns. But, naturally enough, it is rarely done right. On the contrary, almost everything investors hear from the Wall Street marketing machine about investing in developing countries is wrong. As a result, when they do allocate funds to these countries, most investors typically do it for the wrong reasons, at the wrong times and in the wrong way.There is a dreary, “Groundhog Day” sameness to these stories over time. First, we read stories about the new economic boom in little old Freedonia. We read and watch accounts of skyscrapers rising amid former market towns, peasant farmers swapping their rickshaws for Mercedes-Benzes and launching IPOs, and Coach opening its first stores in the capital city. As a “new elite” emerges and sends its children to Harvard, we hear about fantastic fortunes being made amid the latest gold rush.

Just as excitement about the boom grows, the wheels come off. Freedonia Oil & Telecom collapses in an accounting scandal. The stock market plunges. The president is implicated in a scandal. A new government prints money, hikes taxes and seizes the majority of last year’s hot stock (Freedonia Mobile) for no compensation. As inflation rockets, Western investors bail out and swear off developing countries—at least until the next bubble.

And so the boom of the mid-1990s led to the Asian Tiger crash of 1997-98. The boom of 2005 to 2007 was followed by similar crashes in places like Eastern Europe and the Middle East. The 2011 fad of emerging markets came down with a bang in 2012.

What’s wrong with this story? The main explanation heard on Wall Street for investing in developing countries: growth. “This country’s economy is growing much faster than in the developed world,” goes the story. “So its stock market should produce greater returns, albeit with (ahem) ‘volatility.'” The client is urged to “get in on the boom.” This point is repeated so widely and frequently on Wall Street that it has become a kind of mantra. Yet there’s no evidence behind it, in theory or practice.

Professors from the University of Florida and London Business School, and researchers at MSCI Barra, have all investigated the relationship between a country’s economic growth and the returns from its stock market, and they’ve found none. (Indeed if there is a correlation, it’s a weak one—and it’s negative. In other words, investors may have earned on average slightly more from slow-growth countries than fast-growth ones.)

This, of course, goes contrary to conventional wisdom on Wall Street. Why wouldn’t a fast-growth economy, like Freedonia, produce higher returns? One main reason, explained Andrew Lapthorne, quantitative strategist at Société Générale in London, in a 2010 paper, is that the stocks on this year’s “hot” market are usually too expensive. The hot money has come in, driving up prices beyond what is justified. Investors end up paying too much for each dollar of future corporate earnings. Second, he said, investors in these markets often get “diluted out of existence” as new companies enter the market. From 1990 to 2010, SG estimated, the number of stocks on the exchanges of emerging markets rose 26-fold. Someone who had invested $100,000 in emerging markets in 1990, hoping to capitalize on “growth,” would have had to keep selling existing holdings to buy into the new ones.

In total, Lapthorne estimates that average emerging-market equity investors lost about 10 percent a year to such dilution, compared with about 2 percent for those in the U.S. Other problems can also undermine returns, like very high trading costs, poor corporate governance, and political and economic risks.

There’s another concern with emerging-market investing. Many people do so through low-cost, passive investment funds, such as exchange-traded funds. But these are typically dominated by a small number of global megacaps, which have little to do with emerging-market economies and are merely domiciled in developing countries. This isn’t an argument against investing in developing countries. It is argument for doing it in the right way.

Western investors face a growing problem. More and more assets are becoming correlated. Stocks, bonds, REITs and farmland—they’re increasingly moving together. This is all very well when it’s a good year, but it’s a problem when things slide.

Developing markets offer a rare opportunity for uncorrelated assets. The smaller and “riskier” the market, the less correlated it is. The French stock market will be moved next week by much the same things that move Wall Street. But the Freedonian market will dance to its own tune, precisely because that country’s nascent economy is being dominated by domestic developments. So while Argentina’s stock market surged in the first three quarters of 2012, the rest of Latin America tanked because of President Cristina Kirchner’s policy moves.

Furthermore, although developing stock markets typically get overpriced when they become popular, the reverse is also true. In late 2007, when emerging markets were in vogue, stocks in non-Japan Asia and Latin America were often more expensive—based on per-share earnings or net-asset values—than comparable stocks in the developed world. By late 2013, as emerging markets had plunged out of favor, stocks were often much cheaper than in the developed world.

One is wary of that old Wall Street chestnut, “a stock-picker’s market,” but when it comes to developing markets—where analyst coverage is typically thin, and the stocks haven’t been worked over as much as in the West—there may be some truth to it. Research since 1990 has found that emerging-market investors have benefited from investing in higher-quality, smaller company and “value” stocks—those that are inexpensive in regard to dividends, per-share earnings and net-asset values. Remarkably, Lapthorne found that from 2000 to 2009, such a strategy would have both produced higher overall returns and greatly reduced volatility.