“I’m not sure if I’m making an investment or a donation”: Emerging Markets Look Appetizing.Again

Feb 28, 2014

THE INTELLIGENT INVESTOR

Emerging Markets Look Appetizing…Again

JASON ZWEIG

Remember emerging markets?

Four short years ago, the stock markets of the developing world—like China and Brazil, India and Indonesia, Thailand and Turkey—were the place to be. In 2009 and 2010, as these economies grew much faster than the U.S., emerging-market stocks shot up by an average of 46% annually—more than double the returns on U.S. stocks. Investors stampeded in, adding $119 billion to emerging-market mutual funds and exchange-traded funds between 2010 and 2012.

But growth is slowing in China and Latin America; turbulence is swirling in Turkey, Thailand and Egypt; Argentina is flailing. The leading MSCI emerging-market index lost 2.6% last year and roughly 4% so far in 2014. And U.S. investors are turning away. If history is any guide, emerging-market stocks will end up a bargain again for investors with the guts to buy against the grain.

In January alone, investors withdrew a net $9.1 billion from emerging-market exchange-traded funds, or 7% of total assets, according to investment-research firm Morningstar; since the beginning of 2013, investors have pulled out $22.4 billion. In January 2013, emerging-market ETFs held a total of $162 billion; at last count, that had shrunk to $111 billion.

The move out of emerging markets isn’t a panicky exodus—yet. Over the past six months, mutual-fund investors added about the same amount as ETF investors took out, perhaps because people using mutual funds to save in their 401(k)s for retirement are more patient than the financial advisers who favor ETFs. But investors always have either loved or hated stocks in the developing world.

New research by Elroy Dimson, Paul Marsh and Mike Staunton, finance professors at London Business School, has added decades of data on stocks in early emerging markets like China, Russia and South Africa. It shows that over the full sweep of history, emerging markets haven’t outperformed the developed regions, like the U.S. and Western Europe. From 1900 through the end of 2013, emerging markets lagged behind by an average of nearly a full percentage point annually.

But emerging markets have tended to do stunningly well over shorter periods when investors neglected or rejected them.

Antoine van Agtmael, then an economist at an arm of the World Bank, proposed the first emerging-market fund in 1981. He called it the Third World Equity Fund, and “people thought it was a very weird idea,” he told me this past week. Not until 1986 did it open as the Emerging Markets Growth Fund, with $50 million from institutional investors and run by Capital Group, the investment-management giant based in Los Angeles. (Today it has more than $8.5 billion.)

“I’m not sure if I’m making an investment or a donation,” quipped a pension-fund manager who was one of the first investors, according to Shaw Wagener, an early portfolio manager at the fund.

Twenty-seven years ago this past week, the first such portfolio for individual investors, the Templeton Emerging Markets Fund, opened. Soon after, I heard Sir John Templeton make a pitch for it. Always an optimist, he spoke enthusiastically about the potential for these countries to grow. But what appealed to Templeton most was that investors cared about these stocks the least. He expected emerging markets to outperform mainly because they were neglected.

They weren’t for long.

In the five years ended Dec. 31, 1993, emerging markets gained an average of 36% annually—capped off by a 75% gain in 1993. That year, investors poured an estimated $5.8 billion into a passel of newly launched funds.

Right on cue, emerging markets lost an average of 11% annually over the next five years, including a bloodcurdling drop of nearly 28% in 1998.

By 2001, assets at emerging-market funds had dwindled 20% from 1996, and many investors gave up; in 2001 alone, they pulled out 6% of their money.

Naturally, between 2001 and 2010 emerging markets returned an average of 15.9% annually, while U.S. stocks grew at an annualized average of 1.4%.

“One thing that never seems to change,” Mr. Wagener says of investors in emerging markets, “is this mismatch between expectations and what is realistic in terms of returns.”

And so the pendulum of sentiment is swinging back again—from expecting too much to expecting too little.

As Prof. Marsh of London Business School says, “With investors starting to re-evaluate and to see nothing but problems in emerging markets, [these stocks] could eventually come back to the point where they reach real value.”

This coming week, Capital Group will launch a new portfolio in its American Funds lineup, Developing World Growth and Income. The firm has a history of launching funds at times when the underlying assets are unpopular.

The great British biologist J.B.S. Haldane said that ideas pass through four stages of acceptance: 1, “worthless nonsense”; 2, “interesting”; 3, “true, but quite unimportant”; and 4, “I always said so.”

Among investors, stage four never lasts long; complacency breeds carelessness. So stage four often leads abruptly right back to stage one, at which point the cycle starts all over again.

By 2012, emerging-market investors were in the “I always said so” phase. Now they are moving toward the “worthless nonsense” phase. That is when you should get seriously interested.