A few months ago, local brokers in Manila were wondering what was I doing in their city. Apparently I was a year late. While in 2017 the local bourse jumped 25%, since January 2018 the MSCI Philippines index had fallen 15%.
As they went on to explain, foreign investors tend to invest in the Philippines in waves. And I had missed the last one. When it comes to emerging markets, foreigners tend to focus more on trading than investing. It’s hard to blame them.
The US-dollar annualised return of the MSCI Emerging Markets index has been 3.8% over the past ten years, compared with the MSCI World Index at 7.7%. This suggests that trading has likely worked better than buying and holding. The risk of a permanent loss of capital is also higher than in developed markets.
Emerging markets are riskier
Governments frequently intervene in many emerging markets. This covers everything from unfavourable regulation to the Chinese government’s direct intervention in the sharemarket and even the risk of expropriation in some more fragile political environments.
Corporate governance standards are still low. If the government is not running the show, then a controlling family most likely is. Minority shareholders’ interests can often take a back seat. Liquidity is also low. It can take only a few relatively small trades to move stock prices meaningfully.
Finally, investors are exposed to local currency depreciation. This can quickly wipe out the value of their investments. The fall over the last six months of the Argentine peso and the Turkish lira by 50% and 34% compared to the US dollar is emblematic.
These risks are all real for overseas investors. But they also should be well understood. When investors face riskier investments they should demand higher returns. Which implies paying lower prices.
The low returns of the past decade* suggest investors were overpaying for stocks in emerging markets.
Economic growth and stock market performance
An explanation could be that most investors are attracted to the growth of emerging economies. But there is no evidence of a correlation between GDP growth and stock market returns (if anything, there is some evidence of a negative correlation). Studies have shown that workers and consumers often benefit the most from economic growth. Not shareholders.
Growing economies usually attract a lot of capital, and often the returns on that capital end up being worse than in slower-growing economies due to fast change and ferocious competition. Investors tend to focus too much on sales growth and too little on industry structures and company-specific competitive advantages, which eventually determine whether growth translates into profits.
The case for emerging markets
All that said, with prices down so far this year and investors bailing out of emerging markets en masse, might now be the time to consider an increased allocation?
Maybe. If you are considering it, here are some of my thoughts after dipping a few toes in the water and losing the odd piece of skin.
Investing in emerging markets shouldn’t be any different than investing in developed ones. You estimate the present value of an investment’s cash flows and buy at a discount to that value to compensate for the many risks. Keeping this in mind, there are a number of specific things to consider when looking for value in emerging markets.
You should be looking for much bigger discounts to compensate for the higher number of investments that are likely to go wrong.
If you can hedge the currency at a reasonable cost, it probably pays to do so. You might give up some of the upside but this would give you some protection from the extreme downside.
Look for companies that have automatic stabilisers. Meaning, for example, that a lower currency could help the business perform better. This is usually true for exporters provided that most of the production inputs are sourced locally. Avoid companies with foreign currency borrowings but mostly local operations.
Portfolio weighting to any one country should be small enough that you can stomach a loss of close to 100% – treat country exposure as you would one individual risky stock.
And finally, use volatility as your friend. While the average return hasn’t been great, the volatility over the past ten years has meant that you could have entered and left on numerous occasions as other investors’ enthusiasm has waxed and waned and done much better than average.
The time to visit your Filipino brokers is precisely when they are most surprised to see you there**.
* The MSCI Emerging Markets index returned 10.8% per year since its inception in 1987. This performance is nothing to be sneezed at. But considering that developed markets returned over the same period 8.0% per year at a fraction of the risk, emerging markets’ performance remains disappointing.
** We did end up making a small investment. It is currently in the process of being taken over, at a nice premium to our purchase price, but a big discount to our estimate of value.
7 thoughts on “How to Invest in Emerging Markets”
Is the risk of investing in emerging markets worth it? The geopolitical risks and issues with governance are galore. Not to mention opaque accounting. Unless you have any particular edge, its hard to justify investing in emerging markets. Unless the governments in these countries put some good and transparent mechanisms there is very limited opportunity to apply any investing skill or insight. Would love to hear some counter-arguments.
In the context of a portfolio, I think it makes sense to take calculated risks with emerging market equities. A paper by Michael Mauboussin discusses where active managers can find opportunities to outperform in a world dominated by passive funds. Asset classes with a wide dispersion of returns, like emerging market equities, provide an opportunity for active managers to achieve excess returns (or losses). The portfolio weightings should be kept small at first as you’re gaining experience investing in these risky assets. But as you gain the requisite skills in making informed emerging market investments, you then have the potential to make outsized returns for a given level of risk. I’d like to see the Forager International fund continue to head in this direction and I am supportive of the learning mindset being adopted by the Forager team as they venture into new territory.
Check out the paper titled, ‘Looking for Easy Games – How Passive Investing Shapes Active Management’. The recommendations on seeking dispersion are found on p. 29 and p. 34
Thanks for the piece.
There is one manner in which emerging market investing has to be fundamentally different than in developed markets, and that is how inflation is allowed for and valued. In the clamour for emerging market exposure a decade ago, many investors have misunderstood and misvalued inflation, and they continue to in places like India today, very badly.
A company with a real RoE of 10% in an environment of 0% inflation will trade at say 10x Pe and 1x book. The same company in an environment of 10% inflation would have a 20% nominal RoE (10% real), but should still trade at 1x book for the same real return. That is 5x earnings. Unfortunately, investors sometimes end up paying higher multiples not less – perhaps 15-20x, because they don’t understand how inflation affects multiples.
High inflation shows up in currency depreciation. A country with 10% inflation will see roughly 10% currency depreciation over time. So the stock needs to trade on a 20% local currency return to yield a 10% real hard-currency return. Indian inflation has averaged in the mid-high single digits for a long time, and yet stocks trade at 20-30x PEs.
It is therefore no surprise that USD returns have been very poor in hyped markets like India, and will remain so for a very long time until valuations are reset to more sensible levels.
I don’t think you understand.
You change the numerator in your example to get a 20% ROE from a 10% ROE and then you say that 10% inflation will adjust it back to 10% ROE.
Also the idea that you can predict currency movements based on inflation is a poor indicator. Australia had higher inflation than the US for decades but we still managed to get the AUD to $1.10 to the USD. Where is your depreciation in the currency?
$1 earnings *10% inflation
$10 equity *10% inflation
You are right Andrew, in that inflation will impact the numerator as well as the denominator – in the long run (though depending on the composition of the capital in the business, the impact on the denominator may come with a substantial lag).
As such, in the long run, a 20% ROE will be a 20% ROE – whatever the inflation rate. The nominal (underlying, organic) growth rate will be proportional to this ROE (as well as the earnings retention rate). However, the real growth rate will be less in a high inflation environment, than in a low inflation environment, for the same nominal ROE.
If you are a local (ie exist/spend within the local currency), you will experience a real growth rate that is less than the nominal. In short, you will feel an erosion of your real wealth due to the inflation rate.
This will be true whatever the ROE might be. The conceptual error I think LT made, was in thinking in terms of real versus nominal ROE. I think this is wrong – as there can be no such ROE distinction. I think LT was thinking more in terms of nominal versus real growth. However, as growth (underlying and organic) is a direct consequence of ROE, I think the principle he intended is correct.
If a local feels an erosion of wealth, due to inflation, then someone living in a foreign country, holding assets in the local country, must feel the same impact, but through the exchange rate. There can be no other mechanism. Of course, economies are complex, and exchange rates will be influenced by a multitude of factors. Two developed economies with moderate/low inflation rates, may have exchange rates which are diverging/converging for a whole host of reasons which outweigh the influence of inflation rates.
However, all else being equal, the impact of inflation on the exchange rate will be real. How can it not be?
what id your preferred way get exposure to this market? and ETFs you think are worth looking at?
I dipped my toe into the emerging markets waters for the first time about a month ago. In order to gain some country and company diversity, i used an Asian (ex japan) ETF. My investment represents only about 0.6% of the equity portion of my portfolio, which will limit any losses should things go pear shaped e.g. we go through another Asian financial crisis. This low portfolio weighting also gives me the opportunity to increase my exposure to emerging markets, should prices continue to fall. For beginners (such as myself) in emerging market investments, a diverse ETF with a low portfolio weighting is one lower risk option available.