Big picture hides a myriad of strokes

The levels of risk and return in emerging markets are far from straightforward, according to Stuart James. 

Emerging markets have been one of the growth stories of global investment.

One by one through the past two decades, countries around the world that were politically and economically isolated have adopted orthodox fiscal and monetary policies, paid down their debts and benefited from the growth in trade and market opening associated with globalisation. 

Any discussion of the opportunities in emerging markets – which remain considerable – must acknowledge the complexities too.

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For one, the definition of an emerging market does not tell us much. The World Bank defines ‘emerging’ on a per capita income basis.

So China is still emerging, despite it being the world’s second largest economy, as is populous India. 

But from an investment standpoint, those countries that are ‘emerging’ must meet certain other thresholds based on market openness, capital flows and so forth. Thus middle-income Korea is still part of the emerging market universe, for example. 

Implicit in any description of a country as emerging is its opposite – ie, a developed country. The differences between emerging and developed countries have become blurred lately. 

The coinage ‘BRICs’ 10 years ago sought to define the new growth economies. It was timely, helping investors to focus on the future economic powers, rather than the past. 

Since the global financial crisis investors have questioned these differences further. The West is deeply in debt: Europe is trapped in an austerity-led downturn; and investors are only just starting to contemplate the Fed’s exit strategy. 

As a value judgment it seems harder than ever to maintain the belief that emerging markets are somehow inferior. But ask about the level of risk and returns they offer and the answers are far from straightforward. 

One analytical problem with emerging markets is their diversity. They consist of commodity exporters and energy importers; countries with tiny domestic markets and almost continental-sized ones; democracies and one-party states; those with relatively strong institutions (independent central banks, judiciary and executive branches of government) and those without. 

Mexico and Taiwan have as little in common with one another as do Indonesia and Poland. 

Less intuitive is that the higher growth that emerging markets promise is not always, if ever, matched by stock market returns.

China is illustrative here: China H shares have under-performed Indian stocks over the long term despite the manifestly higher growth of the Chinese economy. 

Factors that influence stock market returns can be complicated. In theory returns cannot over the long term exceed the rate of corporate earnings growth. Often that potential is capped by the way companies are run (and regulated). 

If companies are not run for profit, if there are not clear rules in place on governance and money can be removed from the business without censure, then share prices suffer. 

In general, governance standards in emerging markets fall below those of the West, where checks and balances are stronger.

Part of the reason for that is the influence of investing institutions. In Australia, for example, superfunds and corporate investors are sizeable, well-organised and act as owners. 

Further, the presence of such investors is evidence of a deep and liquid pool of savings. In the US and Europe (and Australia too), there has long been an equity culture that is helped by taxation benefits, whether through formal pension schemes or separately. To an extent capital attracts capital. 

Contrast that with many emerging markets, where stock market investments tend to be speculative, where savings are channelled into competing assets (like property) and forms of social security are primitive. 

These structural weaknesses are not permanent, of course, but shallow domestic markets mean that there is often a high dependence on foreign capital. This money can wash out as well as in, exacerbating stock price and currency volatility. 

In 2011 almost US$50 billion was withdrawn from emerging markets and as a whole they under-performed developed markets.

In 2012 these flows reversed direction and emerging market equities did well – but lagged behind Europe and the US.

More recently in 2013 we’ve seen another reversal in flows. Money has left emerging markets due to fears that the Fed will pull back its QE program, thereby reducing global liquidity.  

The lesson overall is that over the long term emerging markets should attract more investment, both from institutions in the West that are over-invested in their domestic markets and need to diversify, as well as from local savers, because of their inherent advantages: demographics, rising living standards, and hence improving demand for goods and services. But they need to attract a more stable base of long-term investors, too. 

A final point is that given the recent under-performance in emerging markets, due to the outflows highlighted above, currently valuations generally look attractive.

Indeed, today emerging market equities trade at around a 29 per cent discount to developed market peers, which is higher than their long-term average of around 24 per cent.

So, as many of the aforementioned risks are technical and short term in nature, not fundamental, and currently valuations are attractive, we see a buying opportunity in emerging markets for those who can take a long-term view.

Over the past 25 years through deep research we have unearthed many companies of excellent quality that have repaid our investment many times over. We are optimistic of finding many more in the years ahead. 

Stuart James is the senior investment specialist at Aberdeen Asset Management.