Emerging Markets Overview

The following is what we wrote in our latest quarterly newsletter about emerging markets: what they are, what are their risks, and why we ultimately think they are an important long-term asset class to own.

A core tenet of our investing philosophy is: know what you own.

With that in mind, we want to highlight an important part of our model portfolios that may not be well understood. Each portfolio we manage has a dedicated allocation to emerging markets ranging from 7.0-16.5%, depending on the portfolio’s risk level. You have also likely come across the term “emerging markets” in our regular meetings or quarterly newsletters. As happens in any profession when you regularly discuss a topic with colleagues, you lose sight of how foreign the topic is to everyone else.

So, we want to take a step back to explain what emerging markets (EM) are and why they are important.

            What are emerging markets?

“Emerging markets” is an asset class of developing countries that share little in common geographically, economically, or in size. What does unite them is higher expected returns and higher risk than developed markets.

Besides EM, the other two categories for countries’ stock markets are Developed and Frontier. Developed markets are more established and Frontier markets less established than Emerging. Economic strength is just one variable that determines the category. More important are the capital markets characteristics e.g. openness to foreign ownership, reliable regulation, accounting standards, and institutions such as rule of law. So, even though China is the world’s second largest economy in terms of GDP, it remains an emerging market because of restrictions against foreign ownership and a high degree of government-owned business.

The three categories are a continuum, and countries occasionally change labels. For instance, Israel and Argentina used to be emerging markets. Now, the former is Developed and the latter Frontier (Argentina was demoted due to imposing stringent controls on capital flows). There is more than just a name at stake. A country that graduates will receive a resulting investment inflow because investors are attracted to more stable environments.

             Why emerging markets?

The thought of investing in unstable countries like Turkey, Egypt, and Thailand can cause understandable unease. So, why bother?

EM countries offer a compelling narrative:

  • Favorable Demographics. Contrary to the developed world – except for the U.S. - emerging market populations are young and growing. Two thirds of the world’s population is in emerging markets.
  • Growing Consumption. EM middle classes, notably China’s, are expanding, and the economies are reorienting to become less dependent on exports and more on consumption.
  • Untapped Productivity Gains. Through technological advances and improved infrastructure, emerging markets are becoming better equipped to realize productivity potential.

For investors, emerging markets increase the benefits of diversification. EM stocks have relatively low correlation with U.S. stocks. So, even though EM stocks are volatile, exposure to emerging markets can actually decrease your portfolio’s overall volatility due to diverging returns.

Emerging markets have paid investors for taking on more risk. Risks in emerging markets run the gamut from political instability to exchange rates to whatever it is Vladimir Putin is doing. Those headline risks keep many on the sidelines. Investors who steel themselves and stay patient have had success. Since 1988, emerging markets have outperformed U.S. equities and significantly outperformed developed international stocks. That history has been very cyclical; the pendulum abruptly swung every six to seven years.

It is important to diversify within EM. The deviation between countries can be powerful; many years the difference between the best and worst performer was 100+%. The temptation is to try to forecast which countries are poised for breakouts and which for busts. But pivots come fast and furious, so owning the a diversified EM basket is the best chance to earn a sizable benefit and significantly mitigate wild swings.

Emerging markets are too large to disregard. They comprise a tenth of the world’s public market value (over $4 trillion) and a third of global GDP. The market cap share has grown from less than 1% in 1988 to over 10% today. The trajectory matches the story on the ground. More EM countries are pursuing structural reforms and more open macroeconomic policies.

Last and most importantly, emerging markets are currently cheap. A great sounding opportunity is still a terrible investment if you pay too high of a price. There are a host of valuation metrics to cite, but suffice it to say that we believe EM companies deliver better bang for your buck than Developed, especially U.S., stocks. Remember that buying stocks means owning slices of companies’ dividends, earnings growth, revenue, etc. You can buy those slices in EM companies at a cheaper price than in the U.S.

Sounds great, but…

While most of the research we follow is bullish on EM, it is far from a universal consensus.

Famed Vanguard founder Jack Bogle recently described EM as “cheap for a reason.” He cites EM overreliance on exports, which leaves them susceptible to a global economic slowdown. Slow growth is more dangerous in EM countries because of potential social unrest and political regime change.

An appreciating U.S. dollar is another concern. Many EM companies and countries have debt denominated in dollars. A more expensive dollar makes those debts tougher to pay in local currencies.

Other analysts fret that the conditions that have favored EM in the past - demand for manufacturing and commodities – are no longer strong.

            Expected returns justify the risks

There is no free lunch in investing. Any asset class without risk is also without return (see 3-month U.S. Treasuries).

As investors, we look at the pros and the cons and view them across a range of scenarios. Ultimately, the decision comes down to valuations. EM’s current discounted prices offer a high safety margin. Even if a lot of things go wrong, and some certainly will, we still expect strong investment results.