Demystifying Emerging Markets: How to Invest Wisely Abroad (original) (raw)

Demystifying Emerging Markets: How to Invest Wisely Abroad

Emerging markets offer investors some of the best long-term growth opportunities, but the risk and volatility can be high.

The risks can be reduced, however, with proper analysis. And the volatility can present amazing entry points for disciplined investors.

This guide provides an overview of how to analyze and invest in emerging markets, mostly via emerging markets ETFs.

Of course, the topic is large enough that no individual guide on the subject could possibly be complete. But what this approach does is basically apply engineering analysis to the problem, meaning it breaks the difficulty down into small parts that can be individually solved more simply.

That’s a key way for investors to think about emerging markets- there are basically four layers of risk involved that can be analyzed separately and then put together for an overall view.

Start from the beginning, or jump straight to the section you want.

In short, the reason to invest in emerging markets is that on average they have more GDP growth than developed markets:

IMF Emerging Markets Growth Forecast

Source: IMF

As a group, they have higher population growth, and higher per-capita GDP growth, which makes for much faster overall growth compared to slow-growing wealthy nations.

For this reason, emerging markets are becoming a larger and larger share of the world’s market capitalization:

Emerging Markets Growth Projections

Chart Source: PwC Global

And this has translated well into stock returns. The MSCI Emerging Markets index produced nearly 10% annualized returns from 2000 until now, compared to just over 5% annualized returns for the MSCI World index.

In addition, right now emerging markets are cheap despite that higher growth. Although they’ve outperformed as a group since 2000, they’ve underperformed over the past 10 years.

For example, China, India, and Brazil’s stock market capitalizations as a percentage of GDP are all much lower than they were during their period of overvaluation in 2007. It has been a few years since I made this chart but the numbers are still low today:

Emerging Markets 2019

Data Source: World Bank, MSCI, Author’s Calculations

Vanguard’s emerging market ETF has average price/earnings of 7.6x and average price/book of 1.9x.

This compares favorably to the United States stock market, which has much higher price-to-earnings (23x) and price-to-book (4x) despite lower GDP growth.

Several emerging markets also have higher dividend yields than most companies in the United States.

Emerging markets are likely a good place to be invested over the next 10-20 years. However, it’s important to be aware of the risks and volatility so that you can navigate them successfully.

Emerging Market Pyramid of Risk

Emerging markets have more layers of risk than domestic stocks or foreign developed stocks.

This is both a problem to be aware of, and an opportunity to profit from.

According to research by Ben Carlson of Ritholtz Wealth Management, approximately every two years, emerging markets have a big 20%+ sell-off:

Emerging Markets Drawdown Table

Chart Source: Ben Carlson, CFA

However, he also found that for investors that buy every time there is a 20%+ emerging market sell-off, their median one-year return is 23%, and their median five-year return is 44%.

More simply, you can hold a diversified portfolio and re-balance occasionally, so that you naturally buy more into emerging markets when they are cheap and sell a bit when they are high. Automatic re-balancing is a smart way to invest money.

But why are there so many 20%+ sell-offs? Every two years seems like a lot. Here’s a visual description of the major emerging market risks:

International Investing Risk Pyramid

Layer 1: Company Fundamentals

The first layer of risk is how well a company or economy performs fundamentally. This applies whether you’re investing in a specific company, or investing in a whole country or region’s economy with an ETF.

Fundamental performance refers to things like earnings growth rates, changes in debt levels, and that sort of thing. The first step to picking good investments is being correct about the forward underlying performance of the thing you’re investing in.

Layer 2: Market Valuations

The second layer of risk is that even if an investment’s fundamentals go the way you expect, reductions in the market valuation of that entity may move against you.

For example, suppose you invest in a company that makes 5inearningspershareannually,andthesharepriceis5 in earnings per share annually, and the share price is 5inearningspershareannually,andthesharepriceis100. The stock therefore has a price-to-earnings ratio of 20x. Let’s say you expect it to grow earnings by 8% per year for the next decade, so you make an investment.

If you are correct, then after ten years of 8% annualized earnings growth, the company’s earnings per share will be 10.79peryear.Ifthestockstillhasa20xprice−to−earningsratio,thesharepriceshouldbe10.79 per year. If the stock still has a 20x price-to-earnings ratio, the share price should be 10.79peryear.Ifthestockstillhasa20xprice−to−earningsratio,thesharepriceshouldbe215.80, implying that you earned 8% annualized returns on your stock investment.

However, if for some reason the market is only paying a 15x price-to-earnings ratio for the stock ten years from now, then the stock price would be only $161.85. Your annualized rate of return on the stock would therefore only be about 5% per year, despite the fact that earnings indeed compounded by 8%.

In this case, you were correct about the company’s forward performance, but nonetheless didn’t get the returns you wanted because the market applies different valuations to stocks over time depending on all sorts of rational and fickle reasons.

Therefore, enterprising investors must buy the right stock or ETF at the right price in order to have solid returns.

Layer 3: Exchange Rates

When you invest internationally, in addition to fundamental risk and market valuation risk, you also have exposure to the pros and cons of varying currency exchange rates.

Suppose, for example, that you invest in a Japanese company, and its fundamental performance goes exactly how you expect, and its price-to-earnings ratio increases because you bought at a great price. Let’s say earnings grew by 8% per year and its price-to-earnings ratio increased from 15x to 20x. This should be an awesome investment.

However, if the Japanese yen weakens considerably compared to your home currency, let’s say the US dollar, your investment might lose value to you in dollars anyway, even if the investment worked out well in terms of yen. And as a US investor in this case, it’s dollars that you care about and pay your expenses with.

In 2011, you could trade one dollar for 76 yen. That was the exchange rate. In 2015, this figure changed to one dollar for 124 yen. That’s a 63% de-valuation of the yen to the dollar in four years. It’s no wonder that American stocks massively outperformed Japanese stocks from 2011-2015 for American investors.

This works the other way as well. If you were a Japanese investor in 2011, and bought American stocks, you did very well for yourself over the next several years. The fundamentals of your investment were good, the valuation increased, and the foreign currency strengthened which accelerated your yen-denominated returns in a major way.

American holders of foreign stocks did very well in 2017, as another example, because the US dollar weakened compared to many foreign currencies.

Over the long term, stable currencies tend to revert to the mean. Exchange rates over 10-year periods between major currencies look like waves, rising and falling. But if you want to make good returns in a specific time period, it’s useful to pay attention to markets that have currencies that are strengthening compared to your home currency.

Lastly, some emerging market countries, both sovereign entities and corporations therein, hold debt in foreign currencies like US dollars, and their currencies tend to be less stable than currencies from highly developed nations. If their home currency that most of their revenue comes from weakens, but the foreign currency of their debt does not, it can dramatically increase their real debt burden and raise their risk of default.

This is what happened in 2018- a strong dollar combined with sell-offs in emerging market currencies made countries like Argentina (with high government debt in U.S. dollars) and Turkey (with high corporate debt in U.S. dollars) run into major problems.

Layer 4: Capital Flow

The final layer of risk applies mostly to emerging markets.

For many smaller countries in the middle stages of development, a large portion of the market capitalization of their stocks is held by foreign investors from advanced, wealthy nations, rather than by locals.

When institutions and investors from wealthy nations re-arrange their portfolios, it could result in significant capital inflows or outflows to certain countries.

For example, Thai citizens and institutions have very little impact on the U.S. stock market. But U.S. citizens and institutions hold a considerable share of Thailand equities (even as a small part of their overall portfolios), and if American investors decide to allocate less money to Thailand stocks, or less money to emerging market stocks in general, the valuations on Thailand stocks could fall rapidly.

To quantify that, total US household net worth is over 100trillion.ThemarketcapitalizationofallcompaniesinThailandisabout100 trillion. The market capitalization of all companies in Thailand is about 100trillion.ThemarketcapitalizationofallcompaniesinThailandisabout550 billion. Thailand represents about 4% of the FTSE emerging market index. If American portfolios decrease their average emerging market allocation from 5% of net worth to 2% of net worth, that’s a 3trillionoutflowofcapitalfromemergingmarkets,ofwhich3 trillion outflow of capital from emerging markets, of which 3trillionoutflowofcapitalfromemergingmarkets,ofwhich120 billion would be withdrawn from Thailand. That’s more than a 20% decrease in valuations for Thai stocks.

European investors, Japanese investors, and other wealthy nation investors add to that. If worldwide portfolios trim or add positions in emerging markets, even as a small portion of their portfolios, it makes a big difference for the valuations in the stock markets of emerging economies because of the sheer amount of capital that is moving around relative to the size of the markets.

In addition to major currency swings, capital inflow and outflow plays a part in why emerging markets can be so volatile. But this also gives enterprising investors attractive entry points when valuations are low.

5 Things to Check For Any Emerging Market

Some countries have better risk/reward ratios than others.

You can invest in a broad emerging markets ETF, or you can invest more specifically in single-country ETFs or individual emerging market companies. If you want, you can do a bit of both, so that you’re broadly invested but also emphasize certain areas.

Either way, the more you know about what’s happening in various countries, the more confident you can be in your investments, and the more resilient you will be when you see big emerging market sell-offs. You’ll hopefully see opportunity rather than fear.

While there are tons of metrics you can analyze for any country, here is the basic set you should be aware of to start with:

Growth Rate

First, make sure you’re aware of the population trends of the country. Countries with increasing populations have an easier time growing their GDP. Trading Economics is a good data source for this stat and many others here.

Next, check GDP growth rates. The IMF regularly releases “World Economic Outlook” reports in their dataset which include forward estimates of the GDP growth rates of every country.

Debt Levels

The Bank for International Settlements has data on the debt levels as a percentage of GDP for most major countries.

You can look up government debt as a percentage of GDP, household debt as a percentage of GDP, and corporate debt as a percentage of GDP.

This way, you can see where there may be debt bubbles, what countries are relatively debt-free, and what countries are mainly relying on debt for growth in recent years.

Trade Balance

Look up the balance of trade on Trading Economics or a similar source to see whether the country you’re interested in has a trade deficit or a trade surplus.

Is it producing more than it consumes, or the other way around? A trade surplus, or a relatively equal balance near zero, shows that a country is economically competitive.

You should also check the current account to see the net inflow or outflow of investments.

I recommend reading my full article on why trade balances and current accounts matter.

Foreign Reserves

One of the biggest tools a country has to protect the value of its currency is its foreign reserves. If their currency weakens, they can sell some of their foreign reserves and buy some domestic currency to strengthen it.

It’s therefore useful to look up the size of a country’s foreign reserves relative to the size of its GDP on Trading Economics or another source. Thailand, for example, has foreign reserves equal to about 45% of its GDP, which is high. Turkey, on the other hand, only has foreign reserves equal to 15% of its GDP, which is low.

You can also check the inflation rates, interest rates, and historical exchange-rate charts. XE is a good source for historical exchange rate data.

Stock Valuations

Lastly, it’s important to be aware of the stock valuations of the country you’re interested in investing with, or average emerging market stock valuations as a whole.

The World Bank has a good chart/data set for stock market capitalizations as a percentage of GDP, so you can see the trend over time.

You can google, “MSCI [country] index” and see MSCI’s PDF fact sheet about any country. It’s updated monthly, and shows the price-to-earnings, forward price-to-earnings, and price-to-book ratios of the nation’s stock index. You can also look at iShares single country ETFs to see their statistics on their holdings.

My Favorite Emerging Markets ETFs

The easiest way to invest in emerging markets is to buy a broad emerging market ETF.

Best Broad Emerging Markets ETFs:

These are simple, diversified, and have extremely low expense ratios. See my full list of the best ETFs for more information and examples.

FTSE and MSCI are the two major index lists that international/emerging funds tend to follow. There are a lot of minor differences, but the biggest is that FTSE considers South Korea to be a developed country, while MSCI still considers it to be emerging. Vanguard mostly follows FTSE indices while iShares mostly follows MSCI.

The WisdomTree XSOE fund is a bit different because it excludes state-owned enterprises, meaning companies with more than 20% government ownership. It has a slightly higher expense ratio at 0.32%, but has mildly outperformed most other broad emerging markets index funds since inception due to its exclusion of government enterprises.

One issue with broad emerging markets ETFs, even though they are great for most people, is that because they are weighted by market capitalization, they are heavily focused in China, South Korea, India, and a few others. If you want more even exposure, or wish to invest in a specific country, then there are single-country and region-specific ETFs you can choose from.

Best Region-Specific and Single-Country ETFs:

Franklin Templeton ETFs are the newest ones with the lowest expense ratios (0.09%-0.19%), but they have low liquidity.

The iShares range of single-country ETFs is more extensive and with higher liquidity, and includes some countries like Thailand that Franklin doesn’t have. However, both the iShares and VanEck ones are much more expensive (often 0.49-0.69% expense ratios).

Final Thoughts

Having emerging markets as part of your portfolio is smart, because it gives you exposure to the bulk of where most of the world’s economic growth is coming from over the next couple decades.

Volatility should be seen as an opportunity for portfolio re-balancing or major entry points, rather than be viewed as something to be avoided.

When you know the growth rates, debt levels, currency resources, balance of trade, and stock valuations of a country, you have a pretty strong snapshot that can show you the potential of a country’s stock market performance over the next 5-10 years. None of these are short-term indicators, but they give you can idea of how the country’s market will do over the long-term.

For most people, sticking to emerging market ETFs is the way to go, for diversification and simplicity. However, the broad emerging markets funds, which are heavily-concentrated in China, may or may not be the best ones. Investors wishing to focus more heavily on other countries, like perhaps India, may wish to also purchase some single-country ETFs.

Further reading:

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