Emerging Markets Offer Risk, but Also Reward for Investors

Emerging Markets Offer Risk, but Also Reward for Investors

Emerging markets are often touted in investment circles and the business media. Yet many investors are unsure of how to invest in emerging markets, or even whether they should. These markets are alluring but can be mysterious, misunderstood or simply difficult to access.

With a prudent strategy, however, emerging markets can strengthen an investor’s portfolio. Before adding exposure, investors should understand the tenets of emerging-market investing, its risks and rewards and a proper approach to investing in them.

So, what is an emerging market? It’s a country or region that is less developed financially and economically than “developed” markets. Meanwhile, its economy is growing rapidly. The largest emerging market economies are known as the “BRIC” nations, an acronym coined by economist Jim O’Neill to describe the world’s highest-growth countries: Brazil, Russia, India and China. These four countries averaged 7.1-per-cent GDP growth over the past three years, while the world GDP growth averaged two per cent for the same period.
Often, less-developed emerging markets, such as Argentina and Vietnam, are referred to as “Frontier Emerging Markets” to emphasize their even higher risk-reward characteristics.

Economic growth should not be the only factor when considering emerging-market investments. Let’s look closer at the pros and cons of investing in these markets.

The most common argument for investing in emerging markets is that their expected high growth rates should help boost growth in earnings and cash flows for companies that are part of those economies. However, exposure to emerging-market economies does not guarantee above-average earnings growth. The company’s financial condition need to be improving and its products or services still need to be successful, so understanding the investment’s fundamentals is always crucial.

Other important reasons for investing in emerging markets include diversification and better investment prices. Diversification implies your investments won’t all behave the same way at the same time. For instance, if Canadian equity markets are flat, emerging-market stocks may be on the rise.
Better prices are found when there is less investor attention and analyst coverage; in that environment, stocks have a greater potential to be mispriced. Emerging markets attract fewer investors and analysts, so the chances of finding undervalued investments are greater.

The cheaper your financial investments, the more likely they are to provide positive investment returns over time. For example, Korean-based and listed POSCO was recently ranked No. 1 among the top 35 steelmakers worldwide for innovation, productivity and profitability, among other criteria, by World Steel Dynamics, a U.S.-based steel information service. However, POSCO is less well known than most of the other steel producers on the list, so today investors can buy it at under 10 times its annual earnings, while its future earnings are projected to grow at more than 15 per cent per year. That’s cheap by comparison to North American steel producers.

Those are some of the rewards of investing in emerging markets. What about the risks? Most risks are due to legal and regulatory controls, which can differ vastly from those of developed countries.

Regulations that protect investors’ ownership in developed countries may not be as effective in emerging countries. This risk should not be underestimated. Without adequate ownership protection laws, a security or asset could be taken away from the owner unlawfully. Mining companies that have struggled with changing rules in the Democratic Republic of Congo during the past decade have painful first-hand experience with this risk.

Risks also arise from different accounting rules and language that can lead to misunderstandings of a company’s financial situation or business. Some investors learned this through Sino Forest, a Canadian-listed company operating in China. Its financial statements didn’t tell the true economic story and the company is now being wound up amid accusations of stock-market fraud.
Differences in currency present one more layer of risk; rising investment valuations could be muted by a declining local currency value or vice versa.
Access to good emerging-market investments is the final challenge. An emerging market ETF (exchange-traded fund) provides possibly the easiest access but it lacks stock selection: most ETFs would own a basket of nearly all companies in emerging-market economies. Since the divide between good companies and poor ones is even more pronounced in emerging markets than developed ones, owning a passive basket of all companies may not produce a positive outcome.

Furthermore, an active manager will also perform due diligence work on the companies being considered, which when done well, includes company site visits, a step that could help avoid investing mistakes like Sino Forest.
You may also want to stick to the same investment style you use with your investments in developed markets. If you believe in value investing, there is no reason to abandon this belief to get access to emerging markets. Find an experienced value manager you trust who invests in emerging markets.
We believe emerging markets should form part of a well-balanced portfolio. Some exposure to the high-growth companies operating well in these markets is healthy but not so much so that if there is a currency or economic surprise, it devastates the portfolio as a whole. Find an investment manager with experience and a long track record of navigating the risks of investing in foreign jurisdictions.

This article is not intended to provide advice, recommendations or offers to buy or sell any product or service.  The info provided in this article is compiled from our own research and is based on assumptions that we believe to be reasonable, accurate at the time the report was written, but, is subject to change without notice.